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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