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.

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