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Proposition 56 Tobacco Tax State Agencies’ Weak Administration Reduced Revenue by Millions of Dollars and Led to the Improper Use and Inadequate Disclosure of Funds Report Number: 2019-046

Introduction

Background

Despite a significant decline over the past 50 years in the number of people who smoke, cigarette smoking remains the leading cause of preventable death and disability in the United States. In California smoking‑related illnesses cause 40,000 deaths per year—approximately 15 percent of all of the State’s deaths. Californians’ tobacco‑related health care costs total $13.3 billion annually, of which $3.5 billion is state spending.

Since 1959 the State has imposed a number of taxes on various tobacco products. The text box shows the historical amounts these taxes levied on each pack of cigarettes. In 2016 California voters raised taxes on tobacco products when they passed Proposition 56, which created the California Healthcare, Research and Prevention Tobacco Tax Act of 2016, which took effect in April 2017. This tax generated more than $1.3 billion in revenue in each of the two following fiscal years.

Supporters of Proposition 56 believed that the measure would improve public health by increasing the costs of tobacco products and thus discouraging consumers from buying them. Further, the majority of Proposition 56 tax revenue goes to programs associated with public health, which supporters argued would help offset tobacco‑related health care costs. As Figure 1 shows, the percentage of the State’s adults who smoke cigarettes has declined as the taxes imposed on cigarettes have increased. However, despite this decrease, the California Department of Public Health (Public Health) has reported that the number of adult tobacco users in California exceeds the population of each of 23 states.

Figure 1

The Percentage of Adult Cigarette Smokers in California Has Declined as Cigarette Taxes Have Increased

Proposition 56 Taxes

Proposition 56 raised taxes on cigarettes and imposed an equivalent tax increase on tobacco products such as e‑cigarettes containing nicotine and chewing tobacco (other tobacco products). The text box lists examples of the latter category. The California Department of Tax and Fee Administration (CDTFA)—which oversees the entities involved in the sale of cigarettes and other tobacco products—is responsible for collecting taxes on these products. Rather than imposing cigarette taxes as a percent of the sales price, Proposition 56 specifies an additional tax of 10 cents per cigarette. Because packs of cigarettes generally contain a standard number of cigarettes, distributors pay CDTFA for cigarette tax stamps of specific denominations and attach them to each pack of cigarettes before distributing them to sellers. Thus, Proposition 56 increased the State’s taxes on a standard pack of 20 cigarettes by $2, to a total of $2.87 as of July 2020.

In contrast, other tobacco products come in a variety of sizes and quantities, making it less feasible to specify in law a specific tax amount for each individual product. Instead, state law directs CDTFA to apply a tax rate to the wholesale price of other tobacco products that is equivalent to the tax rate the State levies on cigarettes. CDTFA uses the wholesale cost of cigarettes to calculate this equivalent rate, which it must determine annually. As Figure 2 shows, the wholesale cost is the average manufacturer price plus the wholesale markup, which is the amount tobacco distributors add to the cost of the product to cover their expenses and generate a profit. The wholesale markup on cigarettes is a key component of CDTFA’s calculation of the tax rate for other tobacco products, and we describe how CDTFA obtains this information later in the report.

Figure 2

The Purchase Price of a Pack of Cigarettes Includes Markups and Taxes

Once CDTFA has estimated the wholesale cost of cigarettes, it calculates the total taxes that apply to other tobacco products. As Figure 3 shows, these include the $2.87 currently applied to each pack of 20 cigarettes and an additional tax equivalent to 50 cents per pack of 20 cigarettes that applies only to other tobacco products. ¹ Proposition 10 added this tax to state law in 1999. CDTFA calculates the annual tax rate for other tobacco products by dividing the total taxes of $3.37 for other tobacco products by the average wholesale cost of cigarettes, which CDTFA calculated as $5.37 per pack of 20 cigarettes in fiscal year 2018–19. This resulted in a tax rate for other tobacco products of slightly less than 63 percent for fiscal year 2018–19. Because this tax rate is based on the wholesale cost of cigarettes—which changes from year to year—the tax rate for other tobacco products also changes from year to year. Each month distributors must use the annual tax rate to determine and pay the taxes they owe on the other tobacco products they sell.

Figure 3

CDTFA Bases Its Calculation of the Tax Rate for Other Tobacco Products on the Wholesale Cost of Cigarettes

As the text box shows, the tax rate on other tobacco products has decreased each year since fiscal year 2017–18. As the wholesale cost of cigarettes has risen, taxes have represented a decreasing proportion of their total cost, and the effective tax rate has thus decreased. In other words, because the taxes on cigarettes do not change, an increase in the wholesale cost of cigarettes causes a decrease in the effective tax rate. The inverse is true as well: if the wholesale cost of cigarettes should decrease, the effective tax rate will increase. These tax rate changes affect how much revenue the State collects from taxes on other tobacco products.

Distribution and Oversight of Proposition 56 Revenue

CDTFA deposits revenue collected from the Proposition 56 taxes into the California Healthcare, Research and Prevention Tobacco Tax Act of 2016 Fund (tobacco tax fund). State law specifies how the money in the tobacco tax fund must be allocated. Because the supporters of Proposition 56 believed the additional tax would lead to a decline in tobacco product consumption, Proposition 56 directs CDTFA to annually determine the amount of certain tax revenues lost due to the imposition of additional taxes by Proposition 56, and it directs the State Controller’s Office (State Controller) to replace those revenues with Proposition 56 funds. The portion of Proposition 56 funding that the State Controller transfers to the funds to replace those other taxes—almost $70 million in fiscal year 2018–19—is called the backfill.

The State Controller must allocate and transfer the remaining revenue in the tobacco tax fund according to requirements in law. Following the State Controller’s backfill allocations, CDTFA receives a portion of the Proposition 56 revenue for its costs to administer the tax. Then five state agencies receive fixed allocations for specific purposes. After the State Controller allocates these defined amounts, it distributes the remaining revenue to specified agencies based on percentages established in state law. The law also includes requirements for how the receiving agencies must use this revenue. For example, the University of California (UC) receives $40 million each year to increase the number of primary care and emergency physicians trained in the State. In deciding how to use these funds, UC must prioritize direct graduate medical education costs for programs serving medically underserved areas and populations, among other requirements. Figure 4 shows how the law allocated the $1.35 billion in Proposition 56 tobacco tax revenue that CDTFA collected in fiscal year 2018–19.

State law also addresses the oversight and transparency of the state agencies’ use of Proposition 56 tax revenue. The agencies may not spend more than 5 percent of their Proposition 56 allocations for administrative costs and they must publish on their websites—and any social media sites they deem appropriate—an accounting of the money they received and how they spent it. Further, state law requires the California State Auditor (State Auditor) to conduct a biennial independent audit of the agencies receiving Proposition 56 tax revenue.

To assess how state agencies are spending Proposition 56 funds, we selected the 12 programs listed in the text box and reviewed the safeguards they have established over selected processes to ensure that Proposition 56 funds are properly spent. Although CDTFA and the State Controller do not oversee Proposition 56 funded grant programs, we reviewed how CDTFA calculates tobacco taxes and how the State Controller distributes the tax revenue.

Figure 4

California Collected and Allocated $1.35 Billion in Proposition 56 Tobacco Tax Revenue During Fiscal Year 2018–19
(Dollars in Millions)

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