TABOR Doesn’t Care About Incidence
Colorado’s nicotine products tax shows how TABOR may collide with the basic economics of who actually pays a tax
In 2020, Colorado voters passed Prop EE, increasing cigarette and tobacco taxes and joining the growing number of states that tax nicotine products commonly used as alternatives to tobacco and cigarettes. Although many states have implemented taxes specific to e-cigarettes, Colorado is (as far as I can tell) unique in that its nicotine products tax applies to “any product that contains nicotine derived from tobacco or created synthetically that is intended for human consumption,” except for tobacco and cigarettes, which are taxed separately, and products such as nicotine gum or patches, which are considered cessation products. Even with those exceptions, the tax covers a wide variety of products including e-cigarettes and increasingly popular nicotine pouches such as Zyn. These products are subject to a percentage tax of the manufacturer’s list price, for which wholesalers and distributors are liable, that started at 30% when the law was implemented and increases to 62% by July 2027.
I’m hopelessly addicted to nicotine, so I have some personal (financial) reasons why I don’t like this tax. And as much as I might like to, I am not going to spend this post railing against it. Instead I am going to use it as an example to talk a bit about tax incidence and how Colorado is in a unique situation because of TABOR. The first two parts of this post will explain the basic economics of tax incidence and revenue. The incidence part will focus on how theory predicts and empirical work supports that for addictive products like nicotine, taxes are almost entirely paid by consumers. For similar reasons, we can also expect that for something like the broad category of nicotine products, a lot of tax revenue can be raised. But where I think this gets interesting is where TABOR comes in.
Colorado’s TABOR (Taxpayer’s Bill of Rights) amendment to the state constitution is a complicated law, but one of its features is to set rules for how the state government must go about implementing new taxes. Among these rules is what happens when revenue from a new tax exceeds projections. The default is to refund the excess to taxpayers and lower the tax in proportion to the excess unless the question is put to voters who may allow the government to retain the excess revenue and keep the tax at the planned rate (note that this is different from the “TABOR refunds” on your state tax return). For the purposes of this post, whether that feature of TABOR is desirable or not in general is beside the point. The nicotine products tax is an interesting case of how TABOR can, in principle, create a situation where the legal taxpayers may receive a refund even if they did not bear the economic burden of the tax.
Revenues from the Prop EE taxes on nicotine products (along with increases in tobacco and cigarette taxes) were ultimately underestimated by more than $20 million. As I argue in the rest of the post, this meant the taxes could have been refunded to suppliers rather than the consumers who bore most of the burden of the tax. But the legislature was able to put the question up to the voters in 2023, who favored allowing the government to retain the excess revenue and keep taxes on their planned schedule.
The taxes discussed here are an extreme example with nearly no overlap between the legal taxpayer and who actually paid. But the TABOR rule that defaults to refund the legal taxpayer means that there are likely many cases where a refund may go to those who only face a portion of the true economic cost of the tax.
Tax incidence and the nicotine products tax
The simplified way to understand the idea of economic incidence is to compare the elasticities of supply and demand. Whichever side of the market is relatively less elastic will bear more of the burden of a tax. All this means is that whoever is less sensitive to changes in prices will bear more of the tax, regardless of who sends the money to the government.
When economists think about tobacco taxes, they point to the addictive nature of nicotine making consumer demand fairly inelastic. When cigarette prices increase, smokers don’t cut back that much. But cigarette producers can shift their supply away from high-tax areas fairly easily. So, smokers tend to bear a much larger share of the burden of tobacco taxes than producers. And this isn’t just an Econ 101 model and some assumptions. There is solid empirical evidence that smokers do in fact bear most of the burden of cigarette taxes.
A 2012 paper from Ryan Sullivan and Donald Dutkowsky that estimates the effects of local and state excise taxes on cigarettes finds evidence of more than full pass-through, meaning a $1 increase in cigarette taxes raises the price of a pack of cigarettes by more than $1. In another paper from the same year by Matthew Harding, Ephraim Leibtag, and Michael Lovenheim using Nielsen Homescan data, the authors find cigarette taxes are less than fully passed through to pack prices (only about $0.85 for every $1 increase in taxes on average).
Although their results differ somewhat, the evidence supports the theoretical reasoning that smokers tend to bear a much larger share of the cigarette tax burden than producers.
I don’t have estimates of demand elasticity for broader categories like nicotine products, but when we think of consumer demand we can make some reasonable assumptions about when demand will be more or less elastic. Demand for Marlboro cigarettes will be more elastic than demand for cigarettes in general. Why? More substitutes generally means more elastic demand. Maybe there is some brand loyalty such that demand for Marlboro Reds would be less elastic than, say, demand for a particular brand of orange juice, but we should still expect that consumers will be more sensitive to price changes even for their favorite cigarette than for cigarettes in general.
One way to convince yourself of this is to consider how much pricing power Marlboro really has. Could they start charging $25 for a pack of cigarettes and expect to lose only a few customers? Probably not. So, if we accept that consumer demand is typically less elastic the fewer substitutes there are, we can extend this to think about what that means for that broad category of nicotine products being taxed in Colorado.
The nicotine products tax encompasses a large share of cigarette substitutes that consumers may turn to, including vapes and nicotine pouches. If we compare demand for tobacco and demand for nicotine products, the intuition is that tobacco demand is more elastic than nicotine products demand simply because there are more substitutes for tobacco than there are for the category of nicotine products. If only e-cigarettes were taxed, we might expect substitution to nicotine pouches, but if both are being taxed at the same time, substitution doesn’t allow a consumer to avoid the tax.
The nicotine products tax in Colorado was not alone either. Tobacco and cigarette taxes were to increase under the same law. And because the taxes on substitutes like tobacco and cigarettes were also going to increase, we shouldn’t expect a large amount of substitution away from things like e-cigarettes and pouches to tobacco products (but maybe some substitution to the exempted medical products like nicotine patches). An additional implication is that we should expect the users of nicotine products to bear an even larger share of these taxes than tobacco users bear of tobacco taxes, unless there is reason to believe that the producers of nicotine products have systematically less elastic supply than tobacco producers, which seems unlikely.
Tax revenue and the nicotine products tax
How the difference in elasticities affects incidence is not all that matters here either. We can also take this understanding of differences in elasticity on the demand side to make predictions about how much revenue may be collected from a tax.
If we assume some fixed elasticity of supply, the less elastic demand is, the more revenue will be raised for a given tax. The reasoning for who bears the burden of the tax is similar to why we expect more revenue with less elastic demand. When consumers are not very responsive to price increases (meaning they don’t reduce their consumption all that much), there is little change in quantity demanded between the pre-tax world and the post-tax world, and the government captures a portion of receipts for each sale.
For the sake of a simple example, assume that an increase in cigarette and nicotine product taxes completely passes through to consumer prices such that a $1 increase in cigarette/nicotine product taxes increases the price of cigarettes/nicotine products by $1. We can use this as a starting point to see how small differences in elasticity create big differences in how much revenue we expect a tax to raise.
Let’s say there is no tax in the market for cigarettes and the price of a pack is $10. At this price, consumers purchase 1 million packs of cigarettes every month. The government introduces a $1 cigarette tax, increasing the price to $11 per pack.
If we want to make a prediction about revenue raised by this tax, we can use the elasticity of demand for cigarettes. Suppose we think the elasticity is -0.4, meaning that when prices increase by 10%, quantity demanded declines by 4%. So, under the $1 tax (equivalent to a 10% increase in price), quantity demanded falls from 1 million packs per month to 960 thousand packs per month, and the government collects $960,000 in tax revenue every month.
Now, we can do the same kind of example for nicotine products. The market price for nicotine products is $10 before any tax and consumers purchase 1 million units monthly. Then, the government implements a $1 tax on nicotine products, but now let’s say that the elasticity of demand for nicotine products is -0.2 (half that for cigarettes). The $1 tax in this market reduces quantity demanded by only 2%, from 1 million units per month to 980 thousand. The government is able to collect $980,000 in taxes in this market. The $20,000 monthly difference in revenue becomes nearly a quarter million over the course of a year.
The sections on incidence and revenue give us two things to keep in mind: 1) Consumers pay more of a tax the more inelastic demand is (relative to the elasticity of supply); 2) Revenue raised from a tax will be higher the more inelastic demand is.
TABOR and the nicotine products tax
Now that we know the basics of tax incidence and revenue, I can explain a weird possibility created by Colorado’s TABOR. I am not going to explain TABOR completely in this post (not sure I even could without reading much, much more about it), but one feature of the law that is relevant here is how new taxes are handled.
When the Colorado government implements a new tax and revenue collections exceed projections, the TABOR default is to refund excess revenue and reduce the tax rate unless voters approve a measure for the government to retain the excess and maintain the new tax rate. The legislature can introduce a ballot measure to seek voter approval on this.
Whether because no ballot measure is referred or because voters reject one, the excess revenue is refunded to whoever paid it to the government. But who pays the government tells us nothing about who bears the economic burden of the tax. So, a nicotine products tax levied on wholesalers and distributors but likely paid almost entirely by consumers could in principle result in revenue being refunded to the side of the market that didn’t bear the tax burden. That would be a windfall for the wholesalers and distributors.
Of course, this is only in principle, but voters were given this option a couple years after the Prop EE taxes went into effect. What happened? The Legislative Council Staff (LCS) is responsible for creating the revenue projections for new taxes in their fiscal impact statements. The fiscal impact statement for the Prop EE cigarette, tobacco, and nicotine products taxes lays out how the LCS went about estimating revenue from the new nicotine products tax based on the limited data they had access to. And one assumption they made in their projections was that demand for nicotine products is more elastic than demand for cigarettes or other tobacco products. If what I am saying about the elasticity of nicotine products is true, then assuming more elastic demand than for cigarettes or tobacco would lead to an underestimate of revenue raised from nicotine products.
By the time the question reached voters in 2023, revenue had already come in above projections. The fiscal impact statement from LCS for the Prop II ballot measure in 2023 showed excess revenue of more than $20 million and noted specifically that the “excess revenue was mostly due to tax revenue from nicotine products, such as e-cigarettes and vaping products.” Maybe the market for nicotine products grew more than expected because Zyn took off. Or maybe this was due to the data issues LCS notes in their initial fiscal impact statement. But I think the more likely story is that nicotine products were a less elastic market than LCS assumed and this led to more revenue being raised. It would be difficult to differentiate between unexpected market growth and the elasticity issue as contributors to the excess revenue. But the elasticity story makes more sense to me in part because the revenue estimate LCS used assumed 3-8% market growth, which is fairly large on the upper end.
To be fair, I am not arguing that the LCS made an obvious error. They were dealing with incomplete data on top of uncertainty about how the nicotine products market might evolve, among other things. This uncertainty is explicit in the fiscal impact statement, where LCS notes, “the market for nicotine and vaping products is expected to continue to evolve in coming years, and the pace of increasing consumption is expected to slow as federal, state, and local regulations on the industry tighten.” Their assumption about demand for nicotine products is not unreasonable either. If I had to guess, they were probably assuming that e-cigarettes make up the largest portion of this market, and I was able to find at least one empirical estimate of e-cigarette demand elasticity that is close to the number LCS used. But it’s hard to say for sure without knowing more about what went into their methodology. These are tough predictions to make, and it is easy in retrospect to point out one area that is a plausible culprit for a missed projection.
Ultimately, voters (by a strong margin) chose to allow the government to retain the excess revenue and keep the taxes in place. Wholesalers and distributors did not get their windfall. But that may not always happen. This TABOR rule doesn’t care about incidence.