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

What Is an Excise Tax?

An excise tax is a legislated tax on specific goods or services at the time they are purchased. They're intranational taxes imposed within a government infrastructure rather than international taxes imposed across country borders. A federal excise tax is usually collected from motor fuel sales, airline tickets, tobacco, and other goods and services.

How an Excise Tax Works

Excise taxes are primarily for businesses. Many of them are paid by merchants who then pass the tax on to consumers through higher prices. Merchants pay excise taxes to wholesalers and consider them in product pricing which increases the retail price overall. As such, consumers may or may not see the cost of most excise taxes directly. But there are some excise taxes that are paid directly by consumers, including property taxes and levies on certain retirement account activities.

Federal, state, and local governments have the authority to institute excise taxes. While income tax is the primary revenue generator for federal and state governments, excise tax revenue also makes up a small portion of total revenue.

Excise taxes are primarily business taxes. They are separate from other taxes that corporations must pay, such as income taxes. Businesses charging and receiving excise taxes are required to file Form 720 Federal Excise Tax Return on a quarterly basis and include quarterly payments. Business collectors of excise taxes must also maintain their obligations for passing on excise taxes to state and local governments as required. Merchants may be allowed deductions or credits on their annual income tax returns related to excise tax payments.

Excise taxes can fall into one of two categories:

• Ad Valorem Taxes: Excise taxes that are fixed percentage rates assessed on particular goods or services
• Specific Taxes: Excise taxes of a fixed dollar amount applied to certain purchases

In some cases, governments levy excise taxes on goods that have a high social cost, such as cigarettes and alcohol. These types of excise these taxes are sometimes called sin taxes because the good being taxed has a reputation for being "sinful" or with negative consequences associated with it.

Ad Valorem Excise Taxes

Ad valorem is a Latin phrase that literally means according to value. An ad valorem tax is charged on a percentage basis. This results in an excise tax that is based on the value of the product or service. For example, the Internal Revenue Service (IRS) levies a 10% excise tax on indoor tanning services. This means that if a tanning salon charges $100 for a tanning session, it must pay the IRS $10 in excise tax.

Other types of ad valorem excise taxes include firearms (10%), airline tickets (7.5%), and heavy trucks (12%). Property taxes can also be considered a type of ad valorem excise tax.

Specific Excise Taxes

Specific excise taxes are a set tax or fee added to a certain product on a per-unit basis. Some examples of federal, specific excise taxes as of Oct. 2023 include small cigarettes ($1.01 per pack of 20), pipe tobacco ($2.83 per pound), beer ($3.50 for the first 60,000 barrels), cruise ship passengers ($3 per passenger), and gasoline ($0.183 per gallon).

Sin taxes on targeted goods like beer and alcohol will often be taxed at the federal level and also taxed again by the state, making the cost of these items higher. For example, New York has a specific excise tax of $4.35 per cigarette pack of 20. Combining this with the federal tax of $1.01 makes the excise taxes alone $5.36. These taxes have a considerable impact on the consumer.

Excise Taxes on Retirement Accounts

Excise taxes are also charged on some retirement account activities. Many people are familiar with these taxes as penalties. A 6% excise tax is applied to excess individual retirement account (IRA) contributions that are not corrected by the applicable deadline. A 10% excise tax penalty applies to distributions from certain IRAs and other qualified plans when an investor makes withdrawals before age 59½.

Also, a 25% excise tax penalty is charged when investors do not take the mandatory required minimum distributions (RMDs) from certain retirement accounts, though this tax is reduced to 10% if the missed distribution is taken before the end of the "correction window." The correction window starts on the date the penalty is imposed, usually January 1st after the year you missed the distribution. The window ends on the earliest of:

• The date the penalty is assessed by the IRS
• The date the IRS sends a notice of deficiency
  
• The last day of the second taxable year after the penalty is imposed

The Bottom Line

Excise taxes are assessed by federal and state governments on certain goods and services. They are paid by the merchants that sell them. Excise taxes can be a flat tax amount, known as a specific excise tax, or a percentage of the cost of the good, known as an ad valorem excise tax. They may also be limited only to goods sold within the state of the taxing authority.

Businesses often add the cost of an excise tax directly onto the price of the taxed good, so the tax is passed onto the customer. Customers may or may not know they are paying the cost of the excise tax on top of the price of the good or service. Some companies are transparent about excise taxes, though, like fuel companies. Next time you go to fill up your gas tank, take a look at the pump. The company may break down how much of the price at the pump goes toward the fuel itself versus how much you pay in taxes.