An Economic Assessment of Proposed Cigarette Excise Tax Hikes in the State of West Virginia

List of Contents

List of Figures

List of Tables

List of Abbreviations

A. Introduction

B. Problem Statement and Solution Structure

I. Determining the Efficient Cigarette Excise Tax Rate in West Virginia
I. 1. Introduction
I. 2. Cigarette Tax Rates in West Virginia as of 08/01/2002
I. 3. Definition and Differentiation of Economic Efficiency
I. 3.1. Introduction
I. 3.2. The Pareto-Efficient Criterion
I. 3.3. Economic Efficiency and Social Welfare
I. 4. Market Failures in the Cigarette Market and Public Policy Response
I. 4.1. Introduction
I. 4.2. Externalities
I. 4.2.1. Description
I. 4.2.2. Public Policy Response
I. 4.3. Incorrect Risk Perception
I. 4.3.1. Description
I. 4.3.2. Public Policy Response
I. 4.4. Addictive Behavior
I. 4.4.1. Introduction
I. 4.4.2. Definition of Addiction in the Realms of Economics
I. 4.4.3. Brief Review of Addictive Behavior Modeling
I. 4.4.4. Rational Addiction Model by Becker and Murphy
I. 4.4.5. Time-Inconsistent Addictive Behavior by Gruber and Koszegi
I. 4.4.6. Conclusion
I. 4.5. Conclusion
I. 5. Efficient Cigarette Excise Tax Rate based on the Rational Addiction Model by Becker and Murphy
I. 5.1. Introduction
I. 5.2. Cost Classification
I. 5.3. Criteria for Social Cost-of-Smoking Studies
I. 5.4. Procedure of the Manning Study
I. 5.5. Assumptions for Manning Study Transferability to West Virginia
I. 5.6. Identifying and Valuing External Costs
I. 5.6.1. Introduction
I. 5.6.2. Medical Costs
I. 5.6.3. Retirement Pension and Disability
I. 5.6.4. Sick Leave
I. 5.6.5. Group Life Insurance
I. 5.6.6. Nursing Home
I. 5.6.7. Taxes on Earnings
I. 5.6.8. Fires
I. 5.6.9. Environmental Tobacco Smoke (ETS)
I. 5.6.10. Pain and Suffering
I. 5.7. Identifying and Valuing Internal Costs due to Incorrect Risk Perception
I. 5.8. Summary and Discussion of Taxable Costs
I. 5.9. Translating Taxable Costs into the Efficient Cigarette Excise Tax Rate
I. 5.9.1. Introduction
I. 5.9.2. Perfectly Elastic Supply Curve
I. 5.9.3. Cost Structure of Taxable Costs of Smoking
I. 5.9.4. Conclusion
I. 5.10. Conclusion
I. 6. Efficient Cigarette Excise Tax Rate Based on the Approach of Time-Inconsistent Addictive Behavior by Gruber and Koszegi
I. 6.1. Introduction
I. 6.2. Taxing Market Failure due to Addictive Behavior
I. 6.3. Conclusion
I. 7. Proposed Excise Tax Hike in West Virginia

II. Potential Effects of Proposed Cigarette Excise Tax Hikes on Resident Cigarette Consumption and Cigarette Tax Revenues in West Virginia
II. 1. Introduction
II. 2. Cross-Border Activities
II. 2.1. Introduction
II. 2.2. Casual Cigarette Smuggling
II. 2.3. Organized Cigarette Smuggling
II. 2.4. Effects of Cross-Border Activities
II. 2.5. Historical Overview of Cross-Border Activities in the U.S
II. 3. A Model of Cigarette Demand in West Virginia
II. 3.1. Introduction
II. 3.2. Developing the Model
II. 3.3. Results of Regression
II. 4. Potential Effects of Proposed Tax Hikes on Cigarette Consumption of West Virginia Residents
II. 5. Potential Effects of Proposed Tax Hikes on State Cigarette Excise Tax Revenues

C. Conclusion and Outlook

References XI

Appendices

Appendix 1: Map: Overview of West Virginia borders

Appendix 2: Map West Virginia: Bootlegging from West Virginia into border states, assignment of bootlegging counties to border states

Appendix 3: Map Kentucky: Bootlegging from Kentucky into West Virginia, assignment of bootlegging counties to West Virginia (does not apply in any year 1970-2000)

Appendix 4: Map Maryland: Bootlegging from Maryland into West Virginia, assignment of bootlegging counties to West Virginia

Appendix 5: Map Ohio: Bootlegging from Ohio into West Virginia, assignment of bootlegging counties to West Virginia

Appendix 6: Map Pennsylvania: Bootlegging from Pennsylvania into West Virginia, assignment of bootlegging counties to West Virginia

Appendix 7: Map Virginia: Bootlegging from Virginia into West Virginia, assignment of bootlegging counties to West Virginia

Appendix 8: An example: Calculation of bootlegging variables for 1970

Appendix 9: Time series data for West Virginia 1970-2000

Appendix 10: Correlation matrix for regression results

Appendix 11: Analysis of stability of results

List of Figures

Figure 1: The Pareto-efficient criterion

Figure 2: Competitive market involving net external costs in consumption

Figure 3: Effect of the tax estimation method of the Manning study when marginal taxable costs of smoking are non-constant

Figure 4: Real price differentials between West Virginia and its border states from 1970-2001

Figure 5: Incentive to smuggle into West Virginia from 1970-2002

List of Tables

Table 1: Taxable costs of cigarette consumption per pack for various discount rates

Table 2: Results of regression

Table 3: Calculation of the price elasticity of demand for the year 2000

Table 4: Calculation of the price increase due to proposed excise tax hikes for the year 2000

Table 5: Calculation of potential West Virginia resident consumption change and in-state cigarette sales change for the year 2000

Table 6: Calculation of potential cigarette tax revenue change for the year 2000..…...63

List of Abbreviations

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Mathematical symbols and variables:

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A. Introduction

Tobacco has been the target of treasuries for many centuries. At the latest, after the use of tobacco had spread through all social classes and become a common pleasure of human kind, tax jurisdictions realized the potential of tobacco products for the generation of revenues. As early as in the 18th century, Adam Smith noticed: ”Sugar, rum, and tobacco are commodities which are nowhere necessaries of life, which are become objects of almost universal consumption, and which are therefore extremely proper subjects of taxation”.^[1]

The twentieth century brought about a tremendous acceleration of tobacco use, largely due to the invention and commercialization of the cigarette. Over the past decades, as the health consequences of tobacco use were discovered, the discussion about the proper taxation of cigarettes intensified. Two major groups have dominated the political process of cigarette tax legislation: The health community and the tobacco industry lobbyists.

The discussion has recently become evident in West Virginia. As the U.S. is undergoing a recession, the State of West Virginia has repeatedly looked for ways to improve its budgetary situation. In order to raise additional funds, legislators are contemplating to increase the state cigarette excise tax, which has remained unchanged since 1978. The state government has to deal with arguments from both lobby sides.

The health community is pushing legislators to raise cigarette taxes in order to reduce smoking and promote the health among citizens. 26% of all adults, 3.5% more than in the national average, and 39% of all high school students smoked in West Virginia in 2000. 4,240 of the roughly 380,000 smokers died annually between 1995 and 1999 due to smoking related illnesses. Thus, more than one-fifth of the approximately 21,000 annual deaths in the state were linked to smoking.^[2] The health community pursues the goal of a smoke-free society based on the belief that cigarette smoking does not provide any value to individuals. However, health advocates have recognized the need for employment of economic arguments in order to gain the attention of decision-makers. The major arguments they put forward to raising cigarette taxes are that smokers impose costs on the society through excessive use of the health care system, that second hand smoke threatens the health of non-smokers, and that young smokers are unaware of the full risks of smoking. Therefore, they demand higher cigarette taxes to deter youth smoking and make smokers compensate the society for the costs they impose on the public. In fact, roughly $670 million in health care costs in West Virginia were attributed to smoking in 2001.^[3]

On the other hand, the tobacco industry has traditionally promoted low cigarette taxes in order to keep cigarette prices down and stimulate consumption. Tobacco planting and manufacturing is a minor economic factor in West Virginia, being only 0.1% of gross state product.^[4] Therefore, lobbyists rely on arguments concerning the demand side of the cigarette market. One of its testable arguments against a tax hike in West Virginia is that the cigarette tax in place is sufficient to compensate for the excess health care costs of smokers. Furthermore, they argue that higher taxes disturb the free market mechanism by depriving consumers of making free consumption decisions.

The strongest argument against a tax hike in West Virginia they put forward is that growing tax differentials between states would promote cigarette smuggling and eventually decrease tax revenues from cigarettes. In fact, the concern is not dismissible without careful examination when considering West Virginia’s geographic proximity to the main tobacco-producing region in the U.S. West Virginia’s border states Kentucky and Virginia, and the nearby North Carolina usually levy the lowest cigarette excise tax rates in the nation, currently being 3, 2.5, and 5 cents per pack. A tax hike on top of West Virginia’s current 17 cents per pack may promote tax evasion and thus counteract the fund-raising efforts of the West Virginia Government.

B. Problem Statement and Solution Structure

The purpose of this study is to provide a scientific framework for the appropriate taxation of cigarettes in West Virginia and to aid the legislative decision making process.

Legislators wish to increase the tax rate but need to support their decision with economic arguments. Part I examines whether a cigarette excise tax hike can be justified by determining the optimal tax rate based on economic efficiency theory. The study particularly stresses the importance of the different approaches towards viewing smoking in the context of addictive behavior and contrasts their fundamentally different impact on the optimal taxation of cigarettes. The study also explains the tight connection between economic efficiency and social welfare in order to illustrate the relevance of a proper tax rate for the well being of the society as a whole.

Second, legislators need to know how consumption, sales, and cigarette tax revenues are going to be affected by a tax hike that raises the cigarette tax to the optimal level. Part II assesses those effects by developing an econometric model of cigarette demand in West Virginia. Special focus in this assessment is placed on the fact that a tax hike leads to substantial tax differentials between West Virginia and three of its tobacco-producing border states. The model accounts for the incentive of tax evasion and allows for the judgment whether or not West Virginia is likely to face a large smuggling problem. Evaluated in conjunction with the results from Part I, the conclusion leads to the recommendation of the range for a cigarette excise tax rate in West Virginia.

I. Determining the Efficient Cigarette Excise Tax Rate in West Virginia

I. 1. Introduction

Part I of the study provides the scientific framework for the determination of an optimal tax rate on economic efficiency grounds. First, the condition that characterizes an efficient economic state is explained in theory and its relevance for the welfare of a society is discussed. Further, with respect to cigarette consumption, the economic justifications for the taxation of cigarettes is extensively examined, embedding particularly the addictive nature of cigarette smoking in the economic analysis. Finally, the procedure of estimating the optimal cigarette tax rate is presented and comprehensively discussed, which finally leads to the recommended tax rate and tax hike on economic efficiency grounds.

I. 2. Cigarette Tax Rates in West Virginia as of 08/01/2002

In West Virginia, cigarettes are subject to federal excise tax, state excise tax, and state general sales tax. The cigarette excise tax is a fixed amount per pack of 20 cigarettes. Currently, the Federal Government charges a cigarette excise tax of 39 cents. The state excise tax is currently 17 cents.^[5] Both taxes are charged when the manufacturers sell their cigarettes to wholesalers or large retailers. Cigarette excise taxes are included in the general sales tax base. General sales taxes are charged as ad valorem, that is, as a constant fraction of the wholesale or retail price. The State of West Virginia charges a rate of 6% on top of the retail price. In the sum, the cigarette-specific tax on every pack of cigarettes sold in West Virginia is 56 Cents per pack, exclusive the general sales tax. The purpose of this part of the study is to determine whether these 56 Cents per pack constitute an economic efficient tax or whether they are too high or too low.

I. 3. Definition and Differentiation of Economic Efficiency

I. 3.1. Introduction

This section presents and discusses the definition of and condition that characterizes an economic efficient state and discusses the relevance of economic efficiency for social welfare.

I. 3.2. The Pareto-Efficient Criterion

In Neoclassical Economic Theory, economic efficiency, also termed allocative efficiency, describes the economic state in which the available resources of a society are allocated in a way that maximizes society’s welfare. The market is considered efficient, or “Pareto-efficient”, when no one can be made better off without making someone else worse off. In a Pareto-efficient condition, none of the economic agents can increase his utility through further trade, thus supply equals demand. The terms Pareto-efficiency, allocative efficiency and economic efficiency are used synonymously here. The condition that is assumed to meet the Pareto-efficient criterion is perfect competition among the economic agents.^[6]

Perfect competition is characterized by the pursuit of every individual’s self-interest that in its aggregation ultimately leads to economic efficiency. An essential underlying assumption in Neoclassical Economic Theory is that economic agents are acting fully rationally, which requires them to possess adequate knowledge on which to base economic decisions and to rationally use this knowledge.^[7]

The analysis of economic efficiency starts out with the individual preferences of the economic agents. Consumers strive to maximize their individual utility derived from consuming goods and services. The additional utility per consumed unit decreases with increasing quantity. The aggregate demand curve, which is the sum of individual demand curves, slopes downward. On the other side of the market, producers act in the same way. Individual firms attempt to maximize profits. In a competitive industry, the aggregate supply curve is flat when inputs are homogenous or slopes upward when inputs differ in quality. As the economic agents interact in a competitive market, the demand and supply curves intersect where demand equals supply. The market is said to be in exchange equilibrium.^[8]

The price is assigned the central role in this allocation process. Prices reflect the preferences of the economic agents. Demand perfectly reflects consumer preferences and supply perfectly reflects costs. Prices affect the input and output decisions of firms as well as they guide the decisions of consumers what and how much to consume. Producers maximize profits by setting price equal to marginal cost, and consumers maximize utility by purchasing goods to the point where marginal utility is equal to price. In a Pareto-efficient condition, prices accurately reflect scarcity conditions. Marginal utility of income between individuals is equalized. For the entire economy holds that the social benefit from consuming an additional unit, the marginal social benefit, equals the additional social cost associated with producing the last unit, the marginal social cost. If this were not to hold, society’s utility could be improved by changing output and thus moving further to the Pareto-efficient point. The essential marginal condition for the Pareto-efficient state can be formulated as:

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I. 3.3. Economic Efficiency and Social Welfare

Although not undisputed in relevant economic theory, a major mission of government should be to foster the social welfare of its citizens. The previous section explained the Pareto-efficient point as a static economic condition at which social welfare is maximized. This section presents how social welfare is affected by policy measures that are designed to improve economic efficiency. As will be shown, for social welfare maximization, the improvement of economic efficiency is a necessary but not sufficient process.

As explained beforehand, a Pareto-efficient economic state is reached when no individual can be made better off without making someone else worse off. The resources available to society are then allocated most efficiently and society’s welfare is maximized. Social welfare is the sum of all individual utilities in a society. Exchanges between individuals are always improvements in economic efficiency and social welfare because no individual would agree to act when it were to his disadvantage.

However, the case is more ambiguous when exchanges involve government activity. When it comes to judging the desirability of government action, it is straightforward to judge the effect of a policy that increases economic efficiency while improving the utility of some individuals without changing that of others. For this case the Pareto-efficient criterion provides an unambiguous guideline. Every move that increases the utility of at least one economic agent without lowering that of any other is an improvement in economic efficiency and social welfare. Those transactions are termed Pareto-efficient exchanges.^[9]

Figure 1 translates the Pareto-efficient criterion into graphic terms. For simplicity it is assumed that the economy consists of only 2 individuals, X and Y. The dotted lines depict utility curves for various combinations of utility distributions between agent X and agent Y. Starting from point a, clearly every policy that improves economic efficiency and that moves the economic agents to points b, c, or d, or any point to the right and/or above of a is also an improvement in social welfare. Therefore, there is no ambiguity about the desirability of such public policy.

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Figure 1: The Pareto-efficient criterion^[10]

However, in most cases public policy involves favorable effects on some individuals and unfavorable effects on others. Public policy usually entails the redistribution of income among various groups within society, which leads to the redistribution of welfare. For example, the tax on a commodity designed to improve economic efficiency, lowers the income of individuals who consume this good and therefore lowers their utility while improving the situation of those who receive transfer payments financed by the tax revenues. A move from point a to point e in Figure 1 corresponds to such an example. This move would improve social welfare if Y’s gain exceeds X’s loss in utility. The problem consists of objectively measuring how much utility X looses and how much Y gains as a result of the policy. X and Y could value their respective change in utility by assigning a price in monetary terms. According to the so-called “Kaldor Criterion”, the move would be an improvement in social welfare if Y could potentially compensate X and still be better off. However, since the Kaldor Criterion does not require the compensation actually be undertaken, the comparison of monetary values implies that the utility of income, which is the utility derived from one dollar, is the same for all individuals independent of their income.^[11]

An often-cited example that explains the problem in this context features a policy that transfers a small amount of money from a rich to a poor person. Assuming equal marginal utility of income across income groups, one will argue that the amount will provide the poor person with more additional utility than the rich person looses. Hence, the policy will be regarded as desirable. However, the statement cannot be proved. As income changes, preferences change too and may alter the marginal utility of income. Therefore, modern economists largely disagree with the premise of equal marginal utility of income.^[12]

Consequently, the comparison of the prices in money terms assigned to personal utility changes does not allow for an objective interpersonal comparison of utility. The only way to ensure that a policy that entails such a move from point A to point E actually leads to an increase in welfare is to really compensate X for his loss by paying him from Y’s gain.

In fact, those compensation payments are usually not undertaken. Any policy undertaken that involves making some individuals better off while making others worse off without compensation payments implicates an interpersonal comparison of utility based on some form of ethical judgment. Those ethical judgments are frequently made in the realms of politics. Economists are no better suited than anyone else to make those kinds of judgments. Decisions on cigarette taxation involve making ethical judgments about the welfare redistribution from smokers to those who receive funds from the cigarette tax revenues. Since it would exceed the scope of this research to comprehensively discuss this part of the implementation of a proposed cigarette tax, the focus lies on the determination of the cigarette tax with allocative efficiency being the only criterion. It is implicitly assumed that subsequent measures are taken, e.g. compensation payments to smokers, so that it is ascertained that overall social welfare in fact increases. Therefore, for purposes of this study, any improvement in allocative efficiency is assumed to increase social welfare.

I. 4. Market Failures in the Cigarette Market and Public Policy Response

I. 4.1. Introduction

As has been shown, a perfectly competitive market leads to the efficient allocation of resources in an economy and social welfare is maximized. However, often, markets are less than perfect and fail to allocate resources efficiently because market failures are present. Three types of market failure can occur with respect to cigarette consumption:^[13] (1) Market failure due to externalities, (2) market failure due to incorrect risk perception, and (3) market failure due to addictive behavior. The first two market failures may commonly apply to the consumption of any commodity. The third market failure may only apply to the consumption of addictive goods, which includes cigarettes.

When market failures are present, and the detrimental effects on social welfare are considerable, it might be the proper role for government to intervene and bring consumption closer and ideally exactly to the Pareto-efficient level. One, but important policy tool available to government is selective tax. Generally, economic theory suggests that selective excise taxes are not desirable because they distort individual consumption choices among goods and services in the market and prevent so the efficient allocation of resources. However, if market failures exist, the case is reversed. Selective excise taxes may then be the appropriate policy measure to actually achieve allocative efficiency.^[14]

This section describes in detail the types of market failure that may occur in the cigarette market and explains in theory, how excise taxes can be used to correct those market failures.

I. 4.2. Externalities

I. 4.2.1. Description

The presence of externalities is one reason why the state of resource allocation may not be Pareto-efficient and therefore cannot maximize social welfare. Externalities, often termed spillovers, are social costs (external costs) or social benefits (external benefits or negative external costs) that a transaction imposes on economic agents outside the market. Outside the market are considered social costs (social benefits) that transacting parties impose on others without being charged (compensated) for. External costs (external benefits) have a negative (positive) impact on the utility of agents outside the market. A transaction may create external costs as well as external benefits, the sum of which yields net externalities. Net external costs (net external benefits or negative net external costs) reduce (increase) social welfare. External effects can be created by the production process as well as by consumption.^[15]

In line with procedures for cigarette tax determination in the relevant literature, the focus here lies on the demand side of the cigarette market. A brief discussion on the tobacco manufacturing industry structure is provided in section I.5.9 in order to explain the influence of cigarette taxes on cigarette prices. Otherwise, it is assumed that no substantial production externalities exist. Particularly, existing environmental and labor legislations are assumed to eliminate or prevent environmental damage from pollution and adverse effects on human health that are not accounted for in workers’ wages. However, cigarette smoking is related to imposing costs on others, e.g. through smokers’ excess use of the health care system and through the adverse effects of second hand smoke.

Externalities lead to market failure in the sense that the market price fails to accurately reflect the true cost of consumption to society. The true cost to society is the sum of private cost and net external cost.^[16] Private costs, also termed internal costs, are entirely borne by the consumer. In general, marginal private cost equals marginal social cost only if the entire costs associated with a transaction are internal to the consumer. As long as this is the case, the market is efficient, assuming the absence of other market failures. However, in the presence of externalities, marginal private cost does not equal marginal social cost and consumers will make consumption decisions that are socially inefficient.

In the context of cigarette consumption, the bulk of the private costs consist of the purchasing price of cigarettes and the discomfort from adverse health effects and risk of premature death from smoking related diseases. However, the costs that result from the effects of second hand smoke, for example, represent external costs to smokers. Since the price for cigarettes does not account for the costs that smokers impose on others, marginal private cost is less than marginal social cost and smokers will smoke more than the efficient quantity. When consumption differs from the Pareto-efficient quantity, social welfare cannot be maximized. The difference between the Pareto-efficient level of consumption and the actual consumption under market failure leads to a loss in social welfare, the so-called deadweight loss.

Figure 2 illustrates a common example of a competitive market involving net external costs in consumption. The net external cost curve is assumed to increase in a nonlinear fashion, which leads to the marginal net external cost curve increasing with the first derivative of the net external cost curve, hence being non-constant. The supply side is depicted as constant-cost industry.

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Figure 2: Competitive market involving net external costs in consumption^[17]

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The example shows the competitive outcome at point c where marginal private benefit (MPB) of consumption equals marginal private cost (MPC) of production. The created marginal net external costs (MNEC) are not taken into account, and consumers receive benefits from consumption that are actually higher than those to the entire society (MSB). The result is a quantity consumed (Qc) that exceeds the Pareto-efficient level (Q*) and does not maximize social welfare.

In contrast, when the marginal net external costs (MNEC) are taken into account by consumers, their marginal private benefits (MPB) are reduced by exactly the amount of the marginal net external costs. The demand curve shifts accordingly down and marginal private benefits equal marginal social benefits (MSB). The level of consumption is reduced to the Pareto-efficient level and social welfare is maximized. Comparing both consumption levels, the competitive outcome leads to a loss in social welfare, the deadweight loss. This can be derived from the graphic as follows.

The welfare assessment for the Pareto-efficient consumption (Q*) is:^[18]

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The welfare assessment for the competitive consumption (Qc) is:

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The comparison between the welfare maximum (Pab) and the amount of welfare under conditions that do not account for externalities (Pad-dcb) yields the deadweight loss (DWL) equivalent to the hatched triangle (dcb).

The fact that an economic inefficient situation due to the presence of externalities does not lead to a social optimal solution can be also intuitively comprehended. Transactions that involve external benefits and lead to an increase in welfare are below the socially optimal level. This is because the external benefits are not included in the price, which leads to the transacting agent not be rewarded appropriately. Therefore, he will not be willing to increase his activity to the Pareto-efficient level. As a result, social welfare is lower than optimal. On the other hand, transactions that involve negative external costs and lead to a decrease in social welfare are above the socially desirable level. Since the price does not reflect the costs imposed on those outside the transaction, the agent is not charged according to the true social costs. Hence, he will consume more than the Pareto-efficient level and social welfare is lower than optimal.

I. 4.2.2. Public Policy Response

When externalities exist, individuals whose consumption creates externalities and those who bear them can engage in a bargaining process and reach a solution on their own. However, often those bargaining processes are associated with high transaction costs, and government might be better suited to facilitate the internalization of externalities.

Internalizing an externality means changing the incentives of the parties involved so that they now act as if there is a market for the external cost or benefit.^[19] Pigou (1962)^[20] provides the theoretical framework for the taxation of goods with market prices not fully reflecting the social costs associated with their production and consumption. If consumption creates externalities, economic efficiency can be improved by taxes that raise consumers’ marginal cost closer to the level of the social marginal cost. Ideally, the taxes equalize private costs with social costs.

In case the consumption is below the Pareto-efficient level because of external benefits, the government may subsidize the product in order to encourage consumption. A subsidy represents a negative tax. If net external costs exist that lead to consumption levels higher than economically efficient, the government may impose taxes on the good in order to reduce consumption to the Pareto-efficient level. In both cases the intervention’s purpose is to equalize private costs with social costs.^[21] Concerning the consumption of cigarettes, an excise tax must raise the price for cigarettes to the level so that the costs imposed by smokers on others, e.g. through environmental tobacco smoke, are incorporated in the price.

In general, the government must levy a tax on the good so that the price of the last unit consumed is equal to its net marginal social cost. At this point consumption is Pareto-efficient and social welfare is maximized.^[22] The efficient marginal tax, the tax per unit, is tied to the shape of the marginal net external cost curve. That is, the efficient marginal tax is equal to marginal net external cost. This requires a tax system that perfectly discriminates against consumers according to their consumption level. The case is straightforward, when net externalities increase in a liner fashion. Then, marginal net externality is constant, and the tax per unit is also constant and simply equals the constant net external cost per unit.

The case is more complex when net externalities increase in a non-linear fashion. Then, marginal net external cost is non-constant, as depicted in Figure 2. In this case, the efficient tax per unit is supposed to change with changing consumption. However, for the taxation of commodities, the implementation of such a tax system is not feasible. Rather, the tax per unit must be uniform over the entire consumption range. The relevance of this issue for the efficient taxation of cigarettes is discussed in I.5.9.3.

In order to improve allocative efficiency it is irrelevant whether the tax is imposed on the consumer or the producer. It is merely essential that the price reflect the true social costs of the good, which includes the externalities created by its consumption. The burden of the tax can be partly shifted to the other side. The ratio between the elasticity of supply and the elasticity of demand determines the tax incidence, that is, which shares of the tax burden consumers and producers each carry. In general, it holds that the lower the market side’s elasticity is, the higher that side’s burden. Considering the example of a constant cost industry with perfectly elastic supply and a non-perfectly elastic demand as depicted in Figure 2, the tax burden would be shifted entirely to the consumer.^[23]

It should be mentioned that taxes can be levied in form of lump sum payments. Also, other forms of regulation, e.g. output restrictions, aim at the same goal of remedying inefficiencies. However, for the purpose of this research, excise taxes as a form of regulatory measure are taken as a mandate set by politics.

I. 4.3. Incorrect Risk Perception

I. 4.3.1. Description

As has been said above, an essential feature of a perfectly competitive market is the assumption that economic agents act in a fully rational way. Rational economic behavior requires both the existence of adequate knowledge on which to base consumption decisions and rational use of the knowledge. If smokers are not fully informed about the health risks they incur by smoking they are not aware of the entire internal costs to themselves. Or in other words, they estimate the personal benefits from smoking as too high. As a consequence, they consume more than the Pareto-efficient quantity, which they would consume if they possessed full information.

Contrary, individuals may underestimate the true inherent benefits or overestimate the harm from consuming a product. In this case, they may consume less than the Pareto-efficient quantity because they have a wrong understanding of the value that the product provides to them. Whereas it can be assumed that marketing efforts of firms prevent this phenomenon from occurring, the former case is more prevalent because firms may take little interest in providing information to consumers about adverse effects of their products.

I. 4.3.2. Public Policy Response

When economic agents cannot make rational decisions due to incorrect risk perceptions, the proper role of government is to close the information gap. Through information campaigns, government supports consumers in drawing an accurate picture of the good at question and the effects of its consumption. Consumers subsequently adjust their consumption decisions and consumption moves towards the Pareto-efficient level. In the cigarette market, the government and health organizations have taken the role of informing consumers about the harm smoking can cause to them. Since it is not the purpose of this study to design new information policies, only taxation as a regulatory tool is considered while regarding the current level of information as constant.

A tax on consumption is levied with the goal of signaling the costs or benefits associated with the consumption of the commodity that have not been recognized by consumers. A tax created to remedy incomplete information regarding inherent costs of consumption ideally moves the consumption to that quantity consumers would consume if they had complete information. Parallel to the taxation of externalities, the optimal marginal tax rate should equal the marginal net internal cost of the information problem. Regarding the cigarette market, taxes may contribute to economic efficiency when individuals smoke too much because they underestimate the adverse health effects from smoking.

I. 4.4. Addictive Behavior

I. 4.4.1. Introduction

The third cause of market failure that may apply to cigarette consumption is addictive behavior. Addictive behavior may hinder smokers from taking rational decisions. Crucial for judging whether addictive behavior prevents consumers from making rational choices is the way of modeling addictive behavior in the realms of economic decision-making. This section first defines addictive behavior from an economic perspective. A brief review of the modeling of addictive behavior is presented. The major part deals with the introduction and discussion of two approaches towards the modeling of addictive behavior and applies their implications to the concept of market failure.

The two approaches are (1) the Rational Addiction Model as developed by Becker and Murphy (1988)^[24] and (2) time-inconsistent addictive behavior as developed by Gruber and Koszegi (2001, 2002). Both models take different stances towards viewing the rationality of smoking decisions and thus imply fundamentally different answers to the question whether addiction constitutes market failure.

I. 4.4.2. Definition of Addiction in the Realms of Economics

Addiction is characterized by the tendency that past consumption raises present consumption because past use of the substance raises the marginal utility of present consumption. Cigarettes contain the addictive substance nicotine. To an addicted smoker, one of the benefits of continued smoking is to prevent nicotine withdrawal. Therefore, past consumption tends to encourage current use. This reinforcement property of an addictive good is reflected in the definition of addiction in economic terms. Economic analyses of addictive behavior define the consumption of a certain good as addiction if an increase in past consumption of the good leads to an increase in current consumption.^[25]

I. 4.4.3. Brief Review of Addictive Behavior Modeling

Until the mid 1980s, economic theory mostly modeled addiction as habit formation. Addicted consumers were viewed as being myopic. It was assumed that past consumption increases present consumption but that addicts ignore the effects of current consumption on future utility when determining the utility-maximizing quantity of the addictive good in the present. A main feature of this view was the assumption that consumption of addictive goods would be entirely unresponsive to price changes. Thus, addictive behavior was viewed as irrational and did not fit in the context of standard economics with fully rationally acting economic agents.^[26]

This view changed with the work of Becker and Murphy. Their approach modeled addiction in the context of rational behavior and became standard among economists. Most recently, attempts have been made to model addiction as time-inconsistent behavior. This approach follows the model of Becker and Murphy to a large extent. However, it embeds a different key assumption, which subsequently leads to different conclusions with regards to the optimal taxation of cigarette smoking.^[27]

I. 4.4.4. Rational Addiction Model by Becker and Murphy

The Rational Addiction Model by Becker and Murphy builds on the presumption that the act of smoking builds an addictive stock. An increase in consumption today increases the addictive stock in the future. A high addictive stock lowers the average utility of smokers in the future because smoking is harmful. However, a higher addictive stock also increases the marginal utility of the addict from smoking. That is, the higher the addictive stock, the more the addict craves for another cigarette. The key aspect of any addiction model is how addicts deal with this intertemporal problem.^[28]

The Rational Addiction Model by Becker and Murphy encounters this intertemporal problem by making two key assumptions: addicts are (1) forward-looking and (2) time-consistent.

Addicts are forward-looking because the model assumes that the amount consumed at present is dependent not only on the past but also on the future consumption level.^[29] As forward-looking economic agents they trade off the utility gains from smoking against the costs of doing so. Smokers derive utility from pleasure, status within their social group, etc. Costs that smokers take into account are the monetary price of cigarettes, current damage that they are doing to themselves through smoking, and the additional future damage caused by ongoing future consumption.

Rational addicts discount future utility and costs exponentially and therefore have time-consistent preferences. Their relative preference for well-being at an earlier date over a later date is assumed to be the same for any point in time. They discount all periods forward by the factor Abbildung in dieser Leseprobe nicht enthalten, where Abbildung in dieser Leseprobe nicht enthalten is the per-period time discount factor and Abbildung in dieser Leseprobe nicht enthalten is the number of years.^[30] Discounting future utility and costs exponentially, addicts arrive at either a positive or a negative net utility from smoking and accordingly make a rational decision to smoke or not to smoke. Thus, consumption of addictive goods is governed by the same rational decision-making process as is consumption of all other goods.^[31] The rational addiction model by Becker and Murphy assumes that smokers are fully aware of the potential to become addicted when they make their smoking decisions.

Therefore, it can be concluded that addiction per se does not constitute market failure and the costs smokers impose on themselves are irrelevant for taxation, unless they are rooted in misperceptions regarding the harmfulness of smoking as outlined in I.4.3.

The standard of the Rational Addiction Model by Becker and Murphy has been reinforced by sizeable empirical literature, which has generally supported the key normative implication of the model: Addicts are forward-looking. Present consumption of addictive goods does not only depend on past consumption but also on future consumption. Moreover, it has been confirmed that higher prices in the future lower current consumption, as would be expected with forward-looking addicts.^[32]

The model has been criticized for two main reasons. First, the perfect foresight of consumers, in particular in their early stages of cigarette consumption, may not be granted. Since each individual possesses a subjective understanding of his potential to become addicted, an individual who underestimates his potential to become addicted may end up regretting his past decisions. Evidence from the observation of smoking behavior of youth suggests that particularly young smokers underestimate the addictive nature of smoking.^[33]

Second, the very assumption of time-consistency is questioned. Casual observation, introspection, and psychological research all rather suggest that the assumption of time consistency is wrong. Instead, humans tend to realize immediate rewards and to avoid immediate costs in a way that does not serve their utility maximization in the long run.^[34] Gruber and Koszegi point to the same issue. They support the key assumption that addicts are forward-looking. However, they argue that the evidence presented in past literature has merely shown that smokers are not fully myopic, whereas the second key premise, time-consistency, has not been tested.^[35]

Both criticisms are accounted for in the approach of time-inconsistent addictive behavior developed by Gruber and Koszegi, which is presented below.

I. 4.4.5. Time-Inconsistent Addictive Behavior by Gruber and Koszegi

Gruber and Koszegi develop an alternative to the Becker-Murphy Model. Their approach is based on the same stock addiction framework as the Becker-Murphy model and also accepts the assumption of forward-looking addicts. Consumption today is dependent on past and future consumption. Increases in consumption today increases the addictive stock in the future, which lowers the average overall utility of a smoker but also increases the addict’s marginal utility from smoking.

However, Gruber and Koszegi take a different approach to encountering this intertemporal problem of addictive behavior. As opposed to assuming time-consistent preferences and exponential discounting, they model addicts to be time-inconsistent and to discount future utility in a quasi-hyperbolic fashion. Addicts discount all except of the next time period forward by the factor Abbildung in dieser Leseprobe nicht enthalten, where Abbildung in dieser Leseprobe nicht enthalten is the per-period time discount factor and Abbildung in dieser Leseprobe nicht enthalten is the number of years. The discount rate of the next time period is Abbildung in dieser Leseprobe nicht enthalten, where Abbildung in dieser Leseprobe nicht enthalten is an extra discount factor that changes the discounting of this period relative to the future. Since the discount factor of this period is Abbildung in dieser Leseprobe nicht enthalten and the relative discount factor between future periods is Abbildung in dieser Leseprobe nicht enthalten, the individual gives a greater relative weight to this period than to any later one. This implies that individuals are assumed to be impatient.^[36]

The key implication of such a hyperbolic model is that addicts are assumed to have self-control problems. Individuals who discount hyperbolically would like to smoke less in the future than they actually can. Whereas their long-run preference suggests a lower level of consumption of the harmful good to increase long-run utility, the immediate preference is to increase consumption to derive instant utility from smoking. Therefore, although addicts would like to smoke less in the future from today’s standpoint, they end up making impatient decisions when the future arrives. Hyperbolic addicts maximize utility in the short-run by giving in to impatient decisions but fail to maximize utility in the long run because they are hooked on their addiction.^[37]

This behavior represents a major deviation from the notion of fully rationally acting agents. This study views this deviation as a form of market failure that is attributed to addiction.

Within the framework of time-inconsistent addictive behavior, Gruber and Koszegi further specify two extreme types of time-inconsistent individuals, both of which influence the assessment of an efficient tax rate: “sophisticated hyperbolic individuals” and “naive hyperbolic individuals”.

Sophisticated hyperbolic individuals are aware of that they discount hyperbolically. Thus, they are aware of their self-control problem and therefore know that they will change their preference in the future. Sophisticates frequently try to combat their self-control problem and quit or reduce smoking by using self-control devices. For example, people set up incentives to refrain from smoking by betting with others, telling others about their decision to quit, and making it otherwise embarrassing to smoke. The characteristic of a self-control device is that it reduces the utility derived from smoking. Taxes can serve as a self-control device for sophisticates to combat their own time-inconsistent tendencies. Taxes help them actualize their long-run preferences, which is to smoke less and thus increase long-run utility. Gruber & Koszegi take the smoker’s long-run preferences as the ones that are relevant for the assessment of the optimal tax rate. Taking the short-run preferences yields in a lower tax. However, as the authors point out, the tax difference is small as long as Abbildung in dieser Leseprobe nicht enthalten is not very small and Abbildung in dieser Leseprobe nicht enthalten is sufficiently large, so that the smoker cares about the future to a significant extent.^[38]

On the other hand, “naive hyperbolic individuals” would also like to smoke less in the future, and they also have self-control problems. However, in contrast to sophisticates, they do not recognize that they discount hyperbolically. Since naive hyperbolic individuals do not realize their self-control problem, they do not choose self-control devices. Naives typically have a misperception problem regarding their desired or predicted future smoking levels. They believe that their preference in the future will be identical with their preference at present. For example, smokers who express the desire not to smoke a certain time from today are not aware of that they will have changed their mind when the future arrives. For youths, there is clear evidence that they underestimate the future likelihood of smoking. Taxes serve naives not only as a self-control device but also help them correct the misperception problem regarding their time-inconsistency.^[39] Since approximately 80% of all smokers adopt their habit before the age of 20 years^[40], the misperception problem is closely linked to the underestimation of the addictive potential of cigarette smoking.

Gruber and Koszegi point to the following types of evidence for their proposition of time-inconsistent as opposed to time-consistent addictive behavior.

First, a large body of laboratory experiments document overwhelmingly that consumers are time-inconsistent. Consumers consistently exhibit a lower discount rate for decisions on time intervals further away than for ones closer to the present.

Second, the calibration of real world behavior against models with and without time-inconsistency confirms the prevalence of self-control problems in decisions such as consumption versus saving. Also, with regards to smoking decisions, the observation of quitting behavior points to time-inconsistent preferences. A time-consistent smoker makes the decision to smoke or to quit and follows through. However, in fact eight of ten smokers in America wish to quit but most of the intentions are not actualized, which indicates rather time-inconsistent preferences to smoke.^[41]

Third, Gruber and Mullainathan (2002) show in an econometric test that higher levels of cigarette excise taxes raise self-reported well-being among smokers but not among non-smokers. The time-inconsistent model can explain this observation, as it provides the self-control device time-inconsistent addicts value; the time-consistent model cannot, because cigarette taxes make time-consistent addicts worse off.^[42]

Gruber and Koszegi acknowledge that this is only a limited set of evidence but argue that there is no evidence, psychological or other, that supports time-consistent preferences over time-inconsistent ones.

It could be argued that appropriate self-commitment devices could be provided via the market system or privately provided self-control mechanisms like betting with others. However, as Gruber and Koszegi point out, market-provided self-control mechanisms are likely to be offset by the market itself: As some firms develop effective self-control devices, other firms have the financial incentive to break them down. Privately provided self-control mechanisms are likely to run into enforcement problems. Therefore, Gruber and Koszegi argue, government is the only institution that can effectively provide such self-control devices.^[43]

I. 4.4.6. Conclusion

Assuming that cigarette consumption behavior follows the time-consistent pattern as described by the Becker-Murphy Model, addictive behavior does not constitute market failure and does not provide justifications for taxing internal costs of smoking. On the other hand, assuming cigarette consumption behavior follows time-inconsistent consumer preferences as recently modeled by Gruber and Koszegi, addictive behavior can be viewed as a form of market failure. The tax on internalities is based on its value as a self-commitment device and compensation for the misperception regarding time-inconsistency.

I. 4.5. Conclusion

Market failures prevent the Pareto-efficient allocation of resources and lead to a loss in social welfare. Market failures can justify government intervention in the free market when private solutions are not feasible. With regards to cigarette smoking, market failure due to externalities, market failure due to incorrect risk perception, and market failure due to addictive behavior may occur. Public policy in form of excise taxes can be designed to remedy those market failures, bring consumption to the Pareto-efficient level, and maximize social welfare.

Market failure due to externalities requires an efficient marginal tax that equals marginal net external cost. Market failure due to incorrect risk perception of smoking requires the taxation of the harm the smoker does to himself by smoking. The efficient marginal tax rate equals the marginal harm attributed to the risk perception problem. Addictive behavior does not constitute market failure if the Rational Addiction Model by Becker and Murphy is applied to smoking decisions. It does constitute market failure if the cigarette smoking is viewed according to the approach of time-inconsistent addictive behavior by Gruber and Koszegi. The taxation of internalities is then based on the tax’s value as a self-commitment device and compensation for misperception regarding time-inconsistency.

In conclusion, the efficient tax rate depends on the approach chosen towards modeling cigarette consumption in the context of addictive behavior. The Rational Addiction Model by Becker and Murphy requires the taxation of externalities and internalities from incorrect risk perception. The approach of time-inconsistent addictive behavior also requires the taxation of externalities and internal costs from incorrect risk perception but in addition, it requires the taxation of internalities on the basis of market failure due to addictive behavior. The next sections assess the efficient tax rate for both approaches.

I. 5. Efficient Cigarette Excise Tax Rate based on the Rational Addiction Model by Becker and Murphy

I. 5.1. Introduction

This section aims at calculating the efficient cigarette excise tax rate based on the Rational Addiction Model by Becker and Murphy. For this purpose, the social costs attributed to smoking are identified. Social costs are categorized into external costs that are borne by others than smokers, and internal costs that are borne by smokers. The external costs are subject to taxation. Among the internal costs, the share that is attributed to incorrect risk perception of smokers must be identified. This share of the internal costs is also subject to taxation.

I. 5.2. Cost Classification

Since the assessment of the costs of smoking is connected with a tremendous effort of data gathering and analysis, this study relies on past research done in this area. Various studies have examined the social costs of smoking. The following classification provides an overview of the cost categories that are included in most cost-of-smoking studies.

The costs categories are:^[44]

- Direct costs, consisting of health care costs associated with all smoking-related diseases.
- Indirect costs, which capture the value of the loss of human capital due to smoking.
- Intangible costs, which capture the value of life lost due to smoking related death or disease.

I. 5.3. Criteria for Social Cost-of-Smoking Studies

Few cost of smoking studies are suited for assessing an efficient tax rate. The CRS Report for Congress (1994) states three essential criteria^[45] for cost-of-smoking studies to be conceptually correct and suited for assessing the efficient tax rate:

1. The costs of smoking must be assessed via the incidence-based approach. The incidence-based approach determines the present value of the additional lifetime costs of cohorts of present smokers. The incidence-based approach is the only appropriate method for corrective tax policy because it captures the long lags between smoking initiation and most smoking-related illnesses. This incidence-based model is in contrast to the often-used prevalence-based model. The prevalence-based model measures the smoking related costs in a given year. Those costs reflect historical trends in smoking and therefore lead to an incorrect tax rate.

2. External costs must be distinguished from internal costs. Also, external costs as well as external benefits from smoking must be considered. In particular, smokers’ excess costs during lifetime must be set off against savings resulting from premature smoking-related death, which represent, strictly speaking, external benefits.

3. Other attributes of individuals than smoking that influence external costs from health care and work absence, such as education, income, and other health habits, must be statistically controlled for in order to isolate the effect of smoking. Therefore, smoking related costs must be assessed by comparing the costs of smokers to the costs of “non-smoking smokers” rather than to the costs of non-smokers.

In fact, it has been found that both teenage and adult smokers are more prone to take risks than non-smokers. The greater risk taking of smokers reflects a broad pattern of behavior and is not limited to smoking decisions.^[46] For example, fewer smokers wear seat belts and smokers tend to take riskier jobs without demanding higher economic compensation.

The CRS Report for Congress examines and analyzes six frequently cited studies according to their compliance with the listed criteria. The report concludes that only the study by Manning/Keeler/Newhouse et al. (1989), referred to as “Manning study” in the further text, qualifies for a comprehensive calculation of an efficient tax rate. The investigations in this study have not found any more recent study after 1989 that is in compliance with the criteria listed by the report and thus could be used instead of the Manning study. Therefore, this research bases a significant share of its calculation on the Manning study.

I. 5.4. Procedure of the Manning Study

The Manning study calculates the external costs of smoking while complying with the rules listed above. Lifetime costs and savings of cohorts of 20 years-old smokers in comparison to cohorts of “non-smoking smokers” of the same age are determined for various discount rates. The data used stems from nationwide surveys, such as the 1983 National Health Interview Survey (NHIS). The paper distinguishes between internal costs that are borne by the smoker and external costs that are imposed on others. The externalities per pack are calculated by dividing the discounted expected lifetime net externalities of a cohort of smokers by the number of packs smoked in a lifetime.

[...]

^[1] See Smith (1789), Book 5, Chapter 3, V. 3.76

^[2] See West Virginia Department of Health and Human Resources (2001)

^[3] See West Virginia Department of Health and Human Resources (2001)

^[4] See U.S. Department of Commerce (2002a)

^[5] See Orzechowski/Walker (2002)

^[6] See Mair/Miller (1991), pp. 71-108

^[7] See Chaloupka/Warner (2001), p. 65

^[8] See Mair/Miller (1991), pp. 71-108

^[9] See Mair/Miller (1991), pp. 71-108

^[10] See Baumol (1972), pp. 401

^[11] See Baumol (1972), pp. 399-403

^[12] See Mair/Miller (1991), pp. 71-108

^[13] See Jeanrenaud/Soguel (1999), p. 146

^[14] See Gravelle/Zimmerman (1994), p. 3

^[15] See Baumol (1972), pp. 392-395

^[16] See Jeanrenaud/Soguel (1999), p. 115

^[17] See Zilberman (2000)

^[18] See Zilberman (2000)

^[19] See Holcombe (1996), p. 65

^[20] In: U.S. Department of Health and Human Services (2000), p. 353

^[21] See Mair/Miller (1991), pp. 71-108

^[22] See Ironfield/Diewert/Lawrence (1999), Appendix 2

^[23] See Holcombe (1996), pp. 180-187

^[24] In: Grossman/Chaloupka/Anderson (1998), pp. 631-643

^[25] See Grossman/Chaloupka/Anderson (1998), pp. 631-632

^[26] See Chaloupka/Warner (2001), pp. 25-27

^[27] See Gruber/Koszegi (2002), pp. 1-3

^[28] See Gruber/Mullainathan (2002), p. 4

^[29] See Gruber/Koszegi (2002), p. 3

^[30] See Gruber/Koszegi (2002), p .4

^[31] See Gruber/Mullainathan (2002), p. 4

^[32] See Gruber/Koszegi (2001), p. 11

^[33] See Chaloupka/Warner (2001), p. 32

^[34] See O’Donoghue/Rabin (1999), pp. 103-124

^[35] See Gruber/Koszegi (2002), p. 9

^[36] See Gruber/Mullainathan (2002), pp. 4-6

^[37] See Gruber/Koszegi (2002), pp. 6-10

^[38] See Gruber/Koszegi (2002), pp. 6-29

^[39] See Gruber/Koszegi (2002), pp. 6-29

^[40] Derived from Evans/Ringel/Stech (1999), Figure 3

^[41] See Gruber/Koszegi (2002), p. 7-8

^[42] See Gruber/Mullainathan (2002), p. 4

^[43] See Gruber/Koszegi (2002), p. 12

^[44] See Jeanrenaud/Soguel (1999), p. 128

^[45] See Gravelle/Zimmerman (1994), pp. 16-18

^[46] See Hersch/Viscusi (1998), pp. 645-646