Tobacco Documents Online

03-01-06 23:a1 T- SOCIAL COSTS AND THE POLITICAL ECONOMY OF TOBACCO TAXATION Presented to the Philip Morris International Seminar on Taxation September 10-12, 1986, Washington DC. Alan E Woodfield Department of Economics and Operations Research University of Canterbury Christchurch 1 NEW ZEALAND

7e-a1-OE 23:02 T- #113-02 1. INTRODUCTION The purpose of this lecture is to provide an economist's perspective on the concept of social costs widely associated with the use of tobacco products. The organization is as follow3. Pirat, I addrooo thc ioouc o5 hvir aoC'.iul-oGn-Ea a:.-G detine~l and measured. Second, I explain how estimated social costs are used in the policy debate surrounding tobacco, with cpocial roforonco to taxation policy. Third, I provido a critical interpretation of the social cost concept, and the implications for tax policy arising from this interpretation. Finally, I consider the social cost concept in ttle wlder discusssion of the political economy of taxation. I conclude with a summary and suggestions for future developments. in the nature of a lecture, a number of arguments must be treated briefly and informally. For a more detailed exposition readers might consult my report "Social Cost and Benefit as a Basis for Industry Regulation", copies of which are available for circulation at this seminar. 2. DEFINITION AND MEASUREMENT OF "SOCIAL COSTS" OF SMOKING In many Western countries, estimates exist for the annual costs I borne by those societies as a consequence of smoking. In my reading of the literature, however, it is disquieting that in no case is there a clear definition of social costs, nor a specific justification for the inclusion of various items under the social cost rubric. They are, in the words of British economists Atkinson and Meade, "commonly thought to be relevant". In my

c0-01-L6 23:03 T- #'113-03 opinion, what this literature believes is being estimated is the annual amount of money that a society has to pay in order to permit smoking to occur at the observed level, and which would saved if there was no smoking at all. Consider the following items which are among the more important to be included as social costs. I Medical Costs (a) Direct Medical Costs Expenditures on hospital services, physician services and prescription drugs required to treat various illnesses supposedly caused by smoking. be (b) Indirect Medical Costs (i) Output and productivity losses due to smoking. (ii) Output losses arising from absence from the workforce due to smoking-related illness and pre-retirement death. The latter is sometimes used as a proxy for the value of the loss of life. (iii) Benefits and pension payments to sick smokers and dependents of deceased smokers. (iv) Lost tax revenue aeso.^,-iated with (ii) abov_e._._ II Non-Medical Costs (i) (ii) (iii) Imports of tobacco products, abroad. Fire damage costs. Psychic costs. and remission of profits (iv) Nuisance and health costs of passive smoking. (v) Expenditures on tobacco products. 2 (vii) Tobacco advertising expenditures.

oU°lJl'rha. _-`7:p-1 7- 1iM..Ll.1 Consider now the procedures used to measure these various costs. Direct medical costs are measured by first estimating the cost of diagnosis and treatment of a particular smoking-related illness (lung cancer, for example) and then estimating the excess morbidity rate for smokers over and above what would be expected for the smoking population if, in fact, there was no relationship between smoking and illness. For example, suppose that 5 out of every 100 nonsmokers contracts a particular illness, but 10 out of every 100 smokers contracts the same illness. Half of the 10 smokers would be expected to contract the illness whether or not they smoked, while the other 5 have their illness attributed to smoking. For every 100 smokers, the cost of treating 5 patients is calculated and the result is an estimate of the medical cost of smoking with respect to this illness. A similar procedure is followed for other smoking-related illnesses (coronary heart 3 .11 .,..~...... ..>.a .-I,- >»i- h~-aor..- . -_- _.......r-'.- - a . 1, costs across all such illnesses are added together. Output and productivity losses supposedly arise because people take time out to smoke, or are less productive while they are smoking, or are less productive because their smoking makes them less healthy and their productivity and health are correlated. To my knowledge, no study has attempted to measure these costs. Output losses due to absence from work are measurea as roitows. First, an estimate is made of the excess rate of temporary absenteeism among smokers, along with an estimate of the average period of absence. From this information, an estimate of total

00-31-G6 23:©a T- #113°75 potential worktime lost by smokers is made. This time loss is then multiplied by average earnings of smokers to give the cost of absence from work due to smoking-related illness. A similar procedure is followed for permanent work absence due to pre-retirement death, except that since the output loss is permanent, the cost is measured in terms of the present value of earnings that would be expected to be generated in the absence of smoking. For example, suppose that 10 out of 100 60-year-o1d nonsmokers die at that age. The argument is that society loses the output that these 10 workers would have produced had they survived until retirement. Now suppose that 15 out of 100 60-year-old smokers dies at that age. Ten of these would be expected to die in any case. The others, however, are argued to die prematurely as a result of their smoking, and society loses the output they would have produced had they not been smokers. Note that no individual is identified here; the discussion is purely in actuarial terms. Benefit payments to sick smokers and dependents of deceased smokers are estimated net of payments that would be made-i-f;"-" instead, smokers had been nonsmokers. Lost tax revenue refers to taxes on earnings which would have been available to the government had sick or deceased smokers been available for work. 4 Imports of tobacco products-and profits sent abroad_hy_#x)bacan companies requires no discussion at this stage. Fire damage costs refer to costs attributable to the careless disposal of

0D-01-06 27-:05 T- q113-O5 cigarette butts, while psychic costs refer to the "costs of pain and grief for smokers and their relatives and friends". No measure of the latter has been provided to date. Again, no attempt has been made to quantify the nuisance costs of passive smoking, and there has been one attempt to estimate the excess medical. costs arising from so-called involuntary smoking by nonsmokers. Only one study counts expenditures on tobacco products as a social cost, and few include tobacco advertising expenditure. 3. SOCIAL COSTS AND THE POLICY DEBATE There are many dimensions to the policy debate surrounding tobacco products. Reference to social costs in this debate appears to have been growing rapidly in recent years. I will illustrate this with some recent Antipodean examples. 5 As might be expected, the anti-smoking lobby draws on social cost estimates in its public statements and submissions to Government. For example, in an article entitled "User pays: smokers to cough up more in tax" published in the March 5 (1983) issue of the Medical Journal of Australia, it was claimed that tobacco taxes no longer compensated "the costs to the community due to smoking", and that "smokers are going to have to cough up increasingly more money to pay for the smoking related damages that are being subsidized by non-smokers", in the New Zealand context, the local press reported (on 11 April, 1986) that Joy Townsend, a visiting British health economist sponsored by the Medical Research Council, had claimed that New Zealand

30-O1-Q5 23:9o T- 4113-©7 6 smokers "cost about three times as much in health services and lost production as the taxes taken from cigarettes". Further, at the beginning of the "Great New Zealand Smoke-Free Week" (described as the world's first nationwide campaign designed to help smokers kick the habit, and funded by more than half a million dollars of taxpayers money to support fun runs, "last puff" ceremonies, "smoke-buster" raffles and the like), Dr Murray Laugeson of the Health Promotion Division of the Health Department claimed (on 1 July, 1986) that New Zealand "pays twice as much for the effects of smoking as it gets in tax revenue from tobacco". It is interesting to note that the costs to which Laugeson referred also included "other losses such as fires caused by cigarettes", and that the figures were "based on studies done in the US, Canada and Australia" since there were "no local studies on the cost of smoking to the nation". Further, in the June 1985 Draft White Paper on tax reform, the Australian Treasury referred to the "costs to society" associated with smoking and recommended the continuation of the tobacco excise (along with alcohol and motor spirits excise) while also recommending a uniform tax rate on all other commodities. The latter tax proposal was rejected, but the excises remain. D]ow Zoaland, howover, hac iPqiF1AtA(3 t.n introduce a comorehensive uniform goods and services tax on 1 October, 1986, which calls for a uniform 10 per cent tax rate on commodities apart from the old faithfuls of tobacco, alcohol, and gasoline. At that date, tobacco will be taxed as follows.

33-01-3F23:06 T- #113-Er~~ 7 (a) a specific excise of $28-21 per 1000 cigarettes. (b) an ad valorem excise set at 90 per cent of the value for excise duty. (c) goods and services tax at the uniform 10 per cent rate. In his Budget Speech of 31 July, 1986, the New Zealand Minister of Finance claimed that the Government's tax reform objectives included broadening the consumption tax base, lowering the rate of tax, and making the tax system more fair. But he also noted that "the Government has been urged to raise taxes on tobacco products by people concerned about public health. It has been pointed out that tobacco taxes in New Zealand are low by international standards". The Minister's response was to add 70 cents tax per pack of 20 cigarettes, raising the tax share of the retail price of a pack from 58 per cent to 71 per cent. This demonstrates the apparent influence of social costs in the determination of differential rates of taxation on tobacco products. A reasonable inference is that where social costs exceed tobacco tax revenues, the Government is "justified" in raising the rate of taxation on tobacco products. The validity of this proposition is now examined. 3. A CRITICAL INTERPRETATION OF THE SOCIAL COST CONCEPT There is evidently a strong superficial appeal to an argument which app2ears to be stating that people should pay all the costs associated with an activity they wish to pursue. This is just an example of the "user pays" principle, which is generally applauded by economists. The critical issue, however, is the

0U-D1-Ci6 23:07 T- li l 1'-' ii' ' 8 extent to which the costs of smoking are not covered by smokers' private expenditures on tobacco products. Apart from onei.nstance, the social cos.t literature, by implication, does not treat smokers' expenditure on tobacco recognized that smokers pay for the resource costs of providing them with tobacco products, and do not require to be taxed on these grounds. Thereforer social costs are viewed as a by-product of the activity of smoking, and are in addition to the resource costs of producing cigarettes. Further, there is a strong implicit view that social costs are externa). to smokers. Surely, if it was widely believed that smokers paid these social costs, it would not be necessary to tax them at differential rates in order to compensate "society" for these social costs. Therefore, it is necessary to examine the question of who pays for the social costs of smoking. The social cost literature answers this question by arguing that society, or the community, or the nation pays these costs. Societies, communities, and nations, however, are simply names for particular groups of individuals. The important question for taxation policy is, which individuals pay for the social costs of smoking? The answer to this question depends on a detailed examination of the various items making up social costs. Here, I will illustrate the issues involved by examining the two components of social costs which are of greatest numerical importance and

c0-191-ui i_:14 T- Gi1d-01 interest, namely, direct medical costs and output losses arising from smoking-related work absence. (a) Direct Medical Costs The social cost literature does not fall into the obvious trap of simply counting up the medical care expenditures of smokers and defining these to be the direct medical costs of smoking. The literature, however, presumably believes that it is appropriately measuring the additional medical costs to society which arise in the presence of smoking and which would not exist in the absence of smoking. In fact, it is doing nothing of the sort, and the estimates are seriously biased upward (in the statistical sense). This is a vital, yet subtle point. It can be illustrated as follows. The social cost argument runs something like this. Take a large sample of nonsmokers who have reached a given age, say 65 years. During their 65th year, a proportion of these people, say 2 out of 10, will contract a serious illness requiring expenditure on medical care. This illness may be one which has been defined to be smoking-related (such as coronary heart disease), but it cannot have been caused by smoking in this case. Now take a large sample of 65-year-old smokers. The social cost literature argues that epidemiological evidence suggests that smoking is associated with ill-health. Suppose it is found that 3 smokers out of 10 contract the same serious smoking-related illness as above. Two out of three smokers would be expected to 9