When It Comes To Vaping In Pennsylvania, Taxes Are More Than Just A Number

Carl V. Phillips | Contributor

Debates about vapor product taxes invariably include claims that they should be taxed the same as cigarettes, or that they should be taxed at some fraction of that rate. But these claims are meaningless because a tax on vapor products that is supposedly the “the same” is going to actually have some very big differences.

As previously presented here, it is easy to show that the optimal tax on vapor products – assuming the goal is to maximize population health or consumer well-being – is zero. If the tax is not zero, lower numbers are better. But the issue is more complicated than simply how low or high the rate should be.

With any tax law, other details matter a lot in terms of how much is paid and by whom.

Take cigarettes taxes, which are paid by the manufacturer the moment the product is stamped for legal sale, typically right at the end of the assembly line. The tax is fronted by the retailer when they purchase inventory, since it is already incorporated into their purchase price.

Ultimately this tax and every other sales tax is paid by the consumer, whether it is collected by the taxman at the factory, the point of sale, or somewhere in between. Tobacco controllers often claim that when such taxes are technically levied on the industry they are actually paid by the industry, but this is simply false. They are incorporated, approximately 100 percent, into the retail price paid by consumers.

But before the consumer pays them, sales taxes can have other impacts for a product like e-cigarettes. Before passing the tax off to the consumer, the retailer effectively fronts the payment; this causes them to invest hundreds of dollars more in their cigarette inventory than they would otherwise. Fortunately for them, selling cigarettes is a just-in-time business like selling fruit, what the trade jargon calls “fast-moving consumer goods” or “FMCGs.” Retailers only stock what experience say they will sell before the next delivery, and a relatively small variety of products.

E-cigarettes are not FMCGs, adding several non-quantitative considerations to how a tax is levied. The current situation in Pennsylvania is a microcosm of the most important ones.

In October 2016, Pennsylvania imposed a tax of 40 percent of the wholesale price of all vapor products. Since that time, about a quarter of the vape shops in the commonwealth have closed, many almost immediately. The tax rate is one of the highest in the country. It was not, however, the rate that had such devastating and immediate impacts. According to Alex Clark, Executive Director of The Consumer Advocates for Smoke-free Alternatives Association, “It’s the floor tax that was the real killer.” He was referring to the provision in the law that requires payment of the tax to the state by the merchant when the item enters inventory rather than when it is sold to a consumer. The tax must be paid in advance for all the inventory a shop keeps on the floor. Shops had to make a lump-sum payment for all existing inventory when the tax took effect.

But making the Pennsylvania vapor product tax “the same” as the cigarette tax in this regard has very different impacts. Retailing vapor products is more like selling furniture or jewelry than selling a FMCG. There is a huge variety of items, and the more of them available at the shop, the greater the chance of making a sale. Stocking all the varieties of a just few brands of e-liquid means keeping an inventory of more units than all but the most artisanal cigarette merchants will ever see. The shop faces the choice of stocking enough of each liquid variety they carry to meet a burst of specific customer demand, paying the extra cost of frequent reordering, or losing sales. Hardware is an even bigger challenge. A shop needs to stock enough varieties of the various components to appeal to a variety of customers (and, frankly, to not have that “this must be a money laundering or drug dealer front” look of a near-empty storefront). That stock is already expensive without investing another 40 percent of the wholesale price. The floor tax means fronting tens of thousands of dollars that may take months – or longer – to recoup.

Clark has talked to many Pennsylvania vape shop owners and says some just sold off all their inventory and shut down, in an attempt to get back what they could of their investment. Others kept their inventory and took out second mortgages to pay the huge up-front tax bill. Many dramatically reduced their inventory to stay in business. It was already hard for vape shops to compete with the huge variety of vapor products online merchants can stock in a central warehouse. Now the floor tax on shop inventory forces them to further reduce the number of products they offer.

“The numbers don’t tell the whole story,” says Clark. “In almost all of these cases, shop owners are heartbroken. Not only have they lost their independence as small-business owners, but their ability to help smokers in their communities has been ripped away. People have taken second jobs in order to keep their vape shops afloat just so they can continue providing safer products to smokers.”

This is the context for a competing proposal that is being supported by many merchants and advocates: a 7.5¢/ml tax on e-liquid, payable only after the product is sold to the consumer. By eliminating the floor tax, this eliminates the 40 percent increase in the investment in e-liquid inventory. It eliminates the extra investment for stocking hardware. Many observers believe this would be sufficient to halt the loss of vape shops and offer great relief to those that have stayed in business.

However, there is some concern about the proposal. Bill Godshall and his organization, Smokefree Pennsylvania, are long-time supporters of low-risk products, widely credited with keeping Pennsylvania’s smokeless tobacco tax the lowest in the nation for a decade. Godshall notes that “a 60ml bottle of cheap e-liquid that wholesales for $6 in PA ([currently] about $2.40 in taxes) would be taxed at $4.50.” That is for cheap liquid, on which the present rate of 40 percent isn’t that great of a burden. For smaller bottles and higher-end liquid, the gap between old and new tax narrows or even reverses. Plus, consumers benefit greatly from the tax no longer being applied to hardware. On average, the proposed e-liquid tax seems to be fairly close to a wash.

But, as Godshall notes, some consumers would benefit more than others. Once again, tax rates are not all that matter. Take the case of vaper who enjoys cigalikes to one who prefers an open-system mod. A cigalike is basically hardware wrapped around a small quantity of e-liquid. Unlike mods, which provide long-term usage, cigalikes are disposable. By eliminating the tax on the hardware portion of a cigalike, the 7.5¢/ml proposal would reduce taxes on those products about 95 percent, according to Godshall.

When the wholesale tax was first implemented, it increased the price-competitive advantage of open systems compared to cigalikes. This would erase that advantage.

However, Godshall is concerned about what happens when the state assesses the net impact on revenue from getting about the same revenue from e-liquid, but none from hardware and far less from cigalikes. He worries that they will simply adjust the per-milliliter rate upward to make up some or all of the difference, resulting in a net loss for vape shop customers. Not all advocates share his concern, as others expect the proposed rate to stick and not become a slippery slope despite the decrease in state revenue.

The Pennsylvania situation involves numerous factions and complex politics. Like all lawmaking, this will probably be resolved based on lobbying and influence, not economic optimization. Some people will be unhappy about the outcome. But one uncontroversial takeaway is that the application of taxes can matter as much as the numbers. A floor tax has impacts beyond what the consumer ultimately pays. A tax on the quantity of e-liquid alone has different impacts than a tax on the wholesale or retail price of all products.

Vape shops, stores that sell cigalikes and online merchants are all in the e-cigarette business. But different tax rules can have enormously different implications for each. There is an overarching struggle that pits vapers, who support the proper zero rate of taxation for vapor products, against tobacco control extremists and government revenuers. But if zero is disregarded as an unrealistic option, not everyone will agree on the optimal rate or structure of the tax. It turns out determining an “optimal” rate of taxation is impossible, simply because what is best for one stakeholder is not necessarily best for the others.

Carl V. Phillips

Contributor

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