The Economics of Smoking

• One of the potential problems (from an economic perspective) with smoking is that there may be an externality in consumption, so there may be difference between the private and social optimal level of cigarette consumption.

• Smokers might impose costs on persons who do not smoke (e.g., second hand smoke and low birth weight in pregnant women) as well as society (e.g., health risks of smoking might lead to higher health care utilization).

Figure 1: External costs of smoking

• In Figure 1 the initial equilibrium, might have too much consumption of cigarettes since the external costs are not factored into a smokers utility function, i.e., they only consider their marginal utility, so end up with a market equilibrium with too much smoking.

• Solution, reduce consumption of cigarettes through corrective taxes or regulation (e.g., bans on smoking in public places, restrictions on who can buy cigarettes)

• Regulation option to try reduce smoking might include:– Warning labels on cigarette packaging highlight the

dangers of smoking– Bans or restrictions on cigarette advertising– Bans on smoking in public spaces or indoors– Restrictions on sales of cigarettes (e.g., must be a

certain age to purchase cigarettes)– Regulation of ingredients in cigarette manufacuring

(i.e., reducing “tar” levels as discussed in Viscusi’s paper on the reading list)

• There can be differences across countries in how they pursue these regulatory options.

• Consider the warning labels on cigarette packaging in Canada and the U.S.

U.S. Cigarette Package

Japanese Cigarette Package for U.S. Market

U.S. Cigarette Brand for Italian Market

Canadian Cigarette Package

Canadian Cigarette Package

Canadian Cigarette Package for Aboriginal Tobacco Product

• Alternative to regulation is taxes.• Can use taxes to make smokers take into

account external costs and reduce their consumption of taxes

• Taxes that are used to correct externalities are referred to as “Pigouvian Taxes”

• Alternative objectives of taxes are generating tax revenues and controlling consumption or other outcomes.

What are the tax rates on cigarettes?

• In the U.S., taxes at the state level can range from about $0.07 per pack (in North Carolina) to about $2.00 per pack (in New Jersey); the federal tax rate is about $1.00 a pack (although it was at $0.39 a pack before it was increased).

• In Canada tax rates tend to be higher, see the attached table.

Grossman, Sindelar, Mullahy and Anderson discuss some of the objectives of taxing cigarettes and alcohol, sometimes referred as Sin Taxes. What is unique about these commodities is that they tend to have relatively inelastic demands so you don’t get much of a drop in a quantity when the price goes up in response to the tax, this makes them a favourite option of governments.

Some examples of link between tax revenue and elasticity (U.S. data)

Tax Rate (per pack)

Price Elasticity Increase in Tax Revenue

$0.24 -0.40 $3 Billion

$2 ??? $18 Billion

$2.24 -0.50 $28 Billion

$1.26 -0.45 $16 Billion

• Revenues from taxes can sometimes be directed to at particular public projects. – As an example, gasoline taxe revenues are

often used to build and maintain roads and highways. Since people who drive use the roads the fuel taxes can collect revenues who actually use the roads

• Can make a similar argument for smoking, taxes from cigarettes can be used to pay for the healthcare costs of smokers. Smoking is generally known to be a risk factor for heart disease and some respiratory diseases and can cause cancer (lungs, mouth, throat) . However, things are a little trickier, since some of these cancers and other health problems can also be caused by other risk factors.

• Another reason for taxing cigarettes is to reduce consumption of cigarettes.

• The health risks of smoking have been well known for some time, but the report of the Surgeon General of the U.S. in 1964 brought greater attention to the health risks of smoking.

• Governments might be concerned with healthcare costs associated with smoking and might want to reduce smoking

• Cigarettes are an addictive good, so current consumption is linked to past consumption. This means that reducing consumption today would also reduce consumption in the future.

• Smokers often begin smoking when they are young (teenagers and early-twenties) and keep the “habit” as they age– This means that policies that prevent people from

smoking at an early age reduce consumption at different segments of the population

• Why focus on youths?– Answer, the elasticity of their demand curves

• Is it possible to target youth smokers with cigarette taxes?– Would depend on elasticities, if youth smokers have

more elastic demand than the answer would be yesLong-run demand is more elastic than the short-

run demand, easier to quit over time, but in the short-run you are hooked.

• Youth smokers also tend to have much more elastic demand curves than adult smokers (restricted incomes)

Elasticity of Demand for Cigarettes by Age

Age Group Elasticity

12-17 -1.2

20-25 -0.74

26-35 -0.44

35+ -0.15

• Complication, smokers can respond to taxes in other ways– Switch to discount brands (cost less than a

premium brand)– Switch to different cigarettes (e.g., a cigarette

with more “tar” and nicotine)– Adjust how they smoke (e.g., inhale,

frequency)– Homeless picking up half smoked cigarettes

• Taxes can also be used for corrective purposes. • One potential externality of smoking is second

hand smoke, so non-smokers can get smoking related illnesses even though they don’t smoke and pregnant women can put their babies at risk of poor health outcomes– Could try to modify the behavior of women who

smoke (e.g., highlight the dangers of smoking for pregnant women) or could use taxes to compensate for the externalities

Estimates of Optimal Tax Rates to Correct for Externalities of Smoking $0.19 a pack Excludes cost of low

birth weight caused by pregnant women who smoke and second hand smoke

$0.65 a pack Include cost of low birth weight and second smoke, but exclude costs of long-term intellectual and physical development costs of low birth weight

$4.80 a pack If include all costs noted above

• An alternative calculation of the optimal taxes are in Viscusi, see next slide.

Which set of optimal tax rates are really optimal?

• First set of optimal tax rates indicate we should be taxing cigarettes.

• Second set of optimal tax rates (from Viscusi) indicate we should be subsidizing smoking, i.e., we should pay people to smoke.

• Which is right?

The Answer…

• It really depends on the assumptions you make. • In a cost-benefit analysis a number is just that a

number; to really understand whether it’s a reasonable number you need to go through each assumption you make– For example, what’s the discount rate; how are we

measuring costs; etc.

And assess which set of assumptions is more reasonable or plausible.

• The calculations in Grossman et al (in the Table) and those in Viscusi also provide some insights into smoking policy in Canada and the U.S.– The calculations in the table are consistent with

Canada, tax rates are higher and there are more restrictions on smoking behavior

– The calculations in Viscusi are more consistent with the U.S.; tax rates are lower and there are less restrictions on smoking behavior.

• Which policy approach to take really depends on the cost-benefit analysis and the assumptions that underlie it.

• We’ve discussed three different uses of taxes for three different objectives.

• From a policy perspective you need to be clear what the objectives are before you decide on what a tax should be.