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.