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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

Summary

Audit Highlights . . .

Our audit of state agencies receiving Proposition 56 tax revenue highlighted the following:

Results in Brief

Cigarette smoking remains the leading cause of preventable death and disability in the United States. Tobacco‑related deaths account for 15 percent of all deaths in California, and the State spends $3.5 billion annually on tobacco‑related health care. In 2016 voters chose to increase taxes on tobacco products by passing Proposition 56, which created the California Healthcare, Research and Prevention Tobacco Tax Act of 2016. The goals of the proposition included reducing tobacco use and increasing funding for public health programs. The tax increase generated more than $1.3 billion in tax revenue in fiscal year 2018–19 alone. The majority of these funds were allocated to the California Department of Education (Education), the Department of Health Care Services (Health Care Services), the California Department of Justice (Justice), the California Department of Public Health (Public Health), and the University of California (UC). However, the California Department of Tax and Fee Administration (CDTFA) has cost the State millions of dollars in additional Proposition 56 revenue because it did not ensure the accuracy of the tax rate it imposed for certain tobacco products. In addition, the state agencies that have received Proposition 56 funds have not consistently used them for the purposes for which they were intended.

Proposition 56 added a tax of $2 per pack of 20 cigarettes to the existing state taxes on cigarettes, for a total tax of $2.87 per pack. To pay this tax, distributors purchase tobacco tax stamps that they must affix to each pack of cigarettes that they sell. However, the proposition also imposed a tax increase on tobacco products, such as cigars, chewing tobacco, and e‑cigarettes containing nicotine (other tobacco products). Because these other tobacco products come in a variety of sizes and quantities, specifying in law a specific tax amount for each individual product would be challenging. Instead, Proposition 56 requires CDTFA to apply a tax rate to the wholesale price of these products that is equivalent to the tax rate the State levies on cigarettes. Because the average price of cigarettes fluctuates while the cost of the tobacco tax stamps that must be applied to each pack does not, the tax rate that CDTFA calculates for other tobacco products changes each year as the price of cigarettes changes.

To determine the appropriate tax rate for other tobacco products, CDTFA must obtain two pieces of information: the average manufacturer price for cigarettes and the amount that distributors add to that price to generate a profit when they sell those cigarettes, known as the wholesale markup rate. The tax on other tobacco products is calculated by dividing the taxes on cigarettes by the sum of the manufacturer price and the wholesale markup. Because the taxes imposed on cigarettes are fixed, when the costs of cigarettes increase, the tax rate for other tobacco products is lower; and when the costs of cigarettes decrease, the tax rate for other tobacco products is higher, as we explain in detail in the Introduction. Small differences in these numbers can change the total amount of tobacco tax revenue collected by millions of dollars.

Nonetheless, we found evidence that indicates CDTFA has used figures that are too high in both components of its calculation of the tax rate for other tobacco products. Specifically, CDTFA has assumed that the highest‑priced class of cigarettes—premium cigarettes—represents the average manufacturer price for all cigarettes, ignoring less expensive discount and deep‑discount cigarettes. If CDTFA had included these other classes of cigarettes in its calculation of the wholesale cost of cigarettes, it would have increased the tax rate it applied to other tobacco products, resulting in more than $1.3 million in additional tax revenue during fiscal year 2018–19 alone. Similarly, for more than a decade, it has used a wholesale markup rate of 6 percent in its calculation of the tax rate for other tobacco products, yet CDTFA could not explain how it arrived at this rate, which makes it appear to be arbitrary. Information from a variety of sources suggests that the markup is actually between 2 percent and 4 percent. Had CDTFA used 4 percent in its calculation, the tax rate for other tobacco products in fiscal year 2018–19 would have been around 1 percent higher and would have provided an estimated $5 million in additional funds. These additional revenues would have gone to programs intended to reduce tobacco use and improve the health of Californians.

In addition, some of the state agencies that receive Proposition 56 funds have not established adequate safeguards to ensure that they properly award and monitor the use of those funds. For example, the law requires Justice to award Proposition 56 funds to law enforcement agencies for enforcing tobacco‑related laws. However, because of weaknesses in the safeguards it established over its process for selecting grants, Justice awarded nine of the 10 grants we reviewed for purposes that included activities that did not comply with the requirements established in the law for these funds. Similarly, Health Care Services receives Proposition 56 funds for a program that repays the student loans of physicians and dentists who provide services through the California Medical Assistance Program. This program is to prioritize, in part, efforts to reduce the areas of the State that are underserved by health care providers. However, Health Care Services’ process for selecting grantees for this program did not require them to be located in areas with a shortage of health care providers, and it consequently awarded tens of millions of dollars to physicians and dentists who practice in areas that do not have shortages.

Four of the six state agencies we reviewed that receive Proposition 56 funding have also failed to adequately disclose the amount of funds they received or how they used those funds, limiting the information available to the public about the use of this tax money. State law requires these agencies to annually publish on their websites how much Proposition 56 funding they received and how the money was spent. However, as of July 2020, four of the six agencies had not published the required information for fiscal year 2018–19, and three of the six agencies had not yet provided information for fiscal year 2017–18. Moreover, the agencies have interpreted the Proposition 56 reporting requirements differently and consequently reported information that was not consistent with the requirements in law. The agencies attributed their failure to publish complete information in a timely manner and the differences in the information that they did publish to their respective interpretations of state law.

Selected Recommendations

CDTFA, Education, Health Care Services, Justice, Public Health, and UC

To provide the public with complete information as state law intends, each state entity that receives Proposition 56 funds should publish the following information on its website by April 2021 for fiscal years 2017–18 through 2019–20, and within six months of the end of each fiscal year, beginning with fiscal year 2020–21:

CDTFA

To increase the accuracy of its calculation of the tax rate for other tobacco products, CDTFA should take the following steps to update its methodology for calculating the tax by March 2021:

To ensure that the other tobacco products tax rate accurately reflects changes in the wholesale price of cigarettes, CDTFA should enact a policy to obtain the current wholesale markup rate for cigarettes no less than every three years and to incorporate this number in its calculation of the tax rate.

Health Care Services

To ensure that it awards funds to applicants who address the need for providers in health professional shortage areas, Health Care Services should amend its application selection process to require by June 2021 that all participants practice in geographic areas that have shortages of such health professionals, and annually verify that participants continue to practice in such areas.

Justice

To ensure that it awards Proposition 56 funding in accordance with the requirements in state law, Justice should implement a formal grant application review process by June 2021 that ensures that it does not award Proposition 56 funds for purposes that are not allowable under the law governing its use of funds.

Agency Comments

CDTFA disagreed with our findings, but indicated it would implement our recommendations. Justice disagreed with our finding that it did not use funds for the purposes defined in law but it did not object to our recommendation regarding publishing required information. Public Health and Education agreed with most of our findings, but disagreed with our finding that they did not meet the reporting requirements.

Health Care Services agreed with three of the four recommendations we made, but indicated that it will not implement our recommendation to require all participants in its physician and dentist loan repayment program to practice in areas with shortages of health care professionals. TEROC and UC both stated that they agreed with and will implement our recommendations.

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