Vertical externalities in cigarette taxation: Do tax revenues go up in smoke?

In federal systems, where tax bases are joint property, the tax policy of one level of government affects the tax base of the other. This paper examines the interdependence of US federal and state cigarette tax rates. Our results suggest that states may reduce their cigarette tax rate by as much as 48 cents per dollar increase in the federal tax rate. Thus, a federal tax hike may reduce the amount of generated state tax revenues both directly (the overall tax rate rises and the state tax base declines), and indirectly (the state tax rate declines).