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I CRS-4 directly-such as his share of medical expenditures or actual lost wages from sick days- are internal costa that do not justify a tax on spillover grounds. Second, costs imposed on the nonsmoking population (external costs) can justify a tax on apillover grounds. This conceptual case for cigarette taxation does not, however, provide information about how large the tax must be to compensate for the external costs. For that, it is necessary to review the literature that measures the magnitude of these external costs. The Mannin~ Study A thorough analysis of spillover effects from smoking must include a lifetime profile of both the external coats smokers impose on nonsmokers and the external savings smokers provide to nonsmokers. While there has been considerable research on the overall health costs of smoking (medical expenditures, lost productivity from sickness and disability, and early death), only the study by Manning, Keeler, Newhouse, Sloss, and Wasserman (hereafter referred to as the Manning study) measures both the lifetime external costs and savings that are needed to gauge the efficient excise tax.3 Their study uses data on health costs of smokers (both current and former) and lifetime nonsmokers (referred to as never-smokers) to develop the estimates. The Manning study found that the net external costs (external costs minus external savings) of smoking are small-smaller than the current combined Federal and State taxes on cigarettes. Part of the reason for this finding is that the external costs smokers impose on society (primarily because their larger lifetime medical expenditures are not reflected in the insurance premiums they pay or in contributions to programs such as Medicare) are substantially offset by the external savings they provide to society: their earlier death reduces their payout from the pension plans (including social security) to which they 3 See Willard G. Manning, Emmett B. Keeler, Joseph P. Newhouae, Elizabeth M. Slo.a, and Jeffrey Waaeerman, The Costs o f Poor Health Habits, A RAND Study, Cambridge, Mase.: Harvard University Press, 1991. The results for alcohol and tobacco appear also in "The Tues of Sin: Do Smokers and Drinkers Pay Their Way?", Journal of the American Medical Aesociation v. 261, March 17, 1989, pp. 1604-1609. The basic data for the study are from the Health Insurance Experiment conducted by the RAND corporation for individuals under age 60 (collected from years 1972-1982), supplemented with data from the 1983 National Health Interview Survey for older individuals. Data are expressed in 1986 dollars. I I I I I I I I I I I I I I I I I I

I r I I I I I I I I I 1 I I I I CRS-5 contribute.` (These pension plan savings are smaller than they would otherwise be because smokers retire earlier than non-smokers.) In 1986 dollars, the Manning study found that the net external cost per pack of cigarettes is 15 cents for a new (young) smoker. This estimate includes 43 cents of external costs imposed on society: 26 cents of additional medical expenditures; one cent of sick leave costs; 5 cents of group life insurance costs; 2 cents of costs from fires; and 9 cents of lost tax revenue smokers would have paid to finance retirement and health programs had they not died early. Offset against these costs are external savings to society of 27 cents: 24 cents from reductions in retirement pensions; and 3 cents from reduced use of nursing homes. Rounding error accounts for the lost cent. This 15 cents of net external costs equals 21 cents in 1995 dollars if the spillover effects are adjusted using the GNP deflator; and 33 cents if the medical expenditure and nursing home components of external costs are adjusted using the medical services price index.a (Unless otherwise stated, the 1995 estimate using this medical services price index will be used for all further per-pack calculations in this report.) The 50-cent current tax (Federal tax of 24 cents per pack and average State and local taxes of 26 cents per pack) is 11i4 times as high as the 33-cent tax justified by the net external costs estimated in the 1Vianning study.g Notably, the Manning study suggests a much stronger case can be made for taxing alcoholic beverages at a higher rate. It estimates net external costs of at least 68 cents per ounce of alcohol.' A large fraction of this cost is associated with loss of life, medical expenditures, and property damage in automobile accidents. Current Federal taxes on alcohol are $13.50 per proof gallon, or 4 Note that counting these reduced coste of pension plan payouts as transfers to the nonsmoking population does not mean that there is a gain to.ociety from premature death-euch premature deaths are costly. That is, transfers have no effect on the total cost (to smobrs and nonsmokers combined) of premar,rse death. Because transfers are made, the cost of premature death to the smoker (internal ccxp:a) has increased-the retirement income the smoker is losing is higher. Costs to nonsmokers (external costs) are decreased by the same amount. This socounting for transfers must be nade in order to analyze separately the two potential market failures identlf ed in this report, aspillover costs and imperfect information. Some have ruggest.d that this treatment implies that aociety benefits from early death, and that, for example, early deaths from breast cancer would be treated as a savings when evaluating the desirability of breast cancer research. This analogy is nat correct. In the case of breast cancer research, the reduction in premature death would obvioua;y be treated as a benefit to society. a Theae adjustments use the GNP deflator as projected by the Congre.sional Budget Office. The medical services price index is taken from actual data for 1986-1992; for additional years, the assumption is made that these costs rise in excess of the GNP deflator by the difference observed from 1986-1992. 6 The average State and local tax of 26 cents per pack was reported in Tax Foundation, Tax Featuree, vol. 37, October 1993. a+ ~ ~ 7 There was not enough division of oosts to separate out the medical expenditures so the cost could be a few cents higher. component of traffic accidents LV 9-1' , .Pk I

I CRS-6 about 21 cents per ounce for distilled spirits; $18.00 per barrel of beer, or about ten cents per ounce; and $1.07 per gallon on table wine, or about eight cents per ounce. State taxes tend to be low (ranging from less than two cents to about ten cents per ounce for distilled spirits, generally less than one cent per ounce for beer, and from less than two cents to about 16 cents per ounce for wine).a These data suggest that much larger taxes would have to be imposed on all of these products if alcohol taxes were to reflect net external costs.9 In short, based on the criterion of matching tax revenue to net external costs, the data indicate that cigarettes are overtaxed and alcohol is undertaxed.'o Qualifications to the ManninQ Study Because the Manning study is alone in its attempt to calculate all financial spillover effects (both costs and savings) as a basis for assessing the economically efficient level of tax, it is important to discuss thoroughly potential issues that may raise doubts about the results. This section considers a variety of such issues: the likelihood of estimation error from model specification; the sensitivity of the estimate to the choice of discount rate; the omission of passive smoking from the external cost estimate; the proper treatment of non-health- related external costs; some miscellaneous issues; and the consistency of the estimate with findings of related studies. Many of these issues and caveats are also discussed in the Manning study. Much of this discussion is quite technical and is presented below. A brief summary of these issuen is provided for those readers who may wish to skip the technical details and proceed directly to the information and addiction discussion in the next section. 8 These are ratee as of September 1992, as reported in Tax Foundation, Facts and Figcnes on Government Finance, 1993, pp. 256-57. Some States do not allow private sale and typically impose taxes as a percentage of price; note also that the higher tax ntes on wine are imposed only in a very few States; most States impose taxes w.ll below the Federal lrv.l. 9 Some argue that signincant differences exist between alcohol and tobaoco in that some alcohol is consumed in moderate amounts by individuals who do not drive while intoxicated. This nonabusive consumption does not generate external costs and should not be subject to an excise tax whose purpose is to correct for externalities. It is also true, however, that the magnitude of external effects from tobaoco depends in pe.rt on the amount of exposure in packs per day and the number of yearo smoked. Those who smoke for a short period are more dmilar to nonsmokers than to smokers in their health and mortality characteristics. Obviously, use of an excise tax as an instrument to correct for external costs is imperfect for both alcohol and tobecoo. to gome might ask why this report does not evaluate the other major selective excise revenue raiser, the gasoline tax, as a substitute revenue source for cigarette taxation. A primary rationale for both alcohol and cigarette excise taxation is control of socially undesirable (costly) behavior. The primary rationale for the gasoline tax is to require highway users to provide tax revenue in exchange for the benefits they receive from highway construction. I I I I I I I I I I I I I I I I

I I I I I I I I I I I I I I I I I I CRS-7 • Estimation error-The Manning study's lower-bound and upper-bound estimates of spillover effects are designed to account for the possibility of estimation error. The lower-bound estimate produces net external savin¢s of 14 cents per pack (recall that all estimates are adjusted to 1995 price levels). The upper-bound estimate produces a net external cost of 53 cents. Neither of these estimates justify a 75-cent increase in the cigarette tax which currently averages 50 cents per pack. • Discount rate-Any study whose results involve a comparison of costs and savings with significantly different time patterns can alter the relative magnitudes by changing the discount rate. Raising the discount rate from five to ten percent would increase net external costs of smoking to 42 cents per pack. Lowering the discount rate w just under four percent would produce net external costs of zero; below that rate net external savings would be generated. In neither case is a 75-cent increase in the tax rate justified on spillover grounds. • Passive smoking-Differences exist about whether passive smoking effects are largely internal or external costs. The link between passive 3moking and disease is uncertain. The best available estimate of this link implies external costs of no more than a few cents per pack, not enough to justify a 75-cent increase in the cigarette tax. • Non-health-related external costs-The Manning study does not incorporate effects such as general distaste and annoyance on the part of many for smoking. These effects cannot be quantified and may be best dealt with through regulation rather than taxation. • Relationship of the Manning study to other studies-The Manning study is likely to be more accurate in its estimates of the economically efficient level of tax because it is the only study that uses the appropriate analytical framework and includes all financial spillover costs. Other studies, when considered in the appropriate framework, are generally consistent with the Manning study. 1. Estinsation error f hons model specf fseatiori The Manning estimate uses a procedure that attributes variations in individuals' total lifetime health costs to smoking status, income, sex, and various other attributes. This is a standard estimation strategy-it attempts to control for the influence of nonsmoking factors on total health costs, thereby isolating the influence of smoking. This is referred to as the "base case" in the following discussion. The Manning study estimates an upper limit for the external costs of smoking that arise from effects on smokers' health by attributing all the variation in total health costs among individuals to smoking status, in effect assuming that no other differences among individuals contribute to the observed I

CRS-8 differences in health costs. This "upper-bound" analysis produces net external costs of 53 cents. This coat is likely to be an overestimate since some of the deleted nonsmoking factors are found to be statistically significant and therefore are likely to have some influence on total health costs. With this upper-bound case, the conceptually desirable tax (on efficiency grounds) would argue for only a three-cent increase in selective cigarette excise taxes. It also is possible that the 33-cent net external cost estimate, based upon total health costs, is an overestimate. This would occur if omitted variables generate nonsmoking health costs that happen to be correlated with smoking. Consider risk. Smokers are found to be more likely to engage in risky activities and as a consequence are, for example, more likely to incur health costs from accidents.il These nonsmoking health costs to some extent would be attributed to smoking status by the base-case methodology, even though they are caused by differences in risk-taking rather than smoking status. The Manning atudy's authors attempt to control for such bias by restricting health costs to those thought to be related to the smoking habit (e.g., certain cancers, respiratory illness, circulatory diseases, and ulcers). Using this approach, they construct a "lower-bound" estimate that also eliminates any effect of smoking on early retirement (which affects the level of pensions s•id foregone taxes). Attributing variations in these smoking-related or habit-related health costs to smoking status, income, sex, etc., and eliminating the retirement effect, produces net external savings (external savings exceed external costs) of 14 cents. Of course, if smoking produces net external savings rather than a net external cost, a cigarette tax justified as compensation for net external costs would not be appropriate. If medical expenditures are adjusted only to reflect habit-related disease, but unlike the case just discussed the effect on early retirement from the base case is retained, the result is a net external cost of 12 cents. If instead early retirement costs in the base case are reduced in the same proportion as the reduction in the change in medical expenditures moving from the base case to the lower bound, the result -4s net external savings of four cents. What is one to make of these three cases and their permutations? The upper-bound case seems unrealistic-it comes from a clearly misspecified model that attributes too many health costs to smoking, yet still produces estimates of net external costs that fall far short of justifying a 75-cent tax increase. The lower-bound estimate (and estimates adjusted to various treatments of early retirement) could be a better estimate of spillover effects than the base case. If the base-case model were perfectly specified (no omitted variables), it would provide the same results for medical expenditures as the lower-bound case (provided the latter correctly identified smoking-related health costs). Which model provides a better estimate of spillover effects depends upon one's belief about whether omitted variables in the base case are more of a problem than the 1 I See W. Kip V'wusi, Smoking: Making the Risky Decision. N®w York: Oxford University Prow, 1992. I I I I I I I I I I I I I I ~ I I I I

I I I I I I I I I I I I I I I I I I CRS-9 measurement error incurred when separating smoking-related health costa from total health costs.12 Neither justifies the current 50-cent cigarette excise tax on the basis of spillover effects. 2. Choice of discount rate Any study whose results involve a comparison of costs and savings with significantly different time patterns can alter the relative magnitudes by changing the discount rate. Discounting provides a way to compare, at a given point in time, amounts that will be received at different points in the future. Discounting accounts for the fact that a dollar received or spent in the future is less valuable than a dollar received at present, since a dollar received now can be invested at interest. The higher the interest (discount) rate, the smaller the value of amounts paid or received in the future. Discounting is important in the Manning study because the external costs of smoking accrue more quickly across time than do the offsetting external savings from smoking. Thus, the relative importance (dollar value) of external costs and external savings is affected by the choice of discount rate. Also, much of the tax is paid in advance of either the savings or the costs. Raising the discount rate from the five percent used in the base case to ten percent increases the difference between the external costs and the offsetting external savings from 33 cents to 42 cents. A further increase in the discount rate has little effect on net extQrnal costs, because at a ten percent discount rate, future external savings are already so heavily discounted that further discounting has a minor effect. Also, all values are reduced relative to tax receipts, which occur earlier in time. Lowering the discount rate has a more powerful effect: external costs equal external savings (net external costs become zero) at a discount rate of slightly under four percent (and at a zero discount rate, smoking produces external savings of $1.18 a pack). A zero discount rate is not reasonable, but the ten percent rate is probably too high. A discount rate re: ecting the pre-tax return on capital would probably be around seven percent, or about halfway between the five percent and ten percent levels.13 Because of the way in which discounting affects net external savings, the seven percent discount rate produces results that are very close to 12 Theae measurement errom could arise from imperfect medical knowledge or from misdiignosis of illness. The dir---tion of such a measurement error is not clear. For example, some smoking-related illnesses could be diagnosed as a non-smoking-related disease because smoking is a contributing rather than primary cause. At the same time, physicians may be more inclined to diagnose aa smoking related the illnesses of smokers than those of non-smokers. See Hans J. Eysenck, "Smoking and Health," in Smoking and Society, ed. Robert D. Tolliaon, L,ezington: D.C. Heath, 1986 for a discussion of evidence on this latter effect. 13 This seven percent rate of return is consistent with two methods of derivation: dividing estimated net capital income by the estimated capital stock, and grossing up an estimated after- tax return by the estimated effective tax rate. I

CRS•10 the ten percent rate. None of these discount rates generate net external costs that justify current excise tax rates. 3. Passive smoking Some suggest the Manning study underestimates net external costs from smoking because it does not include the external costs of passive smoking. The exclusion of these effects is not due to a failure to address the issue. These issues are addressed in a variety of ways in the Manning study. With respect to the data used to estimate costs for active smokers, the Manning study cuts its medical expenditure data eight ways in a search for evidence of passive smoking effects. It examines both total medical expenditures and the subset associated with illnesses related to smoking, for adults and children as outpatients and inpatients. The data analyzed indicate a statistically significant effect for habit-related (smoking-related) inpatient medical expenditures for adults; the data do not indicate an effect for the other categories. Several reasons suggest it may be appropriate to omit passive smoking effects from the calculation of the corrective tax: first, there is much less certainty about the link between passive smoking and health than the link between direct smoking and health; second, to the extent that evidence does exist, it has been associated with effects within families and largely to spouses of smokers, thereby raising questions as to whether the effect should be considered an external or an internal cost; third, taxes may be a flawed instrument to correct for passive smoking effects; and finally, based on available evidence, these costs are quite small relative to current and proposed taxes. Each of these points is discussed. First, the effects of passive smoking on health are far weaker and less certain than the effects of active smoking. There has been a debate about passive smoking's effect on health; much of the discussion about this issue is technical in nature and is discussed in Appendix A. Second, if a passive smoking effect exists, the effect may be most likely to occur within families.t` Reasons exist for considering a family, rather than an individual, to be the decision-making unit when designing externality-correcting taxes. One reason is that corrective governmental action often is not desirable for spillover effects that occur within groups that are small enough to negotiate with each other, since members of the group can come to a mutual agreement that maximizes welfare. Passive-smoking effects that occur within a family unit may fit this descripticn. This is a gray area where public policy might well consider these effects either as internal or as external costs depending upon the 14 Although the Environmental Protection Agency issued a risk aeseesment that clusifes environmental tobacco smoke as a cancer-causing agent, the epidemiologicat etudiea they use are based on studies of passive smoking within the home, not in the workplace or in public places. See United States Environmental Protection Agency, Respiratory Health Effects of Passive Sm.oking: Lung Cancer and Other Disorders, December 1992. 'I I I I I I I I I I I I I I I I I I

I I I I i I I I I I I I I I I I I CRS-11 relative bargaining strengths of those affected. The findings of the Manning data, which tend to show that costs are more likely to be associated with adults (who presumably have relatively comparable bargaining strengths) than with children (who presumably would operate from a relatively weak bargaining position) might argue for treatment as internal costs. In addition, since smoking tends to be initiated at an earlier age than marriage, individuals generally know whether or not their spouses will be smokers. If the smoker or the parents together make the decisions and there are effects on children, there is still a reason to treat costs as internal. Many, one hopes most, parents consider the welfare of each other as well as children in making decisions. Thus, many family smokers should already be taking into account, at least in part, any negative consequences of smoking for other family members, regardless of how decisions are made. Third, if passive smoking effects are considered external costs, equity considerations suggest a tax remedy may not be desirable. The justification for a tax to correct externalities is made on efficiency grounds because it is poasible to make all individuals better off. This "all win" scenario is accomplished (assuming a net external cost) by: (1) imposing the tax on cigarette smokers, thereby reducing their after-tax income; (2) altering smokers' behavior, thereby making nonsmokers better off; and (3) making lump sum payments to compensate smokers for their tax payments. In practice, the third step is omitted, which causes distributional effects-smokere lose and nonsmokers gain. Many people, however, perceive this distributional effect as fair, since smokers impose costs on nonsmokers in the first place. Were a tax used to correct spillover effects within families, however, nonsmoking family members in families with smokers who continue to smoke will be made worse off-they receive little or no reduction in passive smoking costs and their after-tax income is reduced by the amount of the family's tax payments. Thus, while a tax to reflect such passive-smoking costs might be efficient, these equity considerations may make it less desirable. Finally, even if all costs of passive smoking are considered to be external and existing data are used to measure a per pack amount, the costs probably are small relative to current and proposed taxes. The Manning study calculates a total cost of smoking (both external and internal costs in excess of the price of the product) that includes medical expenditures, lost productivity due to illness, lost productivity due to early death, and costs from fires. This total cost equals $2.53 per pack (recall that these numbers are adjusted to 1995 levels). While the literature does not provide good data on the relationship between these active-smoking costs and passive-smoking costs, and indeed does not really show for certain that a passive-smoking cost exists, these total active-smoking costs along with other data can be adjusted to make three rough estimates that are suggestive of the general magnitude of potential passive-smoking costs. Estimate based upon EPA'a estimate of deaths from lung cancer Although the uncertainty of the epidemiological studies on passive smoking is discussed in Appendix A, these results can be used to generate possible passive-smoking I

CRS-12 costs. Divide EPA's estimated 3000 deaths from lung cancer due to passive smoking by the lung cancer deaths attributed to active smoking, and multiply this 0.022 result by the per pack total cost. " This generates passive-smoking total coets of six cents per pack. Estimate based upon EPA'a estimate of child hospitalizations A second epidemiological-based estimate can be made using EPA estimates that hospitalizations of young children due to respiratory disease from passive smoking range between 7,500 and 15,000. The average hospitalization is estimated to cost between $3,000 and $4,500.16 If these amounts are converted into per-pack costs they would range from one-tenth to three-tenths of a cent per pack.17 Estimate based upon relative physical exposure to amoke A third adjustment is to multiply the estimate of total active-smoking costs by the ratio of nonsmokers-to-smokers' physical exposure to smoke and by the ratio of nonsmokers to smokers.1b This calculation generates a passive-smoking total cost of 2.5 to 5 cents per pack. The first and third estimate might understate passive-smoking costs if the $2.53 per pack total active-smoking cost is understated. First, if individuals are willing to pay more than expected lost earnings for the expected change in life expectancy (internal costs for active smokers, but external costs for passive smokers), the $2.53 per-pack cost could rise by as much as $5 a pack, according to Manning. Stated in 1995 price levels, this increase could be as much as $6.84 per pack. Another difficult area to assess is the cost of low birth-weight babies due to maternal smoking. Some have argued that tliese passive-smoking costs 16 Premature lung cancer deaths attributable to smoking are estimated at 137,000 in 1989. See United 3tates Environmental Protection Agency (1992); and U.S. Library of Congre.o. Congre®sional Research Service. :rtorlclity and Economic Cotta Amibtctoble to Smoking and Alcohol Abuse, Report 93-428 SPR by C. Stephen Redhead, Apri120, 1993. Note that this method assumes that the relationship between active and passive premature deaths for lung cancer holds for the overall ratio of health and mortality costs for all diseases. 16 Testimony of Alfred Munzer, American Lung Association, Before the Subcommittee on Specialty Crops and Natural Resourees of the House Committee on Agiiculture, July 21, 1993, stated that 15,000 ho.pitalizatior..s would cost between W million and $68 million. 17 Current Federal taxes at 24 cents a pack account for:5.7 biIIion; thus each penny per p.ek is worth $238 million. The total cost of the hospitalizations would range from $23 million (7,500 at =3,000) to:88 million (15,100 at $4500). Thus, the amount per pack would be from 1erw than one-tenth of a cent to less than !u-ae-tenthS of a oent. 18 Kyle Steenland, "Paa.ive Smoking and the R.iak of Heart Di.eaae," Journal ojtAeAnurican Medical.4iaociation, January 1, 1992, Vol. 267, pp. 94-99 reports urinary cotinine (a marker for nieotine) in nonsmokers to be lese than one percent of that of.mokers, and in nonrmokers living with smokers, two percent or less. Since there are roughly an equal number of never-amokers and former/current smokers, the paseive cost would be one to two percent of active smoking. These estimates may actually be somewhat high: see the discussion of biological markers in Chapter 3 of the Environmental Protection Agency (1992). Note that this method areume@ a linear relationship between exposure and disease. I I I I I I I I I I I I I I

I I I I I I I I I I I I I I I I CRS-13 are very high, but measurement is difficult and only a small group of smokers (pregnant women) impose these costs.19 Adjusting for these higher total active-smoking costs gives passive-smoking costs of 21 cents per pack for the calculation based upon estimated lung cancer deaths and 9 to 18 cents for the calculations based upon physical exposure. These seem rather high for a few reasons. First, as stated above, the epidemiological evidence for passive-smoking-related disease is weak. Second, the estimates based upon physical exposure assume a linear relationship between exposure and disease. In fact, strongly nonlinear relationships in which health effects rise with the square of exposure, and more, have been found with respect to active smoking (see Surgeon General's Report, 1989, p. 44). For example, if health effects rise with the square of exposure, the effects would be one-tenth to one-fifth as large as with a linear relationship. Adjusting the nine to 18 cents per pack to allow for such a nonlinear relationship would reduce passive-smoking costs to a range of one to four cents per pack. These calculations suggest that if a passive-smoking cost were to be considered appropriate for inclusion as an external cost, it would be quite small, and unlikely to raise the estimate of spillover effects above the level of the current tax. Thus, it would not justify the 75-cent tax increase. 4. Non-health-related ealernal costs; intangible costi Some also suggest the Manning results are understated because they do not incorporate non-quantifiable external costs such as irritation from smoke, smell, nuisance, or general distaste. This is a complicated issue whose resolution requires more than economic analysis. The distaste some individuals have for smoking is difficult to quantify. The stance society should take-whether it should protect the observer's right to be free from the sights, sounds, and smells of others, or whether it should protect the individual's right to indulge in the offending habit when there is no way to measure damage-is not subject to clear guidelines. Individuals undertake many activities that others find distasteful, and many, perhaps most, ot them are not subject to government control. In any case, a tax might not be the best approach to correct for such behavior, for choosing the efficient level of tax relies on quantification of dollar value and is imposed whet.~.er or not repelled observers are present. Rather, regulations which separate amokers, allow specific smoking areas, or restrict the See Joel W. Hay, "The Harm They Do Others: A Primer on the External Costs of Drug ~ Abuae," in Searching jor Alternatioea: Drug-Control Policy in the United StAZoes, .d. Melvyn B. 4h Krauac and Edward P. Lazear, Stanford: Hoover Institution Pre.a, 1991. . opt 0 ' ro a ~ c,x cc I