Taxing Cigarettes: More than Revenue

The marked decline in cigarette smoking among almost all age groups has been accompanied by a rising tide of controversy and attention in the news media, with 1985 offering much material for feature articles. New and more direct warning labels now adorn all cigarette packs and printed advertisements. Segments of the medical profession call vigorously for stringent bans on cigarette ads. New data indicate that lung cancer is on the verge of surpassing breast cancer as a killer of women. Preliminary evidence suggests that "passive" cigarette smoking may be a risk factor in sudden infant death syndrome. And in December a major tobacco company survived a product-liability trial that could have had enormous consequences for the tobacco industry, with more trials all but certain.

Not the least of the news stories has been the continuing debate over the future of one of the major public cigarette policies—the federal excise tax on cigarettes. Since 1983 the federal cigarette tax rate has been $8.00 per thousand cigarettes, or sixteen cents per typical pack. Originally scheduled to revert on October 1, 1985, to the previous rate of eight cents per pack, the sixteen-cent rate has been extended; current tax proposals range from a reversion to the eight-cent rate to a doubling to thirty-two cents.

Much of the focus in the debate rightly has been on the revenue-generating capacity of the tax, which is considerable. The Tobacco Institute estimates that the federal cigarette excise tax grossed $4.75 billion in the fiscal year ending June 1984, with state and local cigarette taxes adding another $4.52 billion to the total.

Revenue enhancement obviously is an important consideration in federal tax policy in the 1980s, but public finance theory suggests a variety of other criteria on which tax legislation should be judged. Despite the impressive revenue figures, the overall importance of the federal cigarette tax may for eclipse revenue raising alone, and the wrangling over the tax has heightened public awareness of its role as a policy instrument.

Non-revenue effects

Many empirical studies by economists have shown that changes in the cigarette tax can elicit behavioral responses by smokers: increases in the price of cigarettes do result in decreased demand. Most studies have found that a 10 percent increase in price will effect between a 3 and 7 percent decrease in cigarette sales.

The magnitude of the response to changes in cigarette prices, or price elasticity in the economist's jargon, seems to be largest among teenagers and young adults. In other words, differentials in cigarette prices affect most those least likely to have become habituated to cigarettes. Because most adult smokers began smoking in their teens or early twenties, these findings suggest that the tax could be structured to reduce the number of young smokers or the amount they smoke—considerable gains toward Surgeon General Everett Koop's goal of a smoke-free society. In light of the extraordinary risks of major chronic and acute illnesses faced by smokers, such behavioral changes have significant implications for the health of the smoking population.

The cigarette tax thus is a potentially effective public health policy instrument. Yet one would have a hard time divining this interest from the record: it is stated neither in the intent of the tax legislation nor in much of the public discussion of the tax policy. Nevertheless, as suggested, the total or social valuation of the health effects from reduced smoking might far exceed the value of the revenues generated by the tax.

Calculating health benefits is a complicated task. Indeed, estimates vary widely of the monetary value of the savings in health care costs resulting from lower levels of acute morbidity and premature chronic morbidity and mortality. However, the magnitudes involved are large. One 1975 estimate was that $7.5 billion in health care costs and $18.2 billion in forgone earnings were attributable to cigarette-related health problems. Another study estimates that cigarette smokers report almost 50 percent more days lost from work due to all causes of illness than do individuals who never have smoked.

Other interesting tax policy considerations abound. For instance, given the mounting evidence on the harms associated with passive smoking, an increasingly strong case can be made for higher cigarette taxes on classic economic externality grounds. (An externality occurs whenever an activity undertaken by one or more parties imposes a cost or confers a benefit on another party that is not taken into account by the first one or more.) Thus, as a complement to or substitute for regulatory-based instruments such as restrictions on smoking in public places and private areas, like offices, factories, and commercial airlines, corrective action could internalize enduring externalities. When viewed this way, the federal tax on cigarettes serves yet a other socially valuable purpose—as an instrument to reconcile social costs and benefits.

Another consideration: cross-state sales of cigarettes, including illegal sales, or bootlegging, might be reduced by higher federal taxes on cigarettes. A higher, uniformly applied federal tax, other things being equal, would narrow differences among after-tax state cigarette prices and lower the incentives for cross-border purchases. Such activities consume socially valuable resources, and reducing their scale would be counted on the benefit side of the social accounting ledger.

Finally, because the demand for cigarettes is relatively insensitive to changes in price, increasing the tax would be roughly consistent with one of the criteria for efficient resource allocation: that having price-inelastic demands be taxed at relatively high rates.

Proposals to hike the cigarette tax to raise revenues are likely to run headlong into President Reagan's line-in-the-dust stance against tax increases of any sort. But why not a policy instrument to improve public health, or balance social costs and benefits, or cut bootlegging? The menu of cigarette-tax rationales presented here, while not exhaustive, strongly suggests that increasing federal taxes on cigarettes is a sensible public policy.