Cigarette Tax Hikes - Justified, or in Need of Reform?

October 22, 2012

Patrick El-Hage

Professor Trela

ECON 2169F

October 22, 2012

Cigarette Tax Hikes: Justified, or in Need of Reform?

Cigarette tax hikes as an anti-smoking measure have a tendency to be controversial, sparking debates that are not just back-and-forths between smokers and non-smokers, but even amongst those who don’t smoke. It is truly an economic, social, and political issue that raises many arguments, often with regards to civil liberties. Thousands of Canadians die each year due to smoking related causes which incur subsequent costs on the healthcare system and the rest of society, prompting for legislation that curbs habits. The primary objectives of cigarette tax hikes are to decrease the prevalence of smoking by citizens and raise revenues to offset healthcare costs. Economic arguments are the most objective (as is the usual tendency), and by analyzing the full effects of tax hikes we can see that there are still critical issues that must be addressed. By examining the effects of cigarette taxes on demand, the negative consequences of taxation, and the use of revenue provided by cigarette taxes, we can evaluate the overall effectiveness of tax hikes and conclude that tax hikes are not necessarily an effective means of reducing the consumption of cigarettes and, in fact, limit potential revenue by driving sales to the black market.

In most Econ-101 textbooks, justifications for government intervention within an economy are made when a market failure arises, or in other words, when there is an inefficient allocation of resources within a market. Market failures are most often attributed to information asymmetries, non-competitive markets, externalities, and public goods. In the cigarette market, the negative externalities of smoking are what call for correction through government intervention. An “externality” can be defined as “An economic side effect; Externalities are costs or benefits arising from an economic activity that affect somebody other than the people engaged in the economic activity and are not reflected fully in prices” (Economist). In the cigarette market the externalities of smoking (consumption) are costs to society, and therefore, when looking at a model reflecting the market for cigarettes, affect the marginal social cost curve. The marginal social cost curve is the combination of the marginal externality curve and the marginal private cost curve. The externalities of smoking consist of second-hand smoke passed on to non-smokers, the rise in healthcare costs as a result of smoking-related complications, and any additional rise in costs to the economy, such as excess sick-leave costs of smokers and increases in life insurance premiums.

It is estimated that every year smoking costs Canadian society between $3 and $4 billion in direct health-care costs, $750 million due to increased absenteeism, $3 billion for decreased productivity, and over $250 million in increased life-insurance premiums. The total cost incurred to society as a result of smoking totals to approximately $15.8 billion dollars (“Update on Smoking Costs” 2004) (Appendix D1-D5).

In an efficient market, the marginal social cost curve would be equal to the marginal private cost curve, since there would be no externalities. However, since there are externalities in the cigarette market the social marginal social cost curve is to the left of the private marginal cost curve (supply curve) creating a deadweight welfare loss. In order to make the market socially efficient again, the quantity of consumption must be at the point where social marginal benefit equals social marginal cost. This is achieved through a corrective tax that shifts demand to the left, allowing quantity to reach its equilibrium.

The effect of such a corrective tax on cigarette consumption is dependent on its price elasticity of demand. Elasticity is defined as the degree to which a demand or supply is sensitive to changes in price or income. The more elastic a good is, the more the quantity demanded for the good responds to a change in price. The more inelastic a good is, the less a change in price will have an effect on consumption. Since nicotine is an addictive substance found in tobacco, and therefore less susceptible to changes in consumption as a result of price increases, cigarettes are inelastic goods. The estimated price elasticity of cigarettes varied anywhere between -0.22 and -0.5, however most research publications cited price elasticity for most smokers to be between -0.3 and -0.5 (Chaloupka 194). This means that a 10% increase in overall price will result in a 3 to 5% decrease in the sale of cigarettes. It is important to note, however, that elasticity varies amongst age groups and income level, and that price increases do not affect everyone equally.

In one study, those with lower incomes were cited to have a price elasticity of -0.45 while those with higher incomes had a price elasticity of -0.27 (Franks). Although lower income earners experience a lower price elasticity of demand, lower income earners end up paying a larger portion of their income than those who are better off financially. Such is the case with other “sin taxes” like the tax on alcohol. Some academics argue that since lower income earners are more responsive to price increases, cigarette taxes are not in fact regressive (Gruber 821). However, the fact of the matter is that those with lower incomes have higher rates of smoking (and drinking) than their counterparts. Therefore the tax remains regressive, with a larger portion of lower income earners spending a larger proportion of their income on cigarettes (and alcohol) than those with higher incomes. Meanwhile, the youth are the most responsive to changes in price, with a cited price elasticity of -0.79 (Chaloupka 195).

By increasing taxes on cigarettes the Canadian government is able to achieve its goals to reduce consumption and raise additional revenue; however, the resulting inflated prices also incentivize tobacco smuggling in the underground economy. The black market for cigarettes is estimated to be worth $1.5 billion dollars, costing federal and provincial governments over $2 billion in lost tax revenue (“Cigarette Smuggling”) and the Canadian government estimates that approximately 50% of cigarettes sold in Ontario are tax-free contraband (“Tobacco in Canada”).

Price elasticity of demand, as mentioned previously, is based on legal sales of cigarettes. As a result, while it is certain that legal sales of cigarettes have decreased, it is uncertain to what extent cigarette tax hikes directly reduce cigarette consumption, particularly when society’s attitudes towards smoking and anti-smoking educational campaigns are listed as variables. One study concludes that anywhere between 68 and 87 percent of the price elasticity of demand for cigarettes can be explained by smuggled consumption and that “changes in tax paid sales therefore significantly overstate the consumption effects of cigarette tax increases” (Stehr 290).

One graph (Appendix B1) shows the tax revenue collected by provinces between 1998 and 2009, with revenue peaking around the year 2005 and continuing on a downward trend. While a significant proportion of this decreased revenue is a result of less consumption due to cessation, it is more plausible that increased tobacco smuggling played a more significant role. Looking at the data provided by the National Study for the Canadian Tobacco Manufacturers’ Council (Appendix C1-C3) one could clearly see the rapid increases in smuggled cigarettes found in Canadian homes between 2006 and 2008.

Therefore, government policy to reduce demand for cigarettes and raise revenue through taxation is rendered ineffective to the extent at which smuggling is prevalent, and by increasing taxes it can be assumed that illegal cigarette trade will continue to increase unless otherwise addressed (Gabler 1).

Not only does black market revenue come at the expense of Canadian tax revenue, but it is also used to finance other illegal and criminal behavior. For example, in 2009 The Hell’s Angels Motorcycle Club was discovered smuggling contraband cigarettes and was implicated by Quebec officials for using proceeds to finance sales of firearms and narcotics. (Cherry, Paul) There is also evidence that some of the revenue from smuggled cigarettes is being used to help finance what the Canadian government classifies as terrorist organizations, such as the Lebanese militant and political group known as Hezbollah (White, Ed). This is certainly an ironic conflict of interest for the Canadian military, and an issue the government must address. Similar to how the prohibition of alcohol and drugs leads to increases in violence and other illegal activity, prohibitively high taxation also increases and finances illegal behavior.

The way in which cigarette tax revenue is spent is also vital to the role of reducing cigarette smoking in Canada. As stated previously, cigarette tax revenue is approximately $4 billion annually. $2.6 billion of revenue is spent on direct health care costs due to smoking-related diseases while $95 million (70 million of which is federal) of tax revenue is spent to prevent or reduce smoking through programs involving research, outreach, anti-smoking campaigns and educational awareness (“Tobacco in Canada.”). The remaining revenue is used to finance other governmental activities and programs.

While cigarette tax hikes certainly reduce consumption, again, how much of the reduction that can be attributed to the hikes is less clear. It is very plausible that social attitudes, advertising bans, and educational campaigns that raise awareness of cigarettes’ harmfulness are more effective than tax hikes, particularly when smuggling is taken into consideration. One survey conducted by Health Canada found that of 300 recent quitters, only 10% suggested they quit smoking due to the habit’s costs, and amongst the youth aged 15-19, less than 1%. According to Health Canada, “what this means is that the point price elasticity of participation may be a combination of a price component, approximately 10%, and other causes, 90%.” (Health Canada) Therefore, it should be argued that public funding for cessation and awareness programs ought to increase. The U.S. Centers for Disease Control recommends a minimum budget of US$5 per person in order to establish comprehensive public programs that are geared toward spreading awareness to reduce smoking. The Canadian government currently only spends US$1.50 per person (“Tobacco in Canada.”), so perhaps increasing funding for such programs will be more effective and have less negative consequences compared to cigarette tax hikes

Although the Canadian government makes large revenues from taxing consumers and the tobacco industry, over half of the provinces in Canada have filed multi-billion dollar lawsuits against big tobacco companies in order to regain health costs (“Quebec Tobacco”). These lawsuits are usually justified and supported by stating that tobacco companies “lie” by not being expressive regarding the health hazards of their products. Quebec for instance, is suing tobacco companies for $60 billion based on health costs incurred from 1970 until 2030 (for current smokers). Unless a tobacco company falsely advertises its product by stating that there are no health risks associated with smoking, then by definition it cannot be considered “lying”. Doing so would constitute it as fraudulent by violating the implicit contract between the company and the consumer. There is an important distinction between withholding information and lying, and, whether they ought to or not, companies are not legally obligated to share all of the information related to their product.

With that said, information about the negative and cancerous health effects of cigarettes has been public knowledge since the 1950s, with more information about the subject matter coming to public light each year. Health warnings have been on packages since 1994, and information about the health effects of cigarettes have been publicly available for decades. Even if a company markets its brand as “light”, independent researchers publish data available to the public that analyzes the effects of these types of cigarettes. Ultimately, this is a normative discussion of the responsibility of consumers with regards to their own well-being, and to what extent they are liable for their decisions. Whether provincial governments win their lawsuits to recoup healthcare costs, one way the federal government recoups these costs is through a “health surtax”, which taxes tobacco company profits in addition to the corporate income tax. While this is an effective way to raise revenue, it is possible that some of these taxes are passed onto consumers through higher cigarette pack prices, especially since cigarettes are inelastic goods.

In conclusion, with the evidence provided it can be seen that while tax hikes do correct the market failure, decrease the prevalence of smoking and increase government revenue, negative unintended consequences arise while there still remains uncertainty regarding their effectiveness. Besides the research mentioned in this paper, the majority of data does not reflect whether a decrease in consumption can be attributed to the tax hike or to people seeking cheaper contraband cigarettes. The inflated costs of cigarettes as a direct result of taxation have created unintended yet powerful incentives for people to buy and sell in an underground economy at the expense of business owners, while funding criminal and terrorist behavior that ultimately decreases the safety and welfare of Canadian society. Government revenue from cigarette taxes is decreasing, and an estimated $2 billion in potential tax revenue is lost due to the underground market. Therefore it is certain that something needs to be done to reduce the prevalence of a criminal black market, and to ensure that more efforts are made surrounding policies that directly lead to decreased smoking prevalence. By lowering the excise tax on cigarettes and shifting the sale of cigarettes to a legal market, the tax base can widen and consequently regain part of the $2 billion in revenue lost to the black market. With this added income, government can and should focus more money and resources into public cessation programs and public awareness campaigns that help shift societal attitudes in a more positive way, as recommended by health professionals, and ultimately reduce the negative externalities of cigarette smoking in Canadian society.

Appendix A1: Graph representing cigarette market without externality; Marginal Private Cost and Marginal Private Benefit

Works Cited

Patrick El-Hage

I'm Patrick El-Hage and I live and work in San Francisco. I like to hang on Twitter.