Excise Taxes: When Earmarking Revenue Works – And When It Fails 149

 in Blog / Tax Guide  tagged Excise Taxes by

Excise taxes—those specific levies on goods like fuel, alcohol, or tobacco—generate over two trillion dollars annually worldwide. For policymakers, the central question is how to use this substantial revenue most effectively. While “earmarking,” or tying these funds to specific spending programs, can be an excellent practice, its efficiency hinges on why the tax was imposed in the first place and the nature of the programs it funds.

When to Connect Revenue to Expenditure

Excise taxes are implemented for three primary reasons: generating general revenue, discouraging consumption (often called “sin taxes”), and acting as a user fee. These justifications should guide where the revenue is directed.

1. User Fees: The Earmarking Gold Standard

The most successful form of earmarking links revenue from a user fee directly to the infrastructure or service being used. The prime example is the fuel tax being used for road maintenance and transportation infrastructure.

When drivers purchase fuel, they are effectively paying a fee to use public roads. This alignment is highly effective because:

  • Fairness: Those who use the roads the most (and cause the most wear and tear) pay the most.
  • Information: Consumption data provides policymakers with crucial information about system usage and needs.
  • Behavioral Benefit: The tax slightly discourages driving, which helps reduce congestion and carbon emissions.

2. Harm Mitigation: Funding Related Programs

For taxes on products like alcohol, tobacco, and gambling—often implemented specifically to discourage consumption—the revenue can be effectively used to mitigate the social harms caused by their use.

Instead of funneling this money into general funds, a best practice is to dedicate it to:

  • Cessation and Treatment: Tobacco tax revenue should fund smoking cessation and prevention programs. Gambling revenue should expand support for problem gambling.
  • Innovative Programs: Alcohol tax revenue could scale up programs, such as providing free transportation for intoxicated individuals to reduce drunk driving incidence.

Unfortunately, this is often where policy falls short. The World Health Organization notes that only a small fraction of countries earmark alcohol taxes for health programs. In the U.S., studies show that of the billions states receive from tobacco settlements, only a minimal percentage—as low as 3.5 percent—is spent on prevention.

The Danger of Unstable Funding

Excise tax revenue should never be tied to vital, growing public expenditures like general healthcare, education, or social services. While earmarking sin taxes to popular causes is sometimes used as a “marketing strategy” to garner public support for a tax hike, it creates severe long-term fiscal instability.

The Problem of the Shrinking Base

The major flaw in using excise taxes for essential services is that these taxes rely on a narrow, shrinking, and highly volatile tax base.

  1. Success Breeds Failure: If an excise tax is successful in discouraging consumption (its intended purpose), the tax base shrinks, and the revenue declines.
  2. Volatile Shifts: Policy changes, such as banning a product type, can lead to massive, sudden revenue drops.

The case of California’s First 5 program illustrates this danger. The program, which funds essential child services, received substantial revenue from earmarked cigarette taxes. Following a ban on menthol-flavored cigarettes in 2022, state excise tax revenues plummeted by nearly $192 million, forcing the First 5 program to struggle with a 20% decline in revenue.

This instability is not unique to sin taxes. The once reliable fuel tax is also facing challenges due to increasing vehicle fuel efficiency and the rise of electric vehicles. Even this effective user-fee model is now proving to be an increasingly unstable foundation for transportation budgets, leading many to advocate for more stable alternatives like a Vehicle Miles Traveled (VMT) tax.

Historical data confirms this instability: despite Ireland and the UK increasing cigarette tax rates by over 100 percent between 2000 and 2024, real, inflation-adjusted tax revenue dropped by over 40 percent in both countries.

A Principle for Sustainable Policy

Excise taxes are powerful tools, but they require precise application. Policymakers should adhere to a clear principle:

  • Excise revenue is best used as a complementary source, funding programs directly related to mitigating the harms or covering the costs of the taxed product.
  • Essential, enduring public goods such as education, health care, and social safety nets require broader, more stable tax bases, such as income taxes or value-added taxes (VAT).

By prioritizing the alignment of excise taxes with harm mitigation and user fees, governments can ensure these funds not only shape consumer behavior but also sustainably support the programs they create.

Leave a comment

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.

149 thoughts on “Excise Taxes: When Earmarking Revenue Works – And When It Fails”