The Economic Impact of Tobacco Regulation and Effective Means of Reducing Consumption

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Rensselaer at Hartford

MGMT6300 - Business Economics

Professor Jim Stodder

Term Paper

 

Marc Macintosh

Groton WEMBA 11

 

Excessive cigarette taxes for the purpose of reducing demand and punishing tobacco manufacturers is counter-productive because consumer demand for this product is governed by rational addiction economic models and tobacco prices are not perfectly elastic.

 

 

In 1999, it was estimated that over 25% of the United States population were smokers.  Recent legislation changes have led to a shift in the legal actions taken against the tobacco industry.  Government and public response to this industry is to raise cigarette prices as high as possible through taxation to deter smoking and to punish cigarette manufacturers for past transgressions.  Economic theory of tobacco regulation based on the “rational addiction” model, an approach used to model consumption of goods such as cigarettes, suggests that consumers recognize the addictive nature of their product choices, but still purchase these products.  The rational addiction model will be examined to show that the use of steep tobacco tax increases does not punish tobacco product manufacturers or impact in direct proportion the demand by all consumers, suggesting that this government tactic is not sufficiently effective.  In addition, it will be shown that revenues from optimal levels of cigarette taxation can be successfully applied to curb demand.

 

 

 

            The past decade has dealt significant changes to the tobacco industry.  In the mid-1990s, approximately one-quarter of U.S. adults were smokers and cigarette consumption per capita continued to rise after a 40 percent decrease over the previous fifteen years.  Youth smoking, a traditional target of tobacco companies due to their lifetime consumption potential, had also risen since previous years. The tobacco industry, recovering from a price war in the early 1990s, consolidated their oligopoly and steadily increased tobacco prices (Gruber, 2002).

Historically, annual cigarette consumption per capita grew steadily between the 1860s and 1950s, reaching a high of 2,535 cigarettes.  After a short decline, slower growth continued until 1981, when per capita consumption reached a high of 2,796 cigarettes.  Declines in the 1980s and 1990s led to a 1999 per capita consumption of only 1,621 cigarettes.  The taxes associated with these cigarettes, as a percentage of prices, were constant until the 1970s, where they fell steadily until the 1983 excise tax was imposed.  Taxes again fell until increases from state actions took hold in the early 1990s. The industry also benefited from low levels of real federal and state excise taxes relative to those enforced in the 1960s.  Until the mid-1990s, the tobacco industry had thwarted legal action by smokers and their relatives to receive damages for smoking-related illnesses.  Consideration of legal settlement costs as a tax shows that taxes shares are only 38 percent, however recent price increases appear to greatly exceed these settlement costs (Gruber, 2002).

            Tobacco consumption has historically been regulated through the use of excise taxation, restriction in public places and restriction on youth access.  Recent legal actions have been taken against the industry in efforts to regulate product consumption as well as punish the industry for their misdeeds.  In one recent class-action lawsuit, a jury awarded Florida smokers $145 billion in punitive damages, to be paid by American tobacco companies.  The amount of this lawsuit, none of which will ever be paid out of current profit levels, is exemplary of the irrational concept that these corporations can be “punished” through exorbitant amounts of jury awards to class plaintiffs.  In response, tobacco firms will cover any lawsuit and settlement damages by raising prices.  This practice has led some to believe that a policy of taxation, control and discouragement of use will be successful in curbing the smoking addiction (“Blowing Smoke”, 2000).

 

 

            One of the problems with the current policy on smoking legislation, as noted in many economic publications, is that the regulation of smoking does not take into account the fact that smoking is an addiction.  This position of treating it as a habit for which the tobacco companies are responsible, and therefore punishing the transgressions of these companies, has led to ineffective outcomes (“Blowing Smoke”, 2000).

            Rational addiction models have stemmed from research performed by behavior psychologist R. J. Herrnstein, who provided an illustration of sub-optimal choices, showing that an individual must weigh the marginal values of utility of two products in order to achieve optimal satisfaction.  In doing this, the consumer must resist their increasing rate of consumption of a desirable product, which has been shown to not be the case when many people are presented with such a situation.  This case provides a “matching” application, where consumers equate the expected value of each alternative and select the better value until the point at which the value of each becomes equal.  In addiction, consumers fail to control their desires and allow their urges to select suboptimal behavior over the short term.  For an addict, the initially high marginal returns decrease over time, as one’s health degrades and lifestyle becomes poorer (Stodder, 1997).

            The rational addiction model is often used to provide an economic model of addictive behavior.  In the rational addiction model, consumers recognize the addictive nature of their sub-optimal choices, but continue to make them because the immediate gains they receive far surpass any future costs of the addiction.  A more detailed evaluation of the rational addiction model has suggested that smokers are time-inconsistent with their decisions.  In traditional models, smokers are equally patient in evaluating decisions today versus those decisions in the distant future, whereas the time-inconsistent model shows that they are instead impatient in evaluating these decisions (Gruber, 2002).

One example of this occurs when individuals do not recognize this impatience, where they believe that they cannot quit smoking in a decision today, but could quit smoking if faced with that decision in the future.  Another example occurs when individuals understand the costs of smoking today, but believe that they cannot control the addiction, and could not ever quit.  These examples show that addicts always want to put off the pain (or cost) of quitting, and rationalize that it therefore makes sense to quit at some later time.  In these cases, the rational behavior is assumed to have a component where the individual is always trying to maximize their satisfaction, or “utility”, as defined by John Stuart Mill.  The smoker, by selecting to smoke now and put off the decision to quit until later, is selecting the option with the highest “expected utility”.  Based on these models, smokers would be willing to continue smoking at the given product cost, even if faced with increased prices, since the external costs (“externalities”) are outweighed by the short-term internal costs (“internalities”) and perceived pain associated with quitting (Gruber, 2002; “Rethinking Thinking”, 1999).

 

 

Recent local and federal government policy on tobacco regulation has focused on levying significant taxes on tobacco products and executing legal actions against tobacco companies.  Many legislators and anti-tobacco advocates believe that the purpose of these actions is to punish the industry, however, the impact of this position is ineffective.  Economic studies have been performed to determine the optimal costs of smoking, including the costs on the addict’s health, societal costs, costs to government for healthcare-related expenses, costs to workplaces for reduced productivity and costs to the general public for the annoyance to nonsmokers from smoking.  Estimations of these costs have been used to levy taxes on the industry, and these taxes have been passed on to the nicotine addicts.  In response, tobacco companies have increased their prices to cover the costs of taxes and federal and state litigation settlements.  In fact, price increases in the last 1990s exceeded the amount required to pay these costs, contributing to the profit margins of the tobacco companies (Gruber, 2002).

Price elasticity can be defined as the change in demand for a product that results from a change in price of that product.  Price elasticity is almost always negative, indicating that an increase in price would result in a reduction in demand for the associated product. The price elasticity of a product relies on the importance of a product, the availability of close alternatives, the consumer’s income levels, preferences and brand recognition.  For smokers, the nicotine addiction makes it more difficult to reduce smoking in spite of the price-elastic character of tobacco.  Many studies have attempted to quantify this price-elastic behavior, with the results normally in the range of – 0.47.  This result can be interpreted as saying that, for every 1% increase in price, there will be an associated 0.47% decline in consumption.  This result leads us to believe that a price increase of 106% would result in a 50% decrease in demand, as is suggested by some empirical data (Johnston, 1982; “High Tobacco Taxes Discourage Smoking”, 2002).

Research has also shown that there are differences in the price-elastic characteristics under differing conditions.  Due to the addictive nature of tobacco products, short time price elasticity for cigarettes is lower than that of most other products.  It is also known that large tax increases will reduce current consumption and not only cause some smokers to quit immediately, but will also have a cumulative effect and motivate some to quit a short time later, implying that long-term elasticity is larger than short-term elasticity.   Price sensitivity is also present among various age groups.  Research by the U.S. Surgeon General’s Office concludes that the price elasticity for adults is –0.42, three times lower than that of teenagers, at –1.40.  These findings suggest that a 10% price increase will result in a decrease in demand of 4.2% for adults and 14.0% for teenagers (“High Tobacco Taxes Discourage Smoking”, 2002).

Since the consumption of tobacco products containing nicotine, like many other drugs, is quasi-price-inelastic, this government policy has resulted in increased revenues for tobacco companies.  In this case, the profits lost through a marginal decline in sales were overcome by the increased profits on the balance of the cigarettes sold (“Blowing Smoke”, 2000; Gruber, 2002).

            Another impact of increased tobacco taxes comes into play when the revenues provided to state and local governments are not reinvested in smoking prevention programs.  In this case, the government is profiting from the addiction of smokers by raising taxes and redirecting the revenue towards other programs.  This policy of tobacco taxation may have led to the compensation, and especially the overcompensation, of local governments through their development of tobacco regulation policy.

            A counter-argument to the reduction of tobacco taxes is that particular economic groups are impacted by increased product prices.  Since the poor have a tendency to have increased levels of smoking, they would benefit the most from higher cigarette pricing.  In addition, the poor are much more sensitive to price changes, since lower income individuals have less discretionary finances, making these products more price elastic.  On the other hand, upper income citizens are less sensitive to price changes.  This results in a response where cigarette taxation is beneficial to poor individuals and somewhat ineffective for rich individuals.  This price sensitivity across fiscal delineations of the population can be used to target smoking regulation (Gruber, 2002).

            The second argument is that the revenue from moderate levels of cigarette taxation should be used to address the demand for these products.  Based on studies performed by the U.S. Department of Health and Human Services, there is substantial evidence that public funding of smoking cessation programs is a cost-effective method of decreasing the number of smokers.  This approach differs from that of taxation and litigation, which looks to punish the tobacco industry, recover the costs incurred by smokers, or even profit from the smoking addiction.  The approach of smoking cessation programs is to address the demand presented by the rational addiction model (Gruber, 2002).

Specific smoking cessation programs can be utilized to target addicts based upon the time-consistency category of their addiction.  For time-inconsistent addicts, self-control devices can be used to lower the utility from smoking, since they either want to smoke or they don’t.  For time-consistent addicts, quitting aids can be employed to decrease the disutility from not smoking.  The effectiveness of smoking cessation programs has been evaluated in several studies.  One study, which presents the estimated efficacy of several different types of smoking cessation programs, shows that unaided self-care (or “cold-turkey”) methods of quitting have the lowest efficacy of 3%, but this method can reach a significantly larger number of smokers (680,000) than all other programs.  Other programs with higher efficacy rates include prescription nicotine replacement therapy (NRT), over-the-counter NRT, behavioral methods and in-patient treatment programs, which have efficacy rates of 14%, 14%, 24% and 32%, respectively.  Estimates have also shown that the real price of cigarettes is approximately unit elastic with impact on the success, where a 1% increase in the real price of cigarettes will increase the probability of smoking cessation by 1% (Gruber, 2002; Green, 1998; Tauras, 1999).

Counter-arguments to the investment in smoking cessation programs can be made, since the rational addiction can be time-inconsistent.  In this thread, consumers are unable to realize their desired future levels of smoking.  Many will state or show their intentions to quit, but won’t actually quit.  Statistics show that among younger smokers that smoke more than one pack per day, the smoking rate five years later for those who stated they would quit is actually slightly higher than the number who said they would still be smoking.  Despite the best efforts of state and local governments to invest in these programs, the inherent decrease in “expected utility” from quitting will likely be lower than that of maintaining their addiction (Gruber, 2002; Lampsey, 2002).

            An often neglected, yet sinister, implication of tobacco taxes is the state’s role in profiting from legislation aimed at curbing demand.  In 1993, the American Medical Association (AMA) launched the SmokeLess States National Tobacco Policy.  The purpose of this policy is to develop statewide coalitions to improve the “tobacco policy environment with the goal of reducing tobacco use”.  This programs supports higher state excise taxes for tobacco products.  It is also a self-proclaimed “smart and effective tool (that) can generate hundreds of millions of dollars for state budgets while improving the health of all Americans”.  Many studies have shown that taxes reduce, to some extent, the demand for tobacco products.  Through this program, states can increase excise taxes to “provide a quick boost for sagging state revenues” and implement a long-term solution to rising health-care costs for smokers.  The offer to remedy a state’s budget shortfall through taxation without disregard for its impact is considered inappropriate by some (AMA Member Communications, 2002).

            Historically, states have filed lawsuits against cigarette companies in an attempt to recover costs for smoking-related care.  These lawsuits are based upon it being feasibility to calculate the costs of smoking, however, states are only using the negative costs and are not taking the benefits into consideration.  Since cigarette smoking is expected to cause premature death, there will be higher costs in the short term and few costs in the long term.  Since states fail to recognize real cost savings, the excise taxes imposed are higher than the real costs of smoking to the addict, society and the state.  The state officials, who have a stake in maximizing their budget and tax-based revenue stream, are willing to benefit from the unfounded excise taxes.  These states also fail to implement substantial cessation program efforts with this funding.  Overall, the practice of securing tax revenue through excise taxes will benefit corporations through increased prices and state and local governments through an improved budget, but will offer the smoker little in proven smoking cessation programs unless revenue is properly applied (Viscusi, 1997).

 

 

 

 

 

AMA Member Communications, “AMA encourages increased tobacco tax”, American Medical Association, January 14, 2002, <http://www.ama-assn.org/ama/pub/print/article/2403-5800.html>, Last visited July 18, 2002.

“Blowing Smoke,” The Economist, Jul 22, 2000, Volume 356, Issue 8180, p. 22, <http://www.economist.com/displayStory.cfm?Story_ID=6319>, Last visited July 18, 2002.

Green, L.W., Frankish, C.J., “Smoking Cessation: A Synthesis of the Literature on Program Effectiveness”, University of British Columbia, July 1998, pp.2-3, <http://www.commhealth.ihpr.ubc.ca/mohscr/contents.pdf>, Last visited July 18, 2002.

Gruber, J., “The Economics of Tobacco Regulation,” Health Affairs, Mar/Apr 2002, Volume 21, Issue 2, pp. 146-162.

            “High Tobacco Taxes Discourage Smoking”, Non-Smokers Rights Association, <http://www.nsra-adnf.ca/english/part2.pdf>, Last visited July 17, 2002.

Johnston, M. E., “Still More on the Price Elasticity of Cigarettes”, Philip Morris, Memorandum to H. S. Daniel, March 25, 1982. <http:// tobaccodocuments.org/pm/2043565313-5328.html>, Last visited July 18, 2002.

            Lampsey, H., Collins, D.,  “The Economics of Tobacco Policy,” University of New South Wales, March 3, 2002, <wysiwyg://169/http://factsheets.globalink. org/en/economics.shtml>, last visited July 11, 2002.

“Rethinking Thinking”, The Economist, Dec 18, 1999, Volume 353, Issue 8150, pp. 63-65, <http://www.economist.com/displayStory.cfm?Story_ID =268946>, last visited July 11, 2002.

            Stodder, J., “Complexity Aversion: Simplification in the Herrnstein and Allais Behaviors,” Eastern Economic Journal, Winter 1997, Volume 23, Number 1, pp. 1-15.

            Tauras, J.A., PhD, “Price, Tobacco Control Policies and Smoking Initiation and Cessation”, January 14, 1999, <http://www.saprp.org/fundedgrants/ findingssummaries/taurus.html>, Last visited July 18, 2002

            Viscusi, W.K., “From Cash Crop to Cash Cow”, Regulation, 1997, Vol. 20, No. 3, <http://www.cato.org/pubs/regulation/reg20n3b.html>, Last visited July 18, 2002.

 

 

In 1999, it was estimated that over 25% of the United States population were smokers.  Recent legislation changes have led to a shift in the legal actions taken against the tobacco industry.  Government and public response to this industry is to raise cigarette prices as high as possible to deter smoking and to punish cigarette manufacturers for past transgressions.  Economic theory of tobacco regulation based on the Becker-Murphy “rational addiction” model, an approach used to model consumption of goods such as cigarettes, suggests that consumers recognize the addictive nature of their product choices, but still purchase these products.  The Becker-Murphy model will be further evaluated to determine the impact of tobacco price increases on consumer demand, and how effective this government tactic really is at reducing demand.  Other options for reducing tobacco consumption will be explored, based on smokers being “time inconsistent” and unable to realize desired future levels of smoking.