Tobacco Documents Online

I I I I I I I I I I I I I I I I I I I \0- be mafe~ial may~ bht ~h~s ~ted bY co~' , ~0az1• Pr°te~ ~ 11 U.S• 1a++ CIGARETTE TAXES TO FUND HEALTH CARE REFORM JANE GRAVELLE* & DENNIS ZIMMERMAN* President Clinton presented a compre- hensive plan for universal health care in September 1993. Among the proposed sources of fin3ncing is a $0.75 increase in the current $0.24 per pack federal cigarette tax. The tax increase is about 42 percent of the current price inclusive of tax. The tax, expected to raise around $11 billion a year, will finance a signifi- cant portion of the President's proposed health care plan, particularly in the first year or two. Selective excise taxes often are not con- sidered desirable revenue raisers on eq- uity or efficiency grounds. With respect to equity, they disproportionately burden those who use the taxed products, im- posing horizontal inequities. They also impose a heavier share of the burden on lower-income individuals than does the traditional source of federal revenue, the income tax. The U.S. Congressional Bud- get Office (1990) found the tobacco tax to be especially regressive. However, these vertical equity concerns may be ameliorated by the benefits of the health care program, which would constitute a *Congressional Research sennce. Library of Congress, Wash- ington. D C. 20540 larger proportion of the_ income of lower-income individuals. The efficiency criterion is a focus of this paper. Excise taxes distort consumption decisions. A cigarette tax, however, may be desirable if it compensates for bur- dens that smokers impose on others or because smokers make their smoking decisions without adequate information to assess the health costs of smoking. in fact, the choice of a tax on tobacco to finance health care appears to be moti- vated by a belief that these conditions exist. Whether these market imperfec- tions are present is an empirical question addressed subsequently. Another issue in the choice of the ciga- rette tax to fund health care is revenue adequacy. The health care program is to be a permanent program and the per- manence of its financing sources is of interest. The obvious deficiency is the lack of indexing of the tax. However, as will be shown, even were the tax in- dexed, the long-term decline in smoking participation rates will cause the tax to provide a continually smaller share of program costs. A subsequent section dis- cusses policy implications arising from the analysis. The issues discussed in this 575 - 93 O Nat g- Tc~x J 47 ~3 )'• ri 9 I

I paper are treated in more detail in Grav- elle and Zimmerman (1994); Gross et a!. (1993) and Cordes, Nicholson, and Sam- martino (1990) also review some of the efficiency issues. MARKET IMPERFECTION AS A JUSTIFICATION FOR TAXING TOBACCO It is a generally accepted fact that smok- ing damages the smoker's health. The term "health costs" is a broadly defined measure that includes medical expendi- tures, lost productivity from sickness and disability, and early death. These health costs are divided into two types-those that burden the smoker himself (internal costs) and those that burden society (ex- ternal costs). Two aspects of these costs might make a selective excise tax on c,g- arettes and other tobacco products a correction for market failure and consis- tent with economic efficiency. First, cigarette smoking might impose a financial burden on the rest of society (spillover effects). The next section ad- dresses the magnitude of external cost~ or spillover effects. Second, if the smoker has complete information about the effect of smoking on his own health, he already takes internal health costs into account in making a deasior, and no tax is justified to obtain eco- nomic efficiency. However, people might make their smoking decision without complete information about the negat.ve health consequences; that is, they may make a rational decision based on im- perfect information that would be irra- tional given complete information. A later section deals with the issue of whether imperfect information about -. ternal costs justifies a tax. SPILLOVER EFFECTS To the extent that others in society must pay part of these health costs-in- creased medical expenditures (which are largely pooled through insurance) and increased job absences covered by sick leave payments-a tax may be justified because the cigarette price does not cover the true economic cost of smok- ing. In addition, the external costs of smoking are not limited to the health costs of smokers. For example, smoking contributes to fires whose costs may be borne by others if premiums on fire in- surance are raised for everyone. 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 litera- ture that measures the magnitude of these external costs. The Manning Study A thorough analysis of spillover effects from smoking must include a lifetime profile of both the external costs smok- ers impose on nonsmokers and the external savings smokers provide to non- smokers. While there has been consider- able research on the overall health costs of smoking (medical expenditures, lost productivity from sickness and disability, and early death), only the study by Man- ning et al. (1991), hereafter referred to as the Manning study, measures both the lifetime external costs and savings needed to gauge the efficient tax. Their study uses data on health costs of smok- ers (both current and former) and life- time nonsmokers (referred to as never- smokers) to develop the estimates. The Manning study found that the net external costs (external costs minus ex- ternal savings) of smoking are small- smaller than the current combined fed- eral and state taxes on cigarettes. One reason for this finding is that the exter- nal costs smokers impose on society (pri- marily because their larger lifetime medi- cal expenditures are not reflected in the I I I I I I I I I I I I I I I I 576 I I

I I I I I I I I I I I I I I I I ' TAXING UNHEALTHY BEHAVIOR insurance premiums they pay or in con- tributions 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 secu- rity) to which they contribute. in 1986 dollars, the Manning study found a net external cost per pack of cigarettes of $0.15 for a new (young) smoker. This estimate includes $0.43 of external costs: $0.26 of additional medi- cal expenditures; $0.01 of sick leave costs; $0.05 of group life insurance costs; $0.02 of costs from fires; and $0.09 of lost tax revenue smokers would have paid had they not died early. Off- set against these costs are external sav- ings to society of $0.27: $0.24 from re- ductions in retirement pensions, and $0.03 from reduced use of nursing homes. This $0.15 of net external costs equals $0.33 in 1995 dollars (with medical ex- penditures adjusted by the medical ser- vices price index and other costs ad- justed by the GNP defiator). According to the Tax Foundation (1993b), state- local taxes average $0.26 per pack. The $0.50 current tax (adding the federal tax of $0.24 per pack) is one-and-a-half times as high as the $0.33 tax justified by the net external costs estimated in the Manning study. Notably, the Manning study suggests that a much stronger case can be made for taxing alcoholic beverages at a higher rate. It estimates net external costs of at least $0.68 per ounce of al- cohol. A large fraction of this cost is as- sociated with loss of life, medical expen- ditures, and property damage in automobile accidents. Current federal taxes on alcohol are respectively about $0.21, $0.10, and $0.08 per ounce for distilled spirits, beer, and wine. Tax Foundation (1993a) data show state taxes to be low, generally less than half federal taxes. These data suggest larger taxes would have to be imposed on al- cohol products if taxes were to reflect net external costs. In short, based on the criterion of matching tax revenue to net external costs, the data indicate that cig- arettes are overtaxed and alcohol is un- dertaxed. Qualifications to the Manning Study Because the Manning study is alone in its attempt to calculate all financial spill- over effects (both costs and savings) as a basis for assessing the economically effi- cient level of tax, it is important to dis- cuss thoroughly potential issues that may raise doubts about the results. Estimation error from model specification The Manning study estimates an upper limit of $0.53 for the external costs of smoking that arise from effects on smokers' health by attributing all the variation in total health costs among in- dividuals to smoking status. It alsb is possible that the spillovers are much smaller. Omitted variables may generate nonsmoking health costs that are correlated with smoking. Smokers are more likely to engage in risky activi- ties (Viscusi, 1992) and as a conse- quence are, for example, more likely to incur health costs from accidents. These health costs would be partly attributed to smoking status in the base case, even though they are caused by differences in risk-taking rather than smoking status. If health costs are restricted to those thought to be related to the smoking habit (e.g., certain cancers, respiratory illness, circulatory diseases, and ulcers), the net external cost is $0.12; if the dif- ference in disability costs between smok- ers and nonsmokers is also eliminated, the result is net external savings (exter- nal savings exceed external costs) of $0.14. 577 .1 I

I I Choice of discount rate clear whether any passive smoking effect exists. I Any study whose results involve a com- parison of costs and savings with signifi- cantly 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 $0.42 per pack. Lowering the discount rate to just under four percent would produce net external costs of zero; below that rate net external savings would be gen- erated. . Passive smoking Some suggest the Manning study under- estimates net external costs from smok- ing because it does not include the ex- ternal costs of passive smoking. The exclusion of these effects is not due to a failure to address the issue. The Man- ning study cuts its active smoker medical expenditure data eignt ways in a search for evidence_ of passive smoking effects. It examines both total medical expend - tures and the subset associated with ill- nesses related to smoking, for adults and children as outeat ents and inpa- tients. The data ana!vzed indicate a sta- tistically significant eifect for habit- related (smoking-rela:ed) inpatient medi- cal expenditures for adults; the data do not indicate an effect for the other cate- gories. Several reasons suggest that it may be appropriate to omit passive smoking ef- fects from the calculation of the correc- tive tax. First, the effects of pass ve smoking on health are far weaker and less certain than the effects of act ve smoking. Based on tne most common biological marker (cotinine in urine), the physical exposure to passive smoke is so small relative to active smoking-less than one-half of one percent on average according to the U.S. Environmental Pro- tection Agency (1992)-that it is not The Surgeon General, U.S. Department of Health and Human Services (1986) and the U.S. Environmental Protection Agency (1992), or EPA, have taken the position that passive smoking is linked to lung cancer in adults and respiratory ill- ness in children, based in part on the findings in most statistical studies that somewhat elevated risks exist for wives and children of smokers. The latter re- port was the subject of some contro- versy in a hearing held after the report was released (U.S. Congress, House Committee on Agriculture, 1993), and the findings are disputed by the tobacco industry and some researchers. One reservation about the statistical evi- dence on passive smoking, which com- pares the incidence of disease among those who live with smokers and those who do not, is the possibility that other factors are responsible for the slightly el- evated risks of nonsmoking wives and children of smokers. For_example, if wives of smokers share in poor health habits or other factors that contribute to illness that are not or cannot be con- trolled for, statistical associations may be spurious. Evidence exists that smokers tend to engage in other poor health habits (Manning et al., 1991). Another possibility, in the case of lung cancer, is that some reported nonsmokers are ac- tually former or current smokers, and smokers are more likely to marry other smokers, causing a classification bias. The EPA made a correction for this mis- classification bias, but it is impossible to make a precise correction. Finally, two large new studies published after the EPA's cutoff date for inclusion found either no effect or an effect that was far from statistically significant. Since the ex- posure to passive smoke is extremely small relative to the exposure to active ;"x I I I I I I I I I I I I I ~ I I

I I I 11 I . I I I I I I I I I I I I I I ' TA`ING UNHEALTHY BEHAVI0A smoking, the evidence is subject to some uncertainty. Second, if a passive smoking effect ex- ists, the effect may be most likely to oc- cur within families. Reasons exist for considering a family, rather than an indi- vidual, to be the decision-making unit when designing externality-correcting taxes. One reason is that corrective gov- ernmental action often is not desirable for spillover effects that occur within groups that are small enough to negoti- ate with each other, since members of the group can come to a mutual agree- ment that maximizes welfare. Passive- smoking effects that occur within a fam- ily unit may fit this description. This is a gray area where public policy might well consider these effects either as internal or as external costs depending upon the relative bargaining strengths of those af- fected. The findings of the Manning data, which tend to show that costs are more likely to be associated with adults (who presumably have relatively compa- rable bargaining strengths) than with children (who presumably would operate from a relatively weak bargairiing posi- tion) might argue for treatment as inter- nal 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. Presumably, par- ents consider the welfare of each other as well as children in making decisions and take into account any negative con- sequences of smoking for other family members. Third, if passive smoking effects are con- sidered external costs, equity consider- ations suggest a,tax remedy may not be desirable. The justification for a tax to correct externalities is made on efficiency grounds because it is possible 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 distribu- tional effects-smokers lose and non- smokers gain. Many people, however, perceive this distributional effect as fair, since smokers impose costs on non- smokers 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 consider- ations may make it less desirable. Finally, even if all costs of passive smok- ing are considered to be external, the costs probably are small relative to cur- rent and proposed taxes. The Manning study calculates a total cost of smoking (both external and internal costs in ex- cess of the price of the product) that in- cludes medical expenditures, lost produc- tivity 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). These total active-smoking costs along with other data can be adjusted to make rough estimates that are suggestive of the general magnitude of any potential passive-smoking costs. The EPA's estimates of death from lung cancer for nonsmokers are about 2.2 percent of active smoking deaths. If this 579 0 ,

I I > ratio is extended to all diseases, this esti- mate generates passive-smoking costs of $0.06 per pack (0.022 times $2.53). An alternative approach 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, which is currently approxi- mately one. This calculation generates a passive-smoking total cost of $0.025 even at a one percent exposure ratio, twice the level reported by the EPA (1992). Note that this method assumes a linear relationship between exposure and disease. These estimates might understate pas- sive-smoking costs. 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 the Manning study Stated in 1995 price levels, this increase could be as much as $6.84 per pack, for a total of up to $9.37 ($2.53 plus $6.84). [An- other difficult area to assess is the cost of low-birth-weight babies due to mater- nal smoking. Some have argued that these passive-smoking costs are very high, but measurement is difficult and only a small group of smokers (pregnant women) impose these costs.) Adjusting for the higher total active- smoking costs gives passive-smoking costs of up to $0,21 per pack for the calculation based upon EPA data and up to $0.09 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 physi- cal exposure assume a linear relationship between exposure and disease. In fact, strongly nonlinear relationships in which health effects rise with the square of ex- posure, and more, have been found with respect to active smoking (see Sur- geon General's Report, U.S. Department of Health and Human Services, 1989, p. 44). For example, if health effects rise with the square of exposure, the effects would be one-tenth as large as with a linear relationship. Adjusting the $0.09 to allow for a nonlinear relationship re- duces passive-smoking costs to $0.01 per pack. A supplementary epidemiological-based estimate can be made using EPA esti- mates that hospitalizations of young children due to respiratory disease from passive smoking range between 7,500 and 15,000. According to testimony of Alfred Munzer in hearings on the EPA report (U.S. Congress, House Committee on Agriculture, 1993), the average hos- pitalization is estimated to cost between $3,000 and $4,500. If these amounts are converted into per-pack costs they would range from one-tenth to three- tenths of a cent per pack. These calculations suggest that if a passive-smoking cost were to be consid- ered appropriate for inclusion as an ex- ternal cost, it would be quite small, and unlikely to raise the estimate of spillover effects above the level of the current tax. Non-health-related external costs; intangible costs The Manning results are understated be- cause they do not incorporate nonquan- tifiable 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 in- dividuals have for smoking is difficult to quantify. The stance society should take-whether it should protect the ob- server's right to be free from the sights, 580 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 ' TAXING UNHEALTHY BEHAVIOR 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. Individu- als undertake many activities that others find distasteful, and most of them are not subject to government control. In any case, a tax might not be the best correction for such behavior. Choosing the efficient level of tax relies on quanti- f,cation of dollar value and is imposed whether or not repelled observers are present. Rather, regulations that sepa- rate smokers, allow specific smoking areas, or restrict the activity in close en- vironments might be more appropriate. An argument can be made that, to achieve efficiency, private businesses should be able to make their own dea- ,ions about allowing, disallowing, or separating smokers, since they must re- spond to the tastes of their customers and workers. For example, owners of restaurants and bars will modify their conditions to attract customers so that some will allow smoking, some will not allow smoking, and some might segre- gate smokers from nonsmokers. This ar- gument holds up as long as sufficient choice is available and customers have adequate information. Some decisions would still have to be made about pub- lic facilities that are subject to monopoly provision. Miscellaneous issues The estimates indicate the appropriate tax only for a new (young) smoker, not for the current mix of smokers. This is appropriate because the lifetime per- spective offers the only feasible method of calculating a net external cost and the associated corrective tax. Several other issues generate uncer- tainty. (1) Changes in the tar and nico- tine content of cigarettes may result in a decrease in net external costs for current new smokers as compared to the cross section of existing smokers. (2) The share of cost borne privately may differ in the future from the Manning study assumptions. (3) The estimates include only the foregone tax revenue from early death that is used to finance transfer payments. (4) interview surveys, on which some of the data are based, may be subject to considerable errors in re- call. (5) When comparing the spillover effects with the proposed tax at 1995 price levels, the likelihood that average state taxes would increase during that time period is ignored. Relationship of the Manning study to other studies Other estimates of the costs of smoking and per-pack medical expenditures or total health costs exist. The Manning study is likely to be more accurate in its estimates of the appropriate level of tax because it alone does three things cor- rectly. First, the Manning study attempts to identify all financial costs and savings of smoking that are external to the smoker. Thus, it includes medical expenditures and costs of lost productivity, but adjusts these costs to exclude amounts that are paid out of pocket by the smoker; that is, external costs are distinguished from internal costs. As a consequence of this procedure, it includes changes in the smoker's payments to society and soci- ety's payments to the smoker that result from the smoker's early death. Second, the Manning study controls sta- tistically for many other attributes that might affect observed differences in health care expenditures for smokers and nonsmokers, such as education, in- come, and other health habits. (This control does not necessarily, of course, capture all of these other factors.) 581 I

Third, the Manning study calculates the tax from a lifetime perspective, where costs and savings of smoking are dis- counted over a lifetime and used to generate a tax of equal present value. This lifetime perspective is important be- cause of the time-dependent nature of the smoking/health phenomenon. Typi- cally, individuals smoke for many years before smoking-related disease appears; taxes are collected well in advance of additional medical expenditures, and as a result taxes and medical expenditures have different preserit values. Also, when individuals die early as a result of smoking, health and other costs (e.g., pensions) are foregone (and thus re- duced). These external savings (foregone medical expenditures and pension sav- ings) occur even later in (expected) life and are even more heavily discounted than are sn,,,kers' additional medical ex- penditures. As shown in Gravelle and Zimmerman (1994), approaches that try to estimate the spillover effects by divid- ing current costs by current consumption will be correct only if the discount rate and the growth rate are icientical. Since the growth rate of smokers has been negative, such calculations overstate by several orders of magnitude the per- pack tax appropriate to adjust for spill- overs. Five other studies were discussed in de- tail in Appendix B of Graveile and Zim- merman (1994). Of these, two studies provide evidence on the magnitude of excess lifetime medical exi:enditures of smokers; the Manning stu,-'.y's estimate of excess lifetime medical excenditures falls between these two estimates. Oth- ers of these studies provide calculations of per-pack medical expenditures or to- tal health costs that are inconsistent with the Manning results because they fail to do at least one of the three things done in the Manning study. INFORMATION AND SMOKING CHOICE Aside from spillover effects, standard economic theory holds that a tax is justi- fied on efficiency grounds if individuals are unable to recognize the full costs of smoking to themselves (internal costs). Thus, a second argument for imposing a tax on cigarettes is that people are not informed of the hazards of smoking and do not recognize the full cost to them- selves. Or, they are not able to make sensible choices because the consump- tion of the commodity is habit-forming and they do not fully understand the difficulties of altering future behavior. Before discussing these two issues, it is important to understand a crucial obser- vation from economic theory: the fact that individuals engage in hazardous or dangerous activities does not mean that they are making bad choices. Individuals are presumed to choose activities, in ac- cordance with their subjective tastes and preferences, that make them the happi- est. This choice does not necessarily mean that they will maximize their health or their_lifespan. individuals en- gage in all sorts of behaviors that im- pose some danger in exchange for ben- efit efit (driving small cars or riding motorcycles, working in risky jobs, eat- ing unhealthy diets, engaging in risky sports). Thus, nothing in economic the- ory precludes the notion that individuals smoke because their enjoyment of the activity outweighs the sum of the actual costs of purchasing cigarettes and the internal health costs. Viscusi (1992) summarizes research showing that both teenage and adult smokers are risk takers in a variety of ways and that the average smoker, in continuing behavior involving a health hazard, behaves in a way consistent with other decisions he makes. From an economist's perspective, if there is a market failure, it is not in making a 582 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 ' TAXING UNHEALTHY BEHAVIOR choice to engage in a dangerous or risky activity, but rather in making that choice with incorrect information. Two aspects of this information problem are consid- ered in turn: whether the individual is knowledgeable about the health haz- ards, and whether the individual under- stands the cost of changing behavior in the future. The policy implications of these findings are then discussed. Information on Health Hazards An argument is frequently made that smokers may not be correctly informed about the risks of smoking. The U.S. Congressional Budget Office (1990), for example, cited statistics indicating that some smokers are not aware of the link- age between cigarette smoking and var- ious diseases. Viscusi (1992) uses two surveys of the general population-his own and one provided by the tobacco industry-to quantify smokers' and nonsmokers' perceptions of the health risks of smoking. The two surveys yield similar results. Survey respondents were asked how many of 100 smokers are likely to die from •smoking-related dis- eases. According to Viscusi (1992), mortality statistics on smoking-related deaths indi- cate the total lifetime mortality risk to smokers ranges from 0.18 to 0.36 (18 to 36 of each 100 smokers are likely to die from disease caused by smoking). Survey respondents perceive this risk to be 0.54, largely because of an over- perception of the risk from lung cancer. This perceived risk differs somewhat de- pending on smoking habits-0.47 for current smokers, 0.50 for former smok- ers, and 0.59 for those who have never smoked. The perceived risk is higher for younger ages than for older ages, prob- ably because the young have been more heavily exposed to information on smok- ing and health risks. Viscusi also finds a tendency among respondents to over- state the expected number of years of life lost because of smoking. To summarize, Viscusi (1992) finds that although smokers perceive smaller risks than nonsmokers, smokers also perceive risks to be higher than indicated by sci- entific evidence. Thus, although some in- dividuals may not be aware of or may reject the evidence on the health cost of smoking, this does not appear to be the case overall. These results should not be surprising, as it is common for individu- als to overestimate the risk of a highly publicized discrete event that is reported without reference to the event's fre- quency in the population to whom such an event may occur (common examples are the risks of being killed by tornadoes or struck by lightning). If individuals overestimate the health hazards of smoking, a tax would not correct for imperfect information. Information on Habit Formation and Addiction In addition to inaccurate risk assessment, market failure also could result if individ- uals incorrectly assess the impact tobac- co's addictive property will have on a fu- ture attempt to quit. According to the economic theories ap- plied to addictive behavior (see Chal- oupka, 1991), simply because individuals engage in behavior that involves habit formation or addiction does not mean they are making a mistake, as long as the individual recognizes the difficulty of modifying behavior in the future and the possibility of a need for such modifica- tion. Individuals make many decisions that are difficult to change (and that they are probably aware are difficult to change)-marriage, job, purchasing a home, locating in a given area-without those decisions being seen as bad choices and appropriate targets for gov- ernment intervention. 583 I

I I t- From this perspective, when smokers make a mistake it is due to a failure of information-a failure to understand either the difficulty of altering future be- havior or the likelihood that alteration will be desired. It is not easy to assess the extent to which this problem occurs. A variety of observations support both the view that incomplete information is a serious problem and the view that it is a less important problem. Two types of evidence might shed some light on the severity of this information problem. The first is evidence of the strength of the addiction problem. The less pronounced the addiction problem, the less serious is any failure to under- stand the problem. Second, if the addic- tion problem is serious, is there evidence that individuals are aware of the prob- lem? Evidence on habit formation and addiction The evidence supporting the problem of habit formation is straightionvard. That smoking is habit forming is essentially beyond dispute. There is a:so a sub- stance in tobacco, nicotine, that is physi- cally addictive to some dF;ree. A very large number of smokers say they would like to quit or have tried to quit at least once (U.S. Congressional Budget Office, 1990), and quitters exper ence a high rate of recidivism (Harris, .993, p. 167). Individuals also continue : -- spend money on smoking cessat,on programs. Other observations sugge•si, however, that addiction is not senois enough to make smoking decisions s,gnificantly dif- ferent from many other o~asions in which the government does not inter- vene. For example, although many smokers have tried to qu,: and failed, many also have tried and succeeded, the vast majority without help (Surgeon General's Report, U.S. Deoartment of Health and Human Services, 1989). The number of former smokers is now as large as the number of current smokers. Smoking decisions also respond to changes in prices in a way that is consis- tent with consumption decisions about many other products, and increased publicity about health risks did reduce smoking substantially. Thus, individuals appear to be able to cease smoking when the price (either in actual cost or in implicit, perceived health costs) in- creases substantially. Individuals saying they would like to quit is indicative of the difficulty of breaking pleasurable habits but does not neces- sarily prove a serious addiction problem. Indeed, some of the arguments used to support the case that smoking, addic- tion, and the difficulty of changing be- havior is a serious problem are applica- ble to many other activities. Individuals not only engage in risky activities, but they also fail to initiate or persist in many behaviors that would contribute to their health (e.g., diet and exercise). When they do initiate changes, they ex- hibit a high rate of failure to follow through even when considerable money is spent on programs to attain these ends. Many overweight individuals have made a serious attempt to lose weight and failed; many sedentary individuals have made an effort to initiate and maintain a regular exercise program and failed. Few suggest these behaviors jus- tify government intervention. Evidence on information regarding addiction Even if addiction is a serious problem, there is no market failure if individuals are aware of it when they make the ini- tial smoking decision. The argument that incomplete information is a serious prob- lem begins with the observation that most smokers begin early in life, typically in the teenage years, when a lack of in- formation or understanding may be 584 I I I I I I I I I I I I I I Co L) i:o -R ~ C7 I a I

I I I I I I I I I I I I I I I I I I r TAXING UNHEALTHY BEHAVIOR 4 more severe. A survey of teenagers showed that half expect not to be smoking in five years (Surgeon General's Report, U.S. Department of Health and Human Services, 1989), whereas data show that smoking participation gener- ally does not decrease until much later in life. This evidence suggests that teen- agers may have incorrect perceptions about their ability to stop smoking. On the other hand, some data indicate that even the very young are aware that it is difficult to quit smoking. About 75 per- cent of those 14 and younger, when queried about the difficulty of stopping smoking, identified as true the state- ment "It is very hard to stop smoking." (Viscusi, 1992). Policy Responses The fundamental tax policy issue is two- fold. If smoking decisions are to be rea- sonably informed, then the government should not intervene beyond correcting for spillover effects. If, however, the de- cision is not informed, then intervention may be appropriate and a tax might make smokers better off in the long run if it led them to quit or fail to take up the habit. The preceding discussion suggests uncer- tainty about the degree to which the smoking decision is a wrong decision when it is placed in the context of indi- vidual preferences. The evidence pre- sented suggests that there is not much of a case for a market failure with re- spect to information on the health haz- ards of smoking. Indeed, it is possible that individuals overestimate these health costs, on average. Whether indi- viduals are informed about the difficul- ties of changing future smoking behav- ior is much less certain. As a correction to information problems regarding addiction, a tax has certain shortcomings. First, use of a tax that is set properly requires a quantification of the degree to which information is in- correct, a measure that cannot be made based on current information and that would presumably vary widely across in- dividuals. Second, the tax would be an effective deterrent to smoking primarily for those who have not yet begun and for those smokers who are least ad- dicted. This is not an inconsequential step, but the tax would not be an effec- tive remedy for correcting behavior for those who have made an uninformed choice. Finally, as in the case of spillover effects within the family, a tax aimed at "help- ing the smoker" produces distributional or equity effects that blur the desirability of the policy overall. Consider, for exam- ple, a tax of the magnitude proposed by the health care plan. The short-run price elasticity of smoking participation is about -0.3 and the long-run elasticity is about -1.2. Assuming a constant elastic function with a $0.75 tax, about ten percent of individual smokers will quit smoking in the short run. In the long run, the reduction will be about a third. Thus, the tax makes worse off the ma- jority of those it is intended to help. On the whole, therefore, a tax may not be the most appropriate policy instru- ment to deal with the information prob- lem. Although the $0.75 tax might elicit a one-third reduction in new teenage smokers, adolescent smokers account for only six percent of all smokers (National Cancer Institute, 1993). Nontax alterna- tives may be better targeted. If lack of information about addiction is the pri- mary problem, perhaps a better re- sponse is to disseminate information to the young about the dangers of addic- tion through educational programs in the schools, general advertising, and perhaps through warning labels. If the age of initiating smoking and immaturity of decision making by young smokers seems to be the primary problem, an 585 00 I

I • approach might be to introduce stricter laws limiting the sale of cigarettes to mi- nors and to enforce those laws. To help current smokers who will constitute the great majority of smokers in the near and medium term, more assistance for quitting (including information and bet- ter nicotine replacement devices) may be a desirable public policy. Indeed, one feature that may be desirable in a health care plan is to provide coverage for ex- penditures on smoking cessation. Finally, a policy option that might help all indi- viduals would be the development of a less dangerous cigarette, although Vis- cusi (1992) reports that public health of- ficials have discouraged the "smokeless cigarette." CIGARETTE TAXES AS A REVENUE RAISER The proposed health care program is to be permanent, and the cigarette tax has been presented as a permanent feature of its financing. One standard for evalu- ating the tax might be whether it will generate revenue suff.~ient to finance a constant share of the Drogram's costs over time. If it does r, :~:. policy discus- sions of the proposeci health care pro- gram ought to consider what financing source will replace cigarette tax revenue beyond the budget w!ndow. Real spending is likely either to grow (if the health care "price index" increases faster than the rate of inflation) or to re- main constant (if the !•,eafth care "price index" rises at the rate of inflation), but the real value of every dollar of tax reve- nue will decline as the price level rises because the tax is not indexed. Even were the tax indexed, however, health care costs will grow at the rate of popu- lation growth whereas revenue will grow at less than the rate of population growth: the sensitivity of smoking par- ticipation rates to price changes will in- crease over time and generate larger re- ® ductions in cigarette consumption and tax revenue. The response of cigarette consumption to price changes is summarized by esti- mates of the price elasticity of smoking participation rates and the price elasticity of the quantity of cigarettes smoked per smoker. The smoking participation rate price elasticity (-0.31) is much greater than is the price elasticity of smoking participants' average consumption (-0.11); and the smoking participation rate of the young is much more sensitive to price (-1.2 elasticity for those 12 to 17) than is the participation rate of other age groups (-0.15 elasticity for those 36 to 74) (Surgeon General's Re- port, U.S. Department of Health and Hu- man Services, 1989, p. 537). This differ- ence by age groups is consistent with expectations about demand for an ad- dictive or habit-related product. Since one's addiction or habit dependence presumably increases the longer one consumes a product, the likelihood of quitting in response to a price increase is likely to decrease with age. These elasticity differences have impor- tant consequences for long-term revenue collections. The 12- to 17-year-olds' elas- ticity of -1.2 suggests that a one per- cent price increase would reduce smok- ing participation by 1.2 percent. In contrast, the 36- to 74-year-olds' elastic- ity of -0.15 suggests a one percent price increase would reduce smoking participation by 0.15 percent. As a re- sult, the reduction in smoking partici- pants in response to the $0.75 tax would not be great in the short run- note the weighted price elasticity of par- ticipation rates for all ages is -0.31 (53 percent of current smokers in 1992 were 36 or older). Since the $0.75 cigarette tax represents a 42 percent increase in the average $1.80 price of a pack of cigarettes, the number of smokers will decline in the short run by 10.2 percent, I I I I I I I I I I I I I I 586 I I

I I I I I I I I I I I I I I I I I I ' TAXING UNHEALTHY BEHAVIOR using a constant elasticity function. When the response of quantity per smoker is incorporated, a reduction in cigarette consumption of 15.1 percent becomes the base for the short-run rev- enue estimate. As the years march on, the population of smokers comes to be dominated by new cohorts of 12- to 1 7-year-olds whose initial smoking participation deci- sion will be made in response to a-1.2 elasticity rather than the -0.15 elastic- ity. This process will generate a substan- tial decrease in the long-run aggregate participation rate relative to the rate in effect in the first five or six years of the tax. The expected long-run reduction in consumption of cigarettes will be much greater than in the short run. As is true with econometric estimation of any behavioral parameter, the precise magnitude of these price elasticities is the subject of considerable debate. The estimates used here are from the "tradi- tional" framework, in which quantity de- manded is a function of current price. The long-run price elasticity.is inferred from the differences in elasticities by age group, as described above. Recent re- search has investigated the possibility that an addictive good such as cigarettes is subject to a much more complex de- mand relationship, This "rational addic- tion" framework suggests that today's consumption is dependent upon both past and future consumption (Becker, Grossman, and Murphy, 1993; Keeler et al., 1993; Chaloupka, 1991). This frame- work estimates short-run and long-run elasticities directly, and finds the long- run elasticity to be higher than the short-run elasticity, a result consistent with this study's use of the elasticities from the traditional framework. The ra- tional addiction estimates, however, tend to find a somewhat smaller difference between the short-run and long-run elasticities than is implied by the other estimates. These smaller differences may be less accurate than the differences from the traditional literature for two reasons: the estimates represent a time period considerably shorter than proba- bly is necessary to capture the full re- sponse to price, and the specification of the rational addiction model creates seri- ous econometric estimation problems. The estimates of federal revenue gener- ated by the proposed cigarette tax for the next 69 years assume the tax is in- dexed and passed forward in a higher price The estimates incorporate: zero per capita income growth; population growth; and a changing aggregate par- ticipation rate elasticity as today's popu- lation is aged for 69 years. This allows the entire population (age 12 to 80, an age range that includes almost all smok- ers) to have its initial smoking participa- tion response to the proposed $0.75 tax be made as a member of the 12 to 17 age group. (Further details of the calcu- lation can be found in Gravelle and Zim- merman, 1994.) At constant prices, net annual revenue grows over the 69 years from $11.466 billion to $12.353 billion. This revenue reflects two adjustments: a reduction of $0.24 per pack for the ex- isting cigarette tax that is not collected on consumption discouraged by the $0.75 tax (the difference between before-tax and after-tax consumption), and a reduction of $0.25 per dollar of revenue for the lost federal income tax collections attributable to reduced factor incomes. The time path of this revenue reflects the combined influence of population growth, which increases consumption and revenue, and the population's in- creasing participation rate sensitivity to the tax-induced price change, which de- creases consumption and revenue. The effect of increasing participation rate sensitivity (fewer smokers) on long-term 587 k 11

I I FIGURE 1. Shortfall of Revenue from indexed Ciga- rette Tax Due to increasing Partic pation Rate Sens - tivity: Assumes No Population Growth, No Per Cap- ita Income Growth A.wn+. R tlfa+.l P.rovit WmreaM 12 100 10.8 ~ V.+lopam ... «r-,IMn -i so ss'- ~ 480 i I 8.4- ~70 I ConaaM ao7.2, Omxiv+on r.r s«rwrwy _ -160 I 1 14 27 40 53 aso Jo 66 Number of Yeare after Imposition of Tax revenue collections is isolated in the fol- lowing way. Assume that the five-year-budget-win- dow revenue estimate of about $11.4 billion per year will prevail into the fu- ture. The resulting horizontal revenue line in Figure 1 ignores the influence of both population growth and increasing participation rate sensitivity. The middle line in Figure 1 is actual tax collections "normalized" to remove the effect of population growth, but leaving the influ- ence of increasing participation rate sen- sitivity. In effect, this is the revenue from a tax had it been instituted many years ago; that is, a tax that had been insti- tuted many years ago would provide long-term revenue of $7.7 billion, not $11.4 billion. The difference between the two revenue lines is attributable to increasing participation rate sensitivity. One might say that the shortfall is the amount by which one would overesti- mate long-run revenue collections if one assumed the budget-window revenue estimate would prevail into the future. The percentage shortfall is 15 percent after 20 years, reaches 30 percent about year 43, and becomes a constant 33 percent of the upper revenue line after year 56. POLICY IMPLICATIONS An increased cigarette tax as a method of financing health care reform appears questionable on efficiency, budgetary, and equity grounds. The most straight- forward justification for linking the two-that smokers impose financial costs on nonsmokers-probably has al- ready been corrected oy ax..,ang ciga- rette excise taxes. The revenue from the tax will be substantial, but will decline over time relative to budget-window es- timates and will finance an increasingly smaller share of health care costs. The cigarette tax will fall on a small share of the population and will disproportion- ately burden lower-income individuals compared to almost any other revenue source. On the other hand, the tax does have considerable popular support and would help to deter the young from be- coming smokers, although stricter en- forcement of restrictions against sales to minors and prohibition of smoking in areas frequented by minors might ac- complish the same goal. Several policy alternatives that might be considered, including other tax sources, spending cuts, improvements in the de- sign of the cigarette tax, and alternative policies to target concerns about teen- age smoking are discussed. OTHER TAX SOURCES An alternative revenue source that comes to mind in this context is an in- 588 I I I I I I I I I I I I I I t,i / ..a ~ I I

I I- I I I I I I I I I I I I I I I I I TAXING UNHEALTHY BEHAVIOR• crease in the excise tax for alcoholic bev- erages. As with tobacco consumption, a link exists between alcohol consumption and health (both as a result of damage due to drinking and from traffic injuries). Evidence from the Manning study sug- gests that, unlike tobacco, spillover ef- fects for alcohol substantially exceed cur- rent taxes. Thus, substitution of an alcohol tax for the tobacco tax would improve economic efficiency. Alcohol taxes are also regressive, but they are less regressive than tobacco taxes. Taxes are currently lighter on beer and wine, per ounce of alcohol, than they are on distilled spirits. Another alternative is to increase the rates or broaden the base of the tradi- tional main source of federal revenue, the income tax. Either rate increases or base broadening would be progressive compared to the regressive tobacco tax, and would fall broadly on all individuals rather than on a narrow group. In addi- tion, some base broadening options would seem to be natural for health care reform because they could also pro- mote economic efficiency in the health care market. A prime example is employer-paid health care premiums, which under current law and under the proposed plan distort consumer choices because they are excluded from the indi- vidual's income and are deductible by the employer. PROGRAM REDUCTIONS The health care proposal is a very large, complicated plan, and opportunities may exist to reduce spending. In general, tax revenues collected under the plan are dispensed either in benefit increases to public health programs (such as in- creased drug benefits for Medicare) or in a network of subsidies woven into the plan. One subsidy would prevent man- dated employer premiums from exceed- ing a percentage of salaries; another would help lower-income individuals pay for their share of program costs. Within this network of subsidies, the subsidies for small businesses might de- serve particular attention. Small busi- nesses would receive special subsidies for their mandated premiums, with the subsidies based on a sliding scale that moves with business size and wage in- come. The argument for these subsidies is a transitory one-concern that the im- position of these mandated payments on smaller firms that did not already have such plans will cause unemployment. As a permanent measure, such subsidies are likely to be inefficient-favoring workers of small firms may misallocate resources and generate less economic output. Be- cause of the transitory nature of this problem, these subsidies could be phased out over a few years. MODIFICATIONS TO A CIGARETTE TAX If a cigarette tax is to be used because of its feasibility, short-run revenue gen- erating potential, impact on smoking re- duction (particularly among the young), and ease of administration, policymakers are faced with a revenue source that de- clines in real terms and relative to the program expenditures. A straightforward revision would be to index the tax. One can debate the mer- its of imposing a tax in the first place, but if the tax is to be imposed, indexa- tion would ensure that the tax maintains its real value. A tax that is not indexed creates short-term disruption in the in- dustry for a revenue source that eventu- ally will dissipate. POLICIES TO AFFECT SMOKING AMONG THE YOUNG If the primary focus of the cigarette tax is to decrease youth participation rather _ than to generate revenue, a more tar- 589 .

I geted approach might be increased reg- ulation and information programs. A regulatory approach might target restric- tions in areas frequented by teenagers (such as schools and libraries) or might include stricter laws prohibiting the sale of cigarettes to minors. Wasserman et al. (1991) found evidence that regulatory policies may be eff_ ective in discouraging the initiation of smoking among the young. Indeed, it is possible that price responses actually are smaller than those estimated, and that some of the mea- sured response is reflecting the effect of regulatory policies. Such regulatory poli- cies might be more effective than taxes, as well as more targeted. Such policies would avoid the adverse economic con- sequences that cigarette taxation im- poses on mature smokers. © 0 I I ENDNOTES The views expressed do not necessarily repre- sent those of the Congressional Research Ser- vice or the Library of Congress REFERENCES Becker, Gary S., Michael Grossman, and Kevin M. Murphy. An Emprrcal Analysis of Cig- arette Addiction. NBER Working Paper No. 3322 Cambridge, MA: National Bureau cf Economic Research, March, 1993. Chaloupka, Frank. "Rational Add+drve Behavior and Cigarette Smoking." Journal of Political Economy 99 (August, 1991). 722-42. Cordes, Joseph J., Eric M. Nicholson, and Frank J. Sammartino. "Raising Revenue by Tax- ing Activities with Social Costs." ^labonal Tax Journal 63 (September, 1990): 343 -56. Gravelle, Jane G. and Dennis Zimmerman. "Cigarette Taxes to Fund Health Care Reform: An Economic Analysis." Congre,,= oral Research Service Report 94-214 E. Washington. D.C., March 8, 1994. Gross, Michael, Jody L Sindelar, John Mul- lahy, and Richard Anderson. "Po!.cy Watch: Alcohol and Cigarette Taxes." Journal of Eco- nomic Perspectives 7 (Fall, 1993): 211-22. Harris, Jeffrey. Deadly Choices: Coping With Health Risks in Everyday Life. New York: Basic Books, 1993. Keeler, Theodore E., Teh-Wei Hu, Paul G. Bamett, and Willard G. Manning. "Taxation, Regulation, and Addiction: A Demand Function for Cigarettes Based on Time-series Evidence." Journal of Health Economics 12 (1993): pp 1- 18. Manning, Willard G., Emmett B. Keeler, Jo- seph P. Newhouse, Elizabeth M. Sloss, and Jeffrey Wasserman. The Costs of Poor Health Habits. A RAND Study. Cambridge, MA: Harvard University Press, 1991. National Cancer Institute. The Impact of Ciga- rette Excise Taxes on Smoking Among Children and Adults. Summary Report of a National Can- cer Institute Expert Panel. August, 1993. Tax Foundation. Facts and Figures on Govern- ment Finance. 1992 Tax Foundation. Tax Features 37, (October, 1993). U.S. Congress, House Committee on Agricul- ture Subcommittee on Specialty Crops and Natural Resources. Review of the U.S. Environ- mental Protection Agency's Tobacco and Smoke Study. 103rd Cong., 1st sess., July, 1993. U.S. Congressional Budget Office. Federal Tax- at on of Tobacco, Beverages, and Motor Fuels. Washington, D.C.: U.S. Government Printing Of- fice, August, 1990. U.S. Department of Health and Human Ser- vices. The Health Consequences of lnvoluntary Smoking, 1986. Surgeon General Report, DHHS Publication No. (CDC) 87-8398. U.S. Department of Health and Human Ser- vices. Reducing the Health Consequences of Smoking: 25 Years of Progress. 1989. Surgeon General Report, DHHS Publication No. (CDC) 89- 8411. U.S. Environmental Protection Agency. Respi- ratory Health Effects of Passive Smoking: Lung Cancer and Other Disorders. Washington, D.C.: December, 1992. Viscusi, W. Kip. Smoking: Making the Risky De- cision. New York: Oxford University Press, 1992. Wasserman, Jeffrey, Willard G. Manning, Jo- seph P. Newhouse, and John D. Winkler. "The Effects of Excise Taxes and Regulations on Cigarette Smoking." Journal of Health Economics 10 (1991): 43-64. I I I I I I I I I I i I I 590 I I I