Most of you likely remember the state settlements with tobacco companies. The settlements were set up to pay states a percentage of future tobacco company earnings and sales. But just like a profligate homeowner borrowing against his paper equity in his home after housing prices increased, governments wanted to spend the money NOW, not over 20 years. So they borrowed against future settlement payments. Except that now, given lower smoking rates (incentives work) the settlement payments are less than they were forecast, and states must find a way to make up the difference and pay their creditors.
The tobacco settlement has created funky incentives for state governments form the very beginning. Formerly adversaries, the settlement effectively made large tobacco companies partners with state governments, and states have had substantial incentives to promote the business of large tobacco companies and sit on their rivals
Big tobacco was supposed to come under harsh punishment for decades of deception when it acceded to a tort settlement seven years ago. Philip Morris, R.J.Reynolds, Lorillard and Brown & Williamson agreed to pay 46 states $206 billion over 25 years. This was their punishment for burying evidence of cigarettes' health risks.
But the much-maligned tobacco giants have subtly and shrewdly turned their penance into a windfall. Using that tort settlement, the big brands have hampered tiny cut-rate rivals and raised prices with near impunity. Since the case was settled, the big four have nearly doubled wholesale cigarette prices from a national average of $1.25 a pack (not counting excise taxes) in 1998 to $2.10 now. And they have a potent partner in this scheme: state governments, which have become addicted to tort-settlement payments, now running at $6 billion a year. A key feature of the Big Tobacco-and-state-government cartel: rules that levy tort-settlement costs on upstart cigarette companies, companies that were not even in existence when the tort was being committed.
The government has found over time that it is able to sell higher taxes to the voters on certain items if they can portray those items as representing some socially unwanted behavior. These are often called "sin" taxes. The justification for the tax in its beginning is as much about behavior control as revenue generation. Taxes on cigarettes, alcoholic beverages and even gasoline and plastic grocery bags have all been justified in part by the logic that higher taxes will reduce consumption.
However, a funny thing happens on the way to the treasury. Over time, government becomes dependent on the revenue from these taxes. The government begins to suffer when the taxes have their original effect — ie reducing consumption — because then tax revenues drop. The government ultimately finds itself in the odd position of resisting consumption drops or restructuring the tax so it no longer incentivizes reduced consumption so that it can protect its tax revenue collections.