Here in New York, a $1.60 increase to the state tax on cigarettes has been passed. Everyone seems to have an opinion on this issue. Some say that this is a futile attempt by politicians to indicate that the deficit situation is under control. Others think that the reduction in demand will wipe out the increase in price, making the hike fiscally pointless. Few think it's a good idea. My plan here is to clear up a few things up about the tax.
First, for understanding, let's look at the forms a tax may take.
Specific - A tax based on the quantity purchased, independent of price. Imagine if peanuts were taxed at $.20 a pound, no matter their price.
Lump sum - A certain tax sum that is equally paid by those who qualify, ignoring behavior. A general lump sum tax of $100 forces all living taxpayers to pay 100$. Think of a road toll.
Ad valorem - Literally according to value is the most popular tax. This is a tax based on value. A sales tax that taxes 10% of an item's value is an ad valorem tax. More explanation here.
Now, the cigarette tax is per pack, so it's a specific tax. I believe an ad valorem tax is preferable to a specific tax in this industry.
Now let's look at the underlying issue. This year, New York's deficit seems to be at $9.2 billion - a historical high. As you likely know, states are required to keep a balanced budget. Profit(Loss) = Total Revenue - Total Cost. Costs are government programs and responsibilities, revenues are tax dollars. Thus, New York's choices include cutting programs and raising taxes.
The fact is that the state is already cutting as many programs as is reasonable. As seen in New York's Enacted Budget Financial Plan the state already planned to cut healthcare, eliminate rebates, remove cost of living increases, increase university tuition, close three prisons, reduce transit subsidies, freeze aid, and reduce funding for private education. In the future, there will be further cuts to healthcare, public education, higher education, public safety, energy, transportation, and other services. Despite these cuts, the state remains in deficit. There have been a few revenue increasing measures, taxes on small businesses rose significantly, the state began selling new license plates, they hiked income tax, increases in education tuition (as previously stated), increases in sin taxes and others.
We could continue cutting programs, but most would argue we also need to raise taxes. The question is difficult, What programs do we cut? What taxes do we raise? Taxes on cigarettes and alcohol have increased significantly in the last few years, and will likely rise in the future. The fact is that taxes on cigarettes and alcohol make sense, here's why:
Cigarettes and alcohol are stigmatized in society. Addicts and abusers are seen as societal problems. You can easily increase the sentence of a drunk driver or a pedophile because society dislikes them. The fact is that increasing taxes on cigarettes is more politically viable than increasing the sales tax or decreasing healthcare.
Cigarettes and alcohol also cause negative externalities. A person that consumes a vaccine reduces the chances that other people will get sick, a beekeeper helps pollinate surrounding farms - these are positive externalities. People apart from the initial transaction are being benefited. With cigarettes and alcohol, people are hurting their health and reducing their potential productivity. Friends and family grieve over someone's death. A death due to a drunken driver reduces the nation's productivity. Someone who is standing next to a smoker may become annoyed. These are all negative externalities. A person not party to the initial transaction is being harmed. By reducing the consumption of these goods, we expect a net increase in productivity and quality of life outside of the increase in the government's revenue. This however raises its own question - do increased prices really raise revenue?
For some goods, an increase in price causes a small decrease in quantity demanded. For other goods an equal increase will cause a greater decrease in quantity demanded. The corresponding change in quantity demanded due to an increase in price is called the elasticity of demand.
Example:
For salt, if there is a 1% increase in price, there is a <1% decrease in quantity demanded. This good is considered to have inelastic demand.
For pizza, if there is a 1% increase in price, there is a 1% decrease in quantity demanded. This good would be considered to have unitary elastic demand.
For Froot Loops, if there is a 1% increase in price, there is a >1% decrease in quantity demanded. This good is considered to have elastic demand.
So, if a good is elastic, an increase in price would cause a reduction in revenues as decrease in quantity demanded is outpaced by the increase in price. However, cigarettes tend to be addictive, and their demand tends to be inelastic. This implies that any increase in price will reduce quantity demanded by a smaller amount, increasing (in this case tax) revenues.
So, I believe the preferable form of the tax is ad valorem, as it would cause less economic damage. This tax has potential to increase production in the long run, while taxing most other products will decrease production. Government revenues will certainly increase. A sin tax is one of the most viable options when it comes to closing the budget.
Dr. Stone is rolling over in her bed somewhere in Dansville. You picked the market distorting ad valorem (sales) tax over a non-distorting lump sum tax! A deadweight loss has subsequently been created. You made the right choice.
ReplyDeleteThe recession has created 50 little Herbert Hoovers to roam the country cutting state aggregate demand. Ridiculous and short sighted taxes, like new license plates, are a poor solution to SR budget problems. A great deal of research has shown that cigarettes and alcohol are relatively inelastic goods. But, the primary difference between a sin tax and taxes on other inelastic goods is a question of normative economics.
The moral fabric of society, whether real or imaginary, has decided that cigarettes are a sin and should be legally discriminated against. To say that taxation does not change consumption behavior is a myth that persists within subjective whims. Everyone one wins. Smokers die out and no one can say smokers don't have the freedom to smoke if they want to.
Will a DWL occur? Of course. Is that important regarding normative economics? Not necessarily. The production needlessly being lost is primarily tobacco products (with residual effects on other aspects of aggregate demand). From a normative perspective there is nothing wrong with this. A lump sum tax is still theoretically superior but too difficult to implement politically.
This brings us back to the most significant problem. On one hand the federal and state governments tax consumers for purchasing tobacco products. On the other they actively subsidize tobacco producers to promote 'job growth'! This creates a system of corporatism that hurts consumers, both smokers and nonsmokers, without creating an effective LR solution to the normative problem.
Increasing the tax rate on cigarettes is only a SR fix. Over time the rate of addiction with decrease due to increased taxes. This will cause a relative decline in tax revenue. It is questionable whether positive externalities will make up for lost tax revenue. If you find a study going over the LR consequences of increased cigarette taxes please forward it.
(Full Disclosure: I don't smoke cigarettes but I buy all my cigars from a Native American reservation to avoid taxation.)