July 18, 2016

Are ‘Sin Taxes’ All Smoke and No Fire?

In teaching basic economic concepts, I always enjoy when we arrive at the lesson combining elasticity with taxes. It is an interesting topic, because it allows students to think about the true motivation for different laws, and excise taxes provide a rather simplified example to tie the two concepts together. As an example, I recently came across an article in the Denver Post which details a proposed constitutional amendment in Colorado to implement a pretty drastic increase in the per-pack cigarette tax in the state.

Before I address the article directly, I’ll provide a quick overview of the terms used above. Consider an excise tax to be a tax on a specific item, such as cigarettes, as opposed to a sales tax which would apply to most or all items you purchase. When thinking about elasticity of demand, think of it as measuring the percent increase or decrease in quantity demanded, when the price of that good changes by some percent. Basically, if a good that you want to buy gets more expensive, how much less of that good are you now willing to buy? This elasticity ranges from Perfectly Elastic (you won’t buy any quantity of the good anymore if the price goes up even a penny), to Perfectly Inelastic (you’ll keep buying the exact same amount of the good, no matter how much the price increases).
As you can see in the graphs above, if the price of cigarettes were to increase due to a tax, the quantity demanded would drop off precipitously if demand for cigarettes were very elastic, but would hardly change at all if the demand for cigarettes were very inelastic.

Thus, it is important for us to consider the ultimate goal of those proposing the increased tax. In the article, the proposed initiative is said to include an increase in the per-pack tax on cigarettes in Colorado from $0.84 to a whopping $2.59. It is argued that this would be done “in the hopes of persuading more people never to start smoking.” However, how easy is it really to get people to stop smoking, or never to start, by raising the price of a pack of smokes? This is where elasticity should examined. The article cites “research on consumer behavior” which “suggests as many as 35,000 kids could be kept from starting as smokers by the proposed tax increase.” However, a quick google search finds that estimates of the price elasticity of demand for cigarettes are consistently in the “inelastic” range, with absolute value between 0 and 1.  What this means is that, if the elasticity were -0.50, a 10% increase in the price of cigarettes would only result in a 5% reduction in the quantity of cigarettes demanded. Thus, an increase in the amount of the excise tax on cigarettes wouldn’t get many people to quit smoking, but it would increase tax revenues.  The article notes that the proposed tax is expected “to bring in $315 million in its first year.” If this is the true goal of the tax, the supporters should be clear about it.

The proponents of the amendment seem to be relying on two things in this scenario. The first is that they are focused on preventing children from beginning to smoke, rather than stopping current smokers. Perhaps children’s demand for cigarettes when they do not yet smoke is much more elastic than the other groups cited in the estimates above. Secondly, the money raised through the tax is, for the most part, going to be funneled in to programs aimed at helping people stop or never start smoking. Through these programs, the elasticity of demand for cigarettes could be changed over time. If people did stop smoking, less tax money would be collected, but less money would also be needed to fund programs to help people stop smoking.

A final point of consideration is to keep in mind that elasticities are really just estimating the slope of the Demand curve at one given point. They are great for obtaining an estimate of how steep the Demand curve is in close proximity to this point, and thus for estimating the elasticity of demand for small changes in prices. However, they are much less accurate for estimating how much quantity demanded will change due to extremely large changes in prices. As such, any estimates of a fairly large increase in prices (such as the 159% increase in the proposed amendment) must be taken with a grain of salt.

The point of this post is to keep in mind that when an excise tax increase is proposed, the desired result may be to substantially decrease consumption or to increase tax revenues, but it is difficult to accomplish both.

Home Prices in San Francisco… Decreasing???

In April, 2016, Business Insider published this article which had a headline that was sure to garner some attention from anyone who knows anything about the high cost of living in San Francisco. The article itself is a fairly incomprehensible amalgamation of quotes and data points, so I wanted to take some time to try to unravel its economic points here.

The main thrust of the article seizes on the observation that “house prices fell 1.8% year-on-year in March, the first such drop in four years.” The first takeaway from this is that it may be an indicator that the extremely hot San Francisco housing market is cooling down. To investigate whether this is the case, you should probably be asking yourself, what economic reasoning would produce this result. A decrease in prices could be the result of a decrease in Demand, an increase in Supply, or some combination of the two. I’ll examine the likelihood of either of these scenarios based on the information provided in the article, and then entertain a few other possibilities which should be explored.

A decrease in demand (whether due to people exiting the San Francisco housing market, a change in taste for San Francisco housing, or some other undisclosed reason) would, ceteris paribus, result in a lower quantity of housing demanded as well as a lower equilibrium price for the average unit.

This is a possible cause, and receives support from the quote in the article where the Chief Economist for Redfin talks about the reduction in listings which were subject to a bidding war. However, the article then immediately switches gears by implying that San Francisco has an “undersupply of housing coupled with a healthy demand.” If this is truly the case, then that “healthy demand” would be maintaining or even increasing the level of demand, leading to the opposite result in terms of price and quantity changes.

If Demand isn’t the main cause of lower prices, then surely it must be due to a change in Supply. More specifically, lower prices would be caused by an increase in Supply, which would also lead to an increase in quantity supplied.
Whether we consider this increase in supply to be newly built homes, or simply an increase in the number of homeowners who are considered in the market to potentially sell their homes, an increase in Supply would contribute to lower home prices. However, the article once again contradicts itself, noting that “there simply aren’t enough homes for sale…” and “many sellers are sitting this year out.” The quotes would suggest, if anything, a decrease in Supply, which would actually result in higher equilibrium prices.

So if we can’t be sure whether year-over-year decrease in housing prices is attributable to a change in Demand or Supply, how should we proceed? One option is to consider whether the market is truly in a long-run equilibrium state. It may be that the market is still adjusting to find the correct price for these homes, and therefore does not meet the assumptions used above. Another thing to note is that the data-point used to generate the article in question is simply that -- one data-point. In order to determine whether market forces are contributing to a true and sustained decline in home prices in this area one would want to examine many more data points and possibilities. Long-run trends in home prices and other contributory factors should be examined, to determine whether a slight decreases in one month compared to that same month one year before are truly indicative of a changing market. For instance, it could be that the homes that happened to be sold the previous year were larger and/or higher quality than those sold this year, which would lead to a lower average sales price, even if overall prices were still increasing. All in all, I’m not as confident as the author of the article is to conclude that “[h]omebuyers are so fed up with San Francisco’s crazy housing market that prices are now falling.”