Excise Tax: What It Is and How It Works, With Examples

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An excise tax is an indirect tax that a government places on the sale, manufacture or use of particular goods and services, rather than on purchases in general. Fuel, tobacco, alcohol, airline tickets and firearms are standard examples of excise taxes. The seller, producer or importer usually owes the tax to the government and builds it into the price, so most buyers pay it without seeing a separate line on the receipt.

Key takeaways

• An excise tax applies to a defined list of products or activities, unlike a general sales tax.
• It is charged as a percentage of value (ad valorem) or a fixed amount per unit (specific).
• Businesses normally pay it and pass the cost on through prices. Federal, state and local levies can stack on one product.
• Some excise taxes, including IRS penalties on certain retirement account mistakes, fall on individuals directly.

What Excise Tax Means

England adopted an excise in 1643 to fund its Civil War, and the 1791 U.S. federal tax on distilled spirits set off the Whiskey Rebellion. The logic has not changed: taxing a few high-volume, easily tracked products raises money without taxing every transaction.

Excise taxes are indirect taxes. The legal duty to pay falls on a business, such as a refiner, brewer, importer, airline or retailer, and the cost reaches consumers through the price. A direct tax, such as income tax, is paid by the person it is assessed on.

“Excise duty” means the same thing. “Duty” is the more common term in the U.K., India and many other countries. A customs duty is a different tax: it applies to goods because they cross a border, while an excise applies to goods produced or sold within the taxing government’s territory, whether made domestically or imported.

How an Excise Tax Works

The tax is imposed at a specific point in the supply chain, and that point decides who files. Federal tax on gasoline, for example, is generally imposed when fuel leaves the terminal rack, so the business at that point remits it and the cost travels downstream to the pump. Taxes on airline tickets are collected by the airline from the passenger. Tobacco and alcohol taxes are paid largely by manufacturers and importers.

In the U.S., businesses that owe most federal excise taxes file Form 720, Quarterly Federal Excise Tax Return, and make deposits during the quarter. The IRS explains the federal rules in Publication 510. Alcohol and tobacco taxes are handled separately by the Treasury’s Alcohol and Tobacco Tax and Trade Bureau. States run their own registration and filing systems, so a business can owe federal and state excise on the same product, on separate returns.

Ad valorem excise taxes

Ad valorem is Latin for “according to value.” An ad valorem excise is a percentage of the price, so the tax rises and falls with what the product costs. Federal examples include:

• Indoor tanning services: 10% of the amount paid
• Pistols and revolvers: 10% of the manufacturer’s sale price (other firearms and ammunition: 11%)
• Domestic airline tickets: 7.5% of the fare, plus per-segment charges
• Heavy trucks, trailers and tractors: 12% of the price on the first retail sale

The tanning tax shows the mechanics. If a salon charges $100 for a session, the tax is $100 × 10% = $10, which the salon remits to the IRS.

Specific excise taxes

A specific excise is a fixed amount per unit: per gallon, per pack, per barrel, per pound or per passenger. The price of the product does not affect the tax. Federal specific excises apply to:

• Cigarettes (per pack of 20)
• Pipe tobacco (per pound)
• Beer (per barrel, with reduced rates on a brewer’s first 60,000 barrels)
• Gasoline and diesel (per gallon)
• Cruise ship passengers (per passenger)

Layering shows up most clearly on tobacco. The federal tax on a pack of 20 cigarettes is $1.01, and New York adds its own $5.35 per pack. Before any local tax or sales tax, a New York smoker pays $6.36 in excise per pack, whether the brand sells for a low price or a premium one.

The formulas

• Ad valorem: Tax = Taxable price × Rate
• Specific: Tax = Units × Amount per unit

The two designs react differently to price changes. Take a hypothetical product taxed either at 10% of value or at $1.00 per unit:

The ad valorem tax grows with prices and inflation. The specific tax stays the same in dollars, so its real value shrinks over time unless lawmakers raise it. A specific tax also takes a larger share of the price of cheap versions of a product than of expensive ones.

Interpreting excise tax on a graph

Economics textbooks show a per-unit excise as a vertical shift of the supply curve by the amount of the tax. Buyers pay a higher price, sellers keep a lower price net of tax, the gap between the two equals the tax per unit, and fewer units change hands.

Who bears the cost depends on how much each side responds to price, not on who files the return. When demand is inelastic, as with gasoline or cigarettes, most of the tax shows up in the consumer price. When buyers can easily switch away, sellers absorb more of it through lower net prices. The lost trades are the tax’s deadweight loss: purchases that would have happened without the tax and no longer do.

Why Governments Use Excise Taxes

Raising revenue. Income taxes are the main source of revenue for the federal government and most states. Excise taxes bring in a much smaller share, but a dependable one. The largest federal excise revenue comes from motor fuel, airline tickets, tobacco, alcohol and health-related goods and services.

Discouraging harmful consumption. “Sin taxes” on tobacco, alcohol and similar products are meant to raise the price of goods with social costs, such as health care spending or pollution, that the buyer does not pay at the register. Economists call this a corrective or Pigovian tax.

Charging users for public services. Some excises work like user fees. Federal fuel taxes go mainly to the Highway Trust Fund, which pays for roads, and aviation taxes fund the Airport and Airway Trust Fund.

Excise Taxes on Retirement Accounts

Several federal penalties on tax-advantaged accounts are legally excise taxes. Unlike product excises, they fall directly on the account owner, who usually reports them on Form 5329.

• Excess IRA contributions: a 6% excise tax applies each year the excess stays in the account uncorrected after the deadline.
• Early distributions: withdrawals from IRAs and other qualified plans before age 59½ generally carry a 10% additional tax, unless an exception applies.
• Missed required minimum distributions (RMDs): a 25% excise tax applies to the amount that should have been withdrawn. It drops to 10% if the missed RMD is taken during the correction window.

The reduced 10% rate applies if the missed RMD is corrected before the IRS assesses the tax or mails a notice of deficiency, and no later than the end of the second taxable year after the tax is imposed. RMDs currently begin at age 73 for traditional IRAs and many other tax-deferred plans.

Limitations of Excise Tax

Regressive burden. Lower-income households spend a larger share of their income on fuel, tobacco and similar taxed goods, so the tax takes a bigger bite of their budgets.

Shrinking base when the tax works. A sin tax that succeeds in reducing smoking also reduces its own revenue. Fuel tax receipts fall as vehicles use less gasoline, which strains funds built on that revenue.

Avoidance across borders. Large differences in rates between neighboring states or countries encourage cross-border shopping and, for products like cigarettes, smuggling.

Low visibility. Because the tax sits inside the shelf price, consumers often can’t see how much of what they pay is tax. Fuel is an exception: pumps and receipts often break out the tax share. In some states, sales tax is calculated on a price that already includes excise, so the excise itself is taxed.

Excise Tax vs. Sales Tax, VAT and GST

Countries that use a value-added tax or a goods and services tax still keep separate excise duties on fuel, alcohol and tobacco, so these products carry both.

FAQs

The Bottom Line

Consumers pay excise taxes mostly through higher shelf prices, and lower-income households feel the cost most because taxed goods take a larger share of their budgets. Businesses that make, import or sell taxed products may owe federal and state excise on separate returns. Retirement savers face excise penalties directly, so correcting excess contributions or missed RMDs promptly limits what they owe.