Justifying the Tobacco Tax
Almost as long as there has been a tobacco trade, there has been a tobacco tax.1 Soon after Columbus introduced tobacco to Europe, governments realized the benefit that the weed could yield to their treasuries, and, hence, the tobacco tax was born (Chaloupka, Hu, et al. 237-238). Long designed only as a government revenue-maker, the tobacco tax has undergone a dramatic transformation in the last twenty years. As the health risks of smoking became increasingly apparent and as the cigarette companies lost their chokehold on political power, this excise tax came to be a tool for public health initiatives. The per unit tax rates on cigarettes were driven down by inflation in the 1970's and early 80's, but the rates began to recover in the early 90's, as federal, state, and local governments drove-up duties purportedly in response to the public health concerns (Chaloupka, Hu, et al. 256). Currently, the per-pack federal tax rate stands at $0.39, while, as of 2000, the average state per-pack tax was also $0.39, and further large increases remain under serious consideration (R.J. Reynolds Tobacco Company). This rise in rates has been met with heated debate. On the one hand, detractors depict the tax as nothing more than a vast government windfall, generating inefficiency, burdening the poor, and imposing on the individual. Supporters, on the other hand, argue that the increased taxes can save millions of dollars and thousands of lives per year, while improving both individual and social welfare.
In this paper, I intend to cut through the rhetoric of the tobacco wars, evaluating the tobacco tax in light of the rules of economic efficiency and widely accepted social values. First, I demonstrate that an individual's decision to smoke is potentially rational and utility maximizing. Given that most smokers fall into the habit as adolescents, I next argue that this potential for rational decision-making is rarely realized due to a failure in the individual decision-making process. In particular, adolescents are both ignorant and myopic, and they, therefore, tend to impose exorbitant costs on their future selves. The paper then turns its attention to the elasticity of demand in the tobacco market, concluding that it is relatively inelastic for adults and elastic for children, which makes the tobacco tax a particularly effective and efficient correction for overly exuberant youth tobacco consumption. Next, the paper evaluates the popular notion that smoking imposes negative externalities on society, determining that this justification for the tobacco tax is a faulty one. Finally, I consider the tax's potential benefit as an efficient source of government revenue, as well as its potential detriments, discussing the feared consequences for equity and individual autonomy. Weighing this analysis, I conclude that the benefits of the tobacco tax exceed the costs. While not flawless, the tobacco tax is justified dually justified as a correction on a market that does not adequately account for the risks of smoking and justified as an efficient source of government revenue.
Finding the Sense in Smoking
Until recent years, smoking and other addictive behaviors were assumed to be perfectly irrational. Instead of being guided by utility maximization, drug use, it was believed, came as the result of an uncalculating urge that would violate fundamental economic laws. The behavior was seen as independent of costs and benefits independent even of price. By the late 1970's, economists had grown increasingly dissatisfied with this interpretation of drug demand, as it was inconsistent with the canonical utility maximization and, moreover, precluded any rigorous analysis of the cigarette market (Chaloupka, Tauras, et al. 107).
First, it is important to define the characteristics of tobacco addiction. Cigarette use is distinguished as an addictive behavior by two key factors reinforcement and withdrawal. Reinforcement is a learned response to consumption, leading smokers to grow dependent on the rewards of tobacco use. For cigarettes, positive reinforcement comes in the form of both the pharmacological effects associated with nicotine and also the psychological benefits of lighting up. Moreover, tobacco users are influenced by negative reinforcement. They smoke to avoid negative stimuli such as stress or weight gain. Withdrawal is an extreme physical and psychological form of negative reinforcement, as a smoker's body and mind react adversely to the cessation or reduction of cigarette consumption. The symptoms often include irritability, anxiety, and increased blood pressure. Given that the levels of reinforcement and withdrawal are a function of total consumption over time, past consumption comes to affect the utility of smoking today, and the decision to smoke today comes to affect the utility of smoking tomorrow (Chaloupka, Tauras, et al. 110).
To integrate addiction into a rational framework, many economists have come to rely on the life-cycle model a model that links past, present, and future consumption choices. In this model, a fully informed, rational smoker calculates the future addiction implications of current behavior. This smoker understands that as she builds a stock of cigarette consumption, she reinforces her tobacco habit, thereby threatening to impose a large future transition cost on herself. Taking into account both this transition cost and the net benefits of smoking, the rational smoker decides on a level of cigarette consumption that maximizes utility over her entire lifetime. In other words, tobacco use can be a rational and utility maximizing behavior, although it is also addictive.
Given this potential for rational decision-making, the values of a liberal, market-based system dictate that the consumer should be seen as the best judge of his own self-interest. Government second-guessing of potentially rational individual decision-making is believed to raise the specter of an all encroaching government a government that would tend to limit liberty and that, on the whole, would less effectively protect the individual's self-interest than the individual himself. In the case of cigarettes, this principle implies that, so long as the benefits and costs of tobacco use are fully internalized by the consumers and producers, the government should steer clear of intervening in individual decision-making. Yet, there is a key exception to this principle of consumer autonomy the case of children. It is widely understood that children are often not competent both because of a general lack of knowledge and of judgment to properly evaluate their own self-interest. This point is particularly pertinent to the case of tobacco.
Irrational Exuberance: Teenagers' Failure to Assess the Risks of Cigarettes
Over 90% of smokers in the U.S. start smoking in their teenage years (Gajalakshmi, et al. 19). These are years in which tobacco-users tend to be misinformed about the risk of addiction and, moreover, to discount future costs at exorbitant rates. This leads to an irrational exuberance for smoking an irrational exuberance that costs smokers dearly later in life and that potentially justifies government intervention in the tobacco market.
Young smokers tend to be misinformed about addiction, having unrealistic notions about their ability to break the cigarette habit. A 1994 U.S. Department of Health and Human Services study of teen smokers found that 55% of past month smokers and 45% of daily smokers predict that they probably would not, or definitely would not, be smoking in five years. Yet, in a longitudinal follow-up study five years later, the researchers found that, typically, the teen smokers had maintained or increased their quantity consumed (Kenkel and Chen 193). Some suggest that teens' ignorance may be a function of lack of personal experience. Adults may only come to understand addiction from having observed the effects of the addictive good on others as well as perhaps themselves. Teens, on the other hand, do not have the benefit of this understanding (Chaloupka, Tauras, et al. 120).
Rationality in the cigarette market not only necessitates that consumers understand addiction, but it also requires that the consumers reasonably care about the future. If consumers are too myopic, they will place an exorbitantly high discount rate on the long-term costs of smoking. This will unreasonably reduce the apparent cost of addiction, as well as the costs of the long-term health effects.
Evidence suggests that teenagers tend to discount at exorbitant rates. In constructing models of human development, researchers have found that children are more myopic than adults. Adolescents tend to ignore their futures, and this shortsightedness is reflected in the U.S. Department of Health and Human Services finding that seven out of ten adult smokers regret their choice to start smoking (Jha, et al. 158). So, when teenagers begin lighting up, they may suspect that smoking will lead to future costs, but the young smokers fail to properly internalize those costs in their decisions. They short-sightedly impose these expenses on their future selves expenses that, as adults, they come to regret.
Teenagers' ignorance about the addictiveness of cigarettes in combination with their lack of judgement leads to a failure in the cigarette market. Adolescents' demand schedule for cigarettes does not reflect the true marginal private benefit of consumption. It fails to properly account for costs that will be imposed on smokers in the future. Children are being duped, as they consume a product that is more harmful than they realize, and this justifies some form of government intervention.
Saving the Day: Taxation to Correct the Cigarette Market
Although intervention need not be in the form of a tax, other methods do not appear to be particularly effective. The sale of tobacco to minors is already illegal in every state in the nation, but, as economists Frank Chaloupka and Michael Grossman reported in a 1996 study, these minimum-age-at-sale laws have had little impact on the supply of tobacco to minors (Woolery, et al. 278). Education is another option that has often been tried, but its efficacy is dubious. Even if anti-drug classes managed to fully inform students about the dangers of smoking, teenagers would still be myopic and would not be able to properly integrate such information into their decision-making. This leaves us with the possibility of taxing cigarettes. Admittedly, taxation is a rather blunt tool with which to affect teen cigarette use, since adult consumers must also pay the tax. Yet, in analyzing the elasticities of demand, one finds that the tobacco tax is particularly effective and efficient.
Primarily due to the impact of addiction, the market for cigarettes can be considered segmented segmented into the market for teenagers and the market for adults. In the short run, there is a significant gap between the elasticities for adults and for minors. One study concluded that teenagers are up to three times more sensitive to price than adults, with estimates of teenagers' elasticity running from 0.58 all the way up to 1.31 (Chaloupka, Hu, et al. 252). Unlike adults, teenagers are not constrained by past consumption. Having just begun smoking, most are not yet addicted, and so teenagers' demand adjusts more dramatically to changes in the current price level. This is in contrast to the adult market a market almost universally composed of addicts. Adults' current consumption is not only a function of the price today; it is also a function of the price yesterday. Moreover, adult demand is further insulated from changes in price by adults' relatively large disposable incomes. Since an adult is likely to spend a smaller percentage of disposable income on cigarettes than a teenager, the adult's demand curve is all the more inelastic (Chaloupka, Hu, et al. 252).
An increase in cigarettes' price would therefore substantially decrease teen cigarette demand, while having a much smaller impact on adult consumption. One could not ask for a better effect. As the demand curve for teenagers is relatively elastic, a tax increase reflecting the costs which teenagers irrationally impose on their future selves would substantially increase the market's efficiency. This efficiency would come at the expense of consumer surplus in the adult market, since the tax would also affect assumedly rational adult cigarette consumers. Yet, leading health economists have concluded that, since adult demand is relatively inelastic compared to teenage demand, "the benefits from the large reduction in youth tobacco use resulting from a tax increase would be substantially larger than the losses incurred by adult tobacco users" (Chaloupka, Hu, et al. 265).
The tobacco tax is therefore justified as a correction for teenagers' irrationally exuberant consumption. Still, there is another argument for the tobacco tax that is even more widely accepted. The tax is often mentioned as a Pigouvian-style means of addressing negative externalities. Yet, when rigorously evaluated, this particular justification for the tax proves to be a faulty one.
Evaluating the External Costs and Benefits of Smoking
An externality is either a cost or benefit that a transaction imposes on those not involved and that is not mediated through market prices. The most often cited tobacco externalities are physical (related to second-hand smoke) and financial (related to the costs of healthcare, sick leave, etc.). Yet, the negative physical externalities of second-hand smoke tend to be ambiguous and easily corrected through less invasive measures than taxation, while the net financial externality of tobacco use is very close to zero.
The physical externalities resulting from second-hand smoke can be divided into two categories the adverse health effects and the nuisance of breathing second-hand smoke. In terms of the adverse health impact, it is difficult to differentiate between the external and internalized costs. Environmental tobacco smoke only affects the health of those who are chronically exposed, and most of those chronically affected are smokers' family members. Since the economic decision-making unit is often considered to be the family, the smoker may take into account the total health risks of second-hand smoke. The same may be said for babies' health problems due to exposure to nicotine during pregnancy. The mother may internalize these extra health care costs in her own decision-making (Chaloupka, Hu, et al. 261). Since the health care impact of second-hand smoke may, to a great extent, be internalized, this externality is amorphous and, in all likelihood, small certainly not justifying significant intervention in the market.
Second-hand cigarette smoke is also a nuisance to non-smokers in terms of its odors and physical irritation, but even this does not point towards the remedy of taxation (Jha, et al. 159). The nuisance of second-hand smoke is clearly a negative externality, which leads some to argue for a Pigouvian tax. Yet, interventions in the market should, as much as possible, focus narrowly on the problem at hand. To correct for the nuisance factor, there would seem to be far more effective and far less intrusive corrections than a tax. The trend among states and localities to limit smoking in public areas represents the most appropriate course of action. A Pigouvian tax, on the other hand, simply seems to be too blunt a tool.
The negative financial externalities that smokers impose on society are also frequently cited as another justification for upping the price of tobacco. These negative financial externalities are both clearly apparent and readily calculated. Smokers impose a large external health care cost. This external cost is the portion of the total health care bill due to cigarette use for which smokers do not pay. As private health insurance fails to perfectly discriminate between smokers and non-smokers, the costs are passed on through universally higher premiums. Similarly, group life-insurance premiums also tend to rise, pushed up by smokers' relatively early deaths. External costs are not only passed along through private insurance plans but also through public insurance plans, such as Medicare and Medicaid, that bear part of the brunt of smoking-related illness. The labor market is also negatively affected, as smokers tend to take more days of sick leave. Indirectly, smokers' poor health has an adverse effect on government revenues, as the smoking-related deaths of productive workers cut into tax proceeds. The size of these negative externalities per pack of cigarettes in the U.S., as calculated by the economist W. Kip Viscusi, can be found in a table in the appendix. The externalities are calculated for the two different discount rates of 3% and 5% (Viscusi 74).
Contrary to popular notion, these large negative externalities are counterbalanced by smoking's positive externalities. Cigarette use, by cutting down smokers' life spans, does save society on certain large expenses expenses related to elderly care and living. The primary savings are found in public and private pension plans. Many smokers contribute to pension plans such as Social Security until around retirement age and then die before they can claim a substantial portion of their benefits (Jha, et al. 161). As the required pension contributions are not lower for smokers, the savings are passed on to the rest of society. Cigarettes also lower the nursing home care costs paid by Medicaid, as smokers spend less time in long-term care. The positive externalities per pack of cigarettes, as calculated by Viscusi, are also shown in a table in the appendix (Jha, et al. 161).
Viscusi calculates the net financial externality from smoking to be close to zero. At the lower discount rate of 3%, there is a positive externality of $0.32 per pack, while at the 5% discount rate, there is a negative externality of $0.27. As the external costs tend to come earlier (during the smoker's lifetime) and the external benefits later (after the smoker has died), the higher discount rate simply lowers the value of the external benefits relative to the external costs. Assuming that the true discount rate lies somewhere between 3% and 5%, the present values of the external financial benefits and costs are very nearly equal.
Although the tobacco tax is justified as a correction on an inefficient market, its purpose should not be seen as addressing the harm that smokers impose on others. Instead, the tobacco tax should be regarded as a tool to minimize the unforeseen and unintended costs that adolescent smokers impose on their future selves. As described below, the tax can also be seen in another light as a relatively efficient source of government revenue.
As it has for nearly five hundred years, the tobacco tax continues to provide healthy revenue streams to the government with relatively little welfare loss. The Ramsey Rule dictates that, to maximize the efficiency of consumption taxation, the level of taxes imposed on a good should be inversely related to the price-elasticity of demand. Especially in the short run, the demand for cigarettes is relatively inelastic as compared to other products, and so, under the Ramsey rule, tobacco should be subject to a relatively high tax rate. Although the duty dissuades tobacco use among parts of the population, the overall elasticity is such that the tobacco tax still yields respectable government revenues approximately $12 billion per year over the last decade with relatively little welfare loss (Jha, et al. 161; Chaloupka, Hu, et al. 254).
Although the tobacco tax is a drop in the bucket in terms of total U.S. government revenues (composing only 0.41%), the tax is essential to the specific programs for which it is often earmarked. Increasingly, state and local governments have set aside tobacco funds for specific uses (Chaloupka, Hu, et al. 255). In such states as California, Massachusetts, Arizona, and Oregon, tobacco tax funds are funneled towards tobacco-related education, counter-advertising, and health care for the underinsured. Although the tobacco tax revenues may not be fiscally substantial, they make such programs politically feasible, and, thereby, the tax on cigarettes has real impact on public policy.
Weighing the Tax's Potential Detriments
While the tobacco tax efficiently raises government revenues and protects children from the overuse of tobacco, the tax is not without its potential detriments. The tax, as discussed below, violates the principles of vertical and horizontal equity and, according to some, represents an affront to consumer autonomy. Still, I conclude that the tobacco tax is a justified public policy measure that the benefits of raising revenues and protecting children outweigh the tax's negative impact.
Vertical equity suggests that individuals with the greatest ability to pay should be taxed more heavily, but the duty on cigarettes is a severely regressive tax that undermines this principle (Chaloupka, Hu, et al. 257). The cigarette tax, like many forms of sales tax, is regressive in percentage terms, as lower income individuals devote a higher percentage of their income to paying the tobacco tax than do higher income individuals. Moreover, the tobacco tax is even regressive in absolute terms, and this is unique that lower income individuals actually pay more tobacco taxes per capita than those with higher incomes. This phenomenon results from the inverse correlation between income and education, on the one hand, and smoking, on the other. As people of lower socioeconomic status tend to have higher smoking rates, they pay more tobacco tax, aggravating America's already skewed distribution of income.
Although the tobacco tax is itself regressive, raising the tax is actually progressive, since lower income smokers are more sensitive to changes in price than higher income smokers. A 1998 Center for Disease Control study found that the price-elasticity of demand for those in families at or below the U.S. median household income was 70% larger than for persons in families above the median (Chaloupka, Hu, et al. 253). Therefore, as the tobacco tax rises, the smoking prevalence gap between the socioeconomic classes closes, and the incidence of the tax becomes more equitable. In other words, an increase in the tobacco tax tends to make the tax less regressive (Chaloupka, Hu, et al. 258-259).
Yet, unless the duty is exorbitant, the tobacco tax will still take a larger bite from the wallets of the lower socioeconomic classes than from the higher socioeconomic classes. This is certainly worrisome, but the problem must be viewed in the context of the overall fiscal system a fiscal system replete with programs and taxes that can be used to offset the regressivity of the tobacco tax. For example, new cigarette tax revenues are frequently earmarked for programs that target low-income populations, and so, while the tax may be regressive, the programs that it funds may counterbalance the tax's adverse effects on distribution of income (Chaloupka, Hu, et al. 256). Since the regressive impact of the tobacco tax is readily wiped away, its violation of vertical equity should not disqualify the tax from being used as a public policy tool.
Less easily remedied is the tobacco tax's blatant violation of horizontal equity. Otherwise identical people who consume different quantities of tobacco are taxed at different rates. This is unfair to the many smokers who impose neither externalities on society nor unreasonable costs on their future selves. Yet, the tax's injury to smokers is neither easily avoidable nor rectifiable. The costs to horizontal equity must be weighed against the tax's substantial benefits the benefits from protecting children in the cigarette market and the benefits from efficiently raising government revenue. The judgment is subjective, but I believe that most would agree that the tobacco tax does more good in terms of protecting children and raising revenues than it does harm to horizontal equity.
Finally, the tobacco tax is often characterized as a dangerous violation of personal autonomy. As noted earlier, our society gives great value to consumer freedom to allowing the individual to choose the best course for herself, so long as her decisions do not impose external costs on others. Otherwise, we face the prospect of a government, reaching deep into our lives, dictating the minutiae of life. Many have interpreted the tobacco tax as a troubling, unjustified attempt by the government to impose values on the citizenry. Envisioning a slippery-slope, they ask, "Will a 'fat tax' be next? Will the government someday see no difference between Ronald McDonald and Joe Camel?" (Rosin).
Such alarmism is belied by a unique justification for the tobacco tax that children are irrationally imposing particularly large costs on their future selves through addiction. Our society has long differentiated minors from adults. We have long recognized that children should not have full personal autonomy, as they do not have the same ability to make rational decisions hence the age limits for voting, driving, drinking, etc. The tobacco tax is fully consistent with this precedent as its key purpose is to transform the behavior of young people. The tax's impact on the behavior of adults is an unavoidable byproduct that represents a detriment of the tobacco tax, but this effect is relatively small due to the inelasticity of adult demand. If anything, the tobacco tax, as an intervention in the market, is meant to expand personal autonomy the personal autonomy of tomorrow's adults who will no longer be constrained by the irrational, youthful decisions of today.
The tobacco tax is justified, but the question remains, "At what level?" The tobacco tax exuberance sweeping the nation carries along the myth that higher is always better since higher will always save more lives. The myth is reinforced by the stream of public health reports that focus on the millions of premature deaths that could be avoided under increased rates. Yet, this goal of saving lives is a pie-in-the-sky that will lead us to sacrifice social welfare, as we push up rates too high. Today, the challenge for both economists and public leaders is to calculate and legislate a tax level that maximizes social welfare a tax level that most efficiently raises revenues, while stopping our children from lighting up due to their own ignorance and myopia.
1 In the United States today, the vast majority of tobacco tax revenue (98.7% as of 1993) is accounted for by cigarette taxes, and so I use the terms "cigarette tax" and "tobacco tax" interchangeably. Although issues of smokeless tobacco are gaining importance given its increased use among young Americans, I choose to focus on the central concern in today's public policy debate cigarettes. W. Kip Viscusi, "Cigarette Taxation and the Social Consequences of Smoking," Tax Policy and the Economy 9 (1995): p. 57.
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Kenkel, Donald and Likwang Chen. "Consumer Information and Tobacco Use." In Tobacco Control in Developing Countries, ed. Prabhat Jha and Frank Chaloupka, p. 177-214. Oxford: Oxford University Press, 2000.
Rosin, Hanna. "The Fat Tax," The New Republic. 18 May 1998. (The New Republic Online Archive) Viscusi, W. Kip. "Cigarette Taxation and the Social Consequences of Smoking." Tax Policy and the Economy 9 (1995): p. 51-101.
Woolery, Trevor, Samira Asma, and Donald Sharp. "Clean In door-Air Laws and Youth Access Restrictions." In Tobacco Control in Developing Countries, ed. Prabhat Jha and Frank Chaloupka, p. 273-286. Oxford: Oxford University Press, 2000.
David Kamin '02 graduated with a degree in economics and political science. He is currently a research associate at the Committee for Economic Development (CED), a public-policy think-tank in Washington, D.C. About writing he says, "Both in my current job and at Swarthmore, being able to write cogent, coherent prose has been an invaluable skill. For me, thisability did not comenaturally. I was not born with an innate understanding that each paragraph deserved a topic sentence.My writing skills only developed with hard work, some excellent teachers of prose writing, and plenty of red ink.My teachers showed me how a good essay required not only inspiration butalsoa structure that could effectively convey my ideas. And,even if I was deflated when their pens cut apart my papers, I would try and try again, until their "rules" of prose writing were deeply instilled.For me, this learning process is noteven at an end.I, luckily, workfor a man (a former Swarthmore professor) who is an even better writer than I. So, I continue to see red ink, and I continue to learn." This paper was written for Professor Bernard Saffran's Economics 141: Public Finance.