The Effect of Taxes on the Demand for Cigarettes

Aminadoki Tamuno-omie Holy 7691959

Professor Barry T. Coyle Department of Agribusiness & Agricultural Economics Faculty of Agricultural & Food Sciences University of Manitoba January 1, 2014

Due to the widely known harmful health effects of cigarettes, most governments have long placed higher taxes on them in order to discourage their production and consumption. The taxes are expected to increase the price of cigarettes which should in turn, following the basic economics law of demand, lower their quantities demanded. Thus, governments have often used cigarette taxes as part of a public health policy. Over the years, however, while most studies have proven that higher taxes on cigarettes decrease cigarette consumption, some of the studies have disputed this proof claiming that consumers of cigarettes are relatively less responsive to tax and price increases. This paper will look at a basic econometric analysis of the true impact of taxes on the consumption and output of cigarettes. Cigarette taxes are normally excise taxes which are inland taxes on the sale or production for sale of specific goods. Excise taxes are considered indirect taxes, meaning that the producers or sellers who pay the taxes to the government are expected to try to recover or shift the tax by raising the price paid by the buyer. Thus, although firms bear parts of the cigarette taxes as part of their cost of production, larger proportion of the taxes are borne by the consumers through the increased price of the cigarettes. These taxes are partly based on efficiency grounds - the idea that tobacco users should bear the full costs of their consumption, thus, the tax is a users' or consumer fee. However, the question here is: how would these consumer fees decrease the demand for cigarettes knowing that cigarette consumption is addictive? Economists use estimates of the price elasticity of demand to quantify the impact of a change in price on consumption. Elasticity refers to the degree of responsiveness in supply or demand in relation to changes in price. While a relatively wide range of estimates has been produced for the price elasticity of demand for cigarettes, most of the estimates from the USA and other high income countries tend to fall in the relatively narrow range from 0.25 to 0.50

(Chaloupka, et al., 2002). This implies that if cigarette prices rise by 10%, overall cigarette smoking will fall by between 2.5% and 5%. This elasticity is relatively inelastic compared to most normal goods which strictly follow the law of demand. Meanwhile, taxes on cigarettes have been thought to satisfy the Ramsey Rule that states that consumption taxes should be applied to goods with relatively inelastic demands so that welfare losses associated with taxation will be minimized (Charloupka, 1998). However, the long run response to a permanent change in cigarette prices will be larger than the initial response as some smokers have to gradually adjust to the new prices. Estimates from econometric models that account for the addictiveness of smoking imply that the long run impact of price on smoking is about double the short run impact. So tax policies that are meant to discourage smoking may be relatively ineffective in the shortrun compared to their impacts in the long-run. Most consumption taxes have, as a result, been permanent taxes so that they could affect the aggregate demand of the target good in the longrun. But the problem here is that the long-run cannot be precisely defined as it could range from 10 years to infinite years. So we cannot be certain of when a consumption tax on a cigarette can successfully decrease its aggregate demand. Therefore, taxes will increase the price of cigarettes both in the short-run and in the longrun but might not affect their quantities demanded in the short-run. As a result, some economists have focused more on the puzzle of trying to find out a method of determining the true effect of taxes on cigarette consumption in the short-run. In order to be able to provide a causal interpretation of the effect of taxes on cigarette consumption in the short-run, however, we might need to estimate the effect of the taxes on the prices first which will enable us to be able to determine the effect of the changed prices on the quantity demanded of cigarettes.

Estimation: Structural Model Now suppose that we want to estimate the impact of price and taxes on the quantity supplied and demand for cigarettes, one of many serious problems for such a study will be that other factors such as technological improvements, competition, consumer preferences, consumer expectations, income and many others may be lurking variables hiding in our disturbances. So the causal effect of Price and Taxes on the aggregate output of cigarettes cannot be inferred from simple correlation between the variables. Instead, we need to specify structural equations for the supply and demand for cigarettes and estimate the equations by appropriate instrumental variable (IV) method. Our supply and demand models with the taxes will be: Supply: Y = 0 + 1P + 2T1 + eS Demand: Y = 0 + 1P + 2T2 + eD Where: Y is output level P is price level 0 and 0 are intercepts for the supply and demand models respectively 1 and 1 are the coefficients for the price level in both models T is the tax on cigarettes eS and eD are the disturbances for the supply and demand models respectively

For the purpose of this study, let us assume that the cigarette market in our world is an imperfectly competitive market where the firms choose both the equilibrium price level and quantity with a downward sloping demand curve. So Y and P are endogenous and they both correlate with each other and with e in our model cov (p, e) 0, cov (y, e) 0 and cov (y, p) 0. However, as we have already established earlier in this paper, taxes affect the price level but may not affect the quantity demanded and supplied of cigarettes in the short-run since, for most smokers, the price elasticity of demand for cigarettes is significantly inelastic. So the correlation between P and T will be significantly high in our model (cov (p, t) 0) but there might not be a correlation between Y and T which will mean that the covariance of T and e will be equal to zero (cov (t, e) = 0). Now, since cov (p, e) 0, ordinary least squares (OLS) estimates of our supply and demand models will be biased and inconsistent. However, T can be an acceptable instrumental variable to estimate the impact of price and taxes on the demand and supply of cigarettes using two stage least squares (2SLS) method. It is note-worthy that, with good data, we can obtain estimates of the coefficients of P and T from 2SLS that are consistent. These estimates, assuming cross-sectional data with no heteroscedasticity and autocorrelation, will enable us to provide a meaningful casual interpretation of the impact of P and T on Y. For example, to get the 2SLS estimates of our demand model, we can transform our model into a reduced form, conduct ordinary least squares (OLS) on the reduced form, get an estimate of our endogenous explanatory variable (P), use the price estimate to get an estimate of Y and conduct OLS on this estimate to get 2SLS estimates of our coefficients that can be used for causal interpretation.

Implications of Cigarette Taxes Taxes on cigarettes have often been justified by studies and governments that claim to estimate the social costs of cigarettes which include both tangible and intangible costs. The tangible costs are the quantifiable costs related to identifiable sources such as hospital bills. The intangible costs include costs associated with pain, suffering, emotional distress, and loss of life when smokers are afflicted with health diseases. However, we can see that most of these costs are all personal costs, not social costs. They will be social costs if the estimates are based on the harmful effects of smoking on passive smokers or second-hand smokers. The prevalent studies have also failed to include economic benefits such as the contribution to government revenue through the taxes that tobacco firms pay to the government. According Tomlin, arguments based on harm to tobacco manufacturers or libertarian viewpoints focusing on individual freedom and economic benefits of these industries are often partially or completely discarded by politicians (Tomlin, 2009). This could suggest that these taxes, even though they are thought to be part of a public health policy, serve the selfish needs of governments to increase revenue. However, such selfish needs might be precarious to an economy as most of these tobacco firms provide large amounts of employment opportunities and could decide to shut-down or relocate to a different but favourable economy thus decreasing the aggregate employment level in the economy with higher tobacco taxes. Tax and price increases work even more effectively in reducing cigarette consumption among lower-income smokers. However, in the short-run, these taxes and higher prices contribute to a more unfavourable distribution of wealth towards smokers who are poor in the

economy as they will have to use more of their share of income to purchase cigarettes before adapting fully to the need of decreasing their consumption plans.

References Charloupka, F. 1998. How Effective Are Taxes in Reducing Tobacco Consumption? In the International Conference on the Social Cost of Smoking, Lausanne, Switzerland. Chaloupka F., et al. 2002. Tax, price and cigarette smoking: evidence from the tobacco documents and implications for tobacco company marketing strategies In Tobacco Control. Volume 11, Issue suppl 1 Jonathan, T. 2009. The Economic Impact of Smoking Bans In forbes URL: http://www.forbes.com/2009/06/04/economic-impact-bars-restaurants-opinionscontributors-smoking-ban.html Peterson D. et al., 1992. The Effect of State Cigarette Tax Increases on Cigarette Sales, 1955 to 1988 In American Journal of Public Health. Vol. 82, No. 1, pp. 94-96. Class Notes. Fall 2013. ECON 4120. University of Manitoba.