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94-214 E CRS R,e~ort for Congress Cigarette Taxes to Fund Health Care Reform: An Economic Analysis Jane G. Gravelle Senior Specialist in Economic Policy Office of Senior Specialists and Dennis Zimmerman Specialist in Public Finance Economics Division March 8, 1994 Congressional Research Service • The Library of Congress rrrr ~ O ~ CRS ~;

Cigarette Taxes to Fund Health Care R,eform: An Economie Analysis Executive Summary A cigarette excise tax increase of 75 cents per pack has been proposed to finance part of the President's universal health care program. The tax enjoys considerable public support, would raise about $11 billion per year, and would be relatively simple to administer because it would increase an existing manufacturer's excise tax. The President's fiscal year 1995 budget stressed that the tax would help pay for the additional health care costs of smoking, and would discourage individuals, particularly young people, from smoking. This report discusses these rationales, as well as other effects of and concerns about the tax, organized into the topics of market failure as a justification for the tax (i.e., economic efficiency); potential for revenue; equity; and the job loss the tax might cause in tobacco growing regions. One reason economic theory suggests selective excise taxes generally are not desirable is that they distort individual choices among goods and services in the market and impede efficient resource allocation. Circumstances may exist, however, in which the efficiency case against selective excise taxes is stood on its head: should market failure be present, such taxes may actually be the preferred policy instrument to achieve economic efficiency. Such market failures may exist for cigarettes for two reasons: spillover effects and imperfect information. A cigarette tax is efficient if it forces smokers to pay for costs they impose on nonsmokers (external costs or spillover effects) or if it raises smokers' costs to compensate for the effect that incomplete information has on their judgment about the cost to themselves (internal costs). An initial question is whether the spillover effects alone are sufficient to justify the proposed increase in the excise taxes (Federal and State), which currently average 50 cents per pack. F-,stimates of per-pack spillover effects require information on smoking-related health care costs, sick leave costs, life insurance costs, costs of fires, foregone tax revenue, costs of pensions, and costs of nursing homes. Many of these components are subject to considerable uncertainty due to often conflicting scientific evidence, the less-than-perfect data used for measurement, and the presence of some nonquantifiable factors. These uncertainties produce a wide range of estimates of per-pack spillover effects. Mid-range estimates based upon likely assumptions suggest net external costs from smoking in the range of 33 cents per pack in 1995 prices, an amount that by itself is too small to justify either current cigarette taxes or the proposed tax increase. An upper-bound estimate of net external costs would justify current cigarette taxes and some or all of the proposed 75 cent tax increase. A lower-bound estimate suggests smoking does not impose external costs on nonsmokers, but rather provides net external savings to the nonsmoking population (primarily because smokers' early death leaves their Social Security and pension contributions unused and available to reduce future financing demands on nonsmokers).

CRS-ii One controversial component of the spillover effect calculation is passive smoking. The epidemiological evidence on the health effects of passive smoking is far less certain than evidence on the effect of active smoking. In addition, any effects may be more likely to occur within families (and on spouses rather than children). This leaves two critical issues unresolved: the magnitude of the passive smoking effect; and whether the effect should be classified as an internal or external cost. If one resolves these and several related conceptual and estimating issues in favor of the option that would produce the largest passive- smoking effect, external costs from passive smoking would be approximately 21 cents per pack. Resolving these issues in a manner that weighs the uncertainties of both overestimation and underestimation would produce external costs from passive smoking as low as zero to four cents per pack. Considering passive-smoking effects to be external costs raises an additional policy issue if a tax is used to compensate for the external costs of smoking. Available evidence suggests the majority of smokers will not be deterred by the tax. As a result, the majority of spouses and children of these undeterred smokers will not benefit from reduction of passive-smoking effects, but will be penalized because the tax will reduce their disposable family income. In this case, the tax would accomplish the opposite of what was intended. These estimates of spillover effects are confined to effects that can be quantified-they do not account for factors such as the general distaste many individuals feel for smoking. Regulation rather than taxation might be best suited to deal with these spillover effects. No value of "distaste" exists to provide guidance on the correct magnitude of the tax, the tax must be paid for smoking even when no repelled observers are present, and it is relatively easy to separate smokers and nonsmokers in many business and social settings. In fact, it is arguable that a more efficient outcome may occur if private business regulates smoking without formal government regulation. Some argue these estimates of net external costs are inaccurate because they do not account for the intangible costs of premature death (e.g. the grief of family and friends). On the efficiency grounds being discussed here, the relevance of this issue depends upon whether the individual accurately values the effect of this risk on his family and friends. There is no compelling reason to believe individuals, on average, undervalue this risk. In any case, a policy that assigned an arbitrary value for the underassessment of intangible cost of premature death would have far-reaching implications. It would imply imposition of the rights and preferences of groups relative to those of individuals, a policy that could be viewed as inconsistent with certain basic political and economic values of society. Pleasure driving, many recreational activities, some dietary practices, and some occupations, to name just a few activities, involve the same actuarially-validated risks of premature death and grief. In fact, we do not impose taxes on these activities. Taxing such activities involves value judgments that are beyond the scope of economic analysis. A tax also may be justified on grounds of market failure if smokers have imperfect information about the health hazards of smoking or about the

CRS-iii F difficulty of quitting in the future. Although surveys suggest that some smokers are not aware of or do not accept the health hazards of smoking, available data indicate the average smoker is aware of, or overestimates, the health risks of smoking. Thus, there is considerable evidence that smokers seem to make their smoking decision with knowledge about the health risks of smoking. Evidence on the adequacy of information about the difficulty of quitting is mixed. The major policy concern with this aspect of market failure is its effect on young people who are less capable of making informed decisions. Imposition of a tax to correct for their lack of understanding of the habit-forming nature of smoking would likely be effective in reducing their participation; it also would penalize a much larger number of adult smokers. Non-tax mechanisms, such as educational programs and strengthened enforcement of laws restricting sales to minors, might be better suited to deal with the problem. While the available evidence will not support precise findings or conclusions, the proposition that efficiency improvements justify the proposed tax is subject to question: existing taxes exceed some reasonable estimates of the social cost of smoking; and the average smoker appears to have made the smoking decision while in possession of adequate information, at least with regard to health hazards. For those smokers who make poor decisions because of inadequate information, such as the young, increased education and regulation might be more effective market corrections and have fewer undesirable economic effects than a tax. The cigarette tax would provide a significant source of revenue. However, the unindexed cigarette tax will finance a continually smaller share of health care costs. Even if the tax is indexed, the relatively high sensitivity of youth smoking rates to the tax increase will cause the total smoking participation rate to fall gradually over time. This declining total smoking participation rate will cause long-term cigarette tax revenue to fall gradually over time. After fifteen years revenue would be about ten percent less than the initial $11.4 billion annual budget-window estimate. Without further increases in the tax rate, after manyyears, the revenue would decline to about two-thirds of the budget-window estimate. This effect on revenue is separate from the effect that would result should there be a continuation of the long-term downward trend in smoking participation rates that is attributable to non-tax-related causes. Equity is also an important consideration in the evaluation of tax proposals; this issue has been addressed extensively with respect to tobacco taxes in other studies. The cigarette tax is not horizontally equitable; it imposes higher taxes on smokers than on nonsmokers of equal income. The tax also is regressive, imposing larger taxes as a percent of income on lower-income individuals. The publicized claim of 273,000 lost jobs from the cigarette tax in the health care proposal includes job losses from the export share of the market that will not be affected by the tax, losses that would be offset by Government spending, and losses from workers who shift to new jobs. After eliminating job

CRS-iv losses from these sources, tobacco-related job losses are estimated to be: about 7 percent of total tobacco-related jobs in North Carolina, 0.2 percent of total State employment; about 8 percent of total tobacco-related jobs in Kentucky, 0.3 percent of total State employment; and about 9 percent of total tobacco-related jobs in Virginia, less than 0.1 percent of total State employment. Even large regional multipliers would be unlikely to increase these total shares of State employment beyond one percent. Short-term regional job losses should not necessarily determine national policies, although losses can be significant in local areas, and some transition assistance or phase-in of the tax might be justified. If the Congress is interested in exploring alternatives to cigarette tax financing, several are available. An alcohol tax would appear to be more efficient and more equitable: the best estimate of alcohol's net external cost exceeds current tax levels; alcohol taxes are also regressive but less so than cigarette taxes. Increased income tax rates or base broadening would be more equitable, and a base-broadening option such as taxing employer-paid health care premiums also would promote economic efficiency in the health care market. Elimination of some spending provisions in the health care proposal could reduce the need for revenue and promote economic efficiency, e.g., the small business subsidies for mandated premiums. The President's budget proposal stressed the adoption of a cigarette tax to decrease youth participation as one of its rationales. Recent research suggests increased regulation and increased enforcement of existing regulations against sale of cigarettes to minors might be effective, and would avoid the adverse economic consequences that cigarette taxation imposes on the mature smoking population. Should taxation remain the preferred deterrent, greater reductions in smoking might be obtained if the tax was cut loose from the health care program and its revenue earmarked for increased antismoking regulatory and education efforts, perhaps including a system of grants to the States. Such earmarking was a feature of California's 25 cent per-pack tax that was enacted in 1989.

CONTENTS I. MARKET IMPERFECTION AS A JUSTIFICATION FOR TAXING TOBACCO .............................................. 3 SPILLOVER EFFECTS .................................... 3 The Manning Study ................................... 4 Qualifications to the Manning Study ...................... 6 1. Estimation error from model specification ............ 7 2. Choice of discount rate .......................... 9 3. Passive smoking ............................... 10 4. Non-health-related external costs; intangible costs .... 13 5. Miscellaneous issues ............................ 14 6. Relationship of the Manning study to other studies ... 15 7. Summary ..................................... 17 INFORMATION AND SMOKING CHOICE ................... 17 Information on Health Hazards ......................... 18 Information on Habit-Formation and Addiction ............. 19 1. Evidence on habit formation and addiction .......... 20 2. Evidence on information regarding addiction ......... 21 Policy Responses .................................... 22 II. CIGARETTE TAXES AS A REVENUE RAISER ................ 25 INDEXING ............................................ 25 SHORT-RUN VERSUS LONG-RUN PARTICIPATION RATE ..... 26 Federal Revenues .................................... 29 Net Budgetary Effect ................................. 31 INCOME GROWTH ..................................... 32 STATE REVENUE LOSS ................................. 33 III. INDUSTRY EFFECTS OF TOBACCO TAXES ................. 35 JOB LOSS AS A NATIONAL ISSUE ......................... 35 JOB LOSS AS A REGIONAL ISSUE ........................ 36 IV. THE EQUITY ISSUE .................................... 39 V. POLICY IMPLICATIONS: ALTERNATIVE FINANCING SOURCES AND OTHER POLICIES .................................. 41 OTHER TAX SOURCES .................................. 41 PROGRAM REDUCTIONS ................................ 42 MODIFICATIONS TO A CIGARETTE TAX ..... . . . . . . . . . . . . . . 42 POLICIES TO AFFECT SMOKING AMONG THE YOUNG ...... 43 APPENDIX A: EVIDENCE ON PASSIVE SMOKING EFFECTS ...... 45 APPENDIX B: COMPARISON OF ESTIMATING PROCEDURES OF MANNING AND OTHER STUDIES ......................... 51 RICE, ET AL . .......................................... 51 OFFICE OF TECHNOLOGY ASSESSMENT (OTA) ............. 51 LIPPIATT ............................................. 53 HODGSON ............................................ 54

YiARRiS ............................................... 54 CONCLUSION ......................................... 55 MATHEMATICAL COMPARISON OF MANNING, OTA, AND HARRIS ESTIMATES OF PER-PACK COSTS ............. 56 APPENDIX C: ESTIMATING PROCEDURE FOR REVENUE PROJECTIONS ......................................... 61 SIZE OF POPULATION BY AGE ........................... 61 PARTICIPATION RATES AND AVERAGE CONSUMPTION ..... 62

Cigarette Taxes to Fund Health Care Reform: An Economic an.a2ysis President Clinton presented a comprehensive plan for universal health care in September 1993. Among the sources of financing proposed in this plan is an increase in taxes on tobacco products at a rate of $12.50 per pound of tobacco content. Virtually all of the tax (96 percent) would be collected on cigarettes. If adopted, this tax would raise the Federal cigarette tax by 75 cents per pack, from the current 24 cents to 99 cents. The tax increase is about 42 percent of the current price (inclusive of existing Federal and State-local taxes). The tobacco tax, expected to raise around $11 billion a year, will finance a significant portion of the President's proposed health care plan as presented in the FY 1995 budget, particularly in the first year or two. It is a relatively simple tax to administer, as it increases a currently existing manufacturer's excise tax. The tax enjoys considerable public support and may be viewed by some to be the most politically feasible alternative available. Reasons given in the budget document for including the tax are the additional health care costs of smoking which the tax will help pay for and the desire to discourage individuals, particularly young people, from smoking.l This report discusses these rationales as well as several concerns that have been raised about this proposed tax. First, selective excise taxes normally are not rated as desirable revenue sources because they distort consumption decisions. A cigarette tax, however, may be desirable if it compensates for burdens that smokers impose on others or because smokers make their smoking decision without adequate information to assess the health costs of smoking. In fact, the choice of a tax on tobacco to finance health care may have been motivated by both of these links between smoking and poor health. If smokers generate additional health costs, some of which nonsmokers pay, why not impose a tax on smokers to offset the burden they impose on nonsmokers? And if smokers make inadequate risk assessments, shouldn't they be discouraged from smoking? Whether these conditions, or market imperfections, are present is an empirical question addressed in section I. Second, the health care program is to be a permanent program and the permanence of its financing sources is of interest. Section II investigates the effect of several factors on the long-term adequacy of cigarette tax revenue: the lack of indexing of the tax; the long-term deterioration of smoking participation rates; and per capita income growth. 1 Budget of the United States Government, Facal Year 1995, Washington, D.C.: United States Government Printing Office, p. 187.

CRS-2 A third issue is the potential loss of jobs in the tobacco industry and the concentration of these lost jobs in regions of the country that are heavily dependent on the growing of tobacco and the manufacture of tobacco products. Section III discusses the conceptual and empirical foundation for these industry and regional effects. A fourth issue is the regressivity of this excise tax (that it takes a higher fraction of income of lower-income individuals) and that it also tends to impose different amounts of tax on people who, by virtue of having equal income, are generally considered to be equals. These effects are well documented by numerous studies, and this equity issue is discussed briefly in section IV. Section V discusses policy implications arising from the analysis. Appendix A discusses the evidence on passive smoking, Appendix B compares the estimating procedures for various studies of the external costs of smoking, and Appendix C explains the model used to calculate long-term cigarette tax revenue.

CRS-3 I. MARKET IMPERFECTION AS A JiTSTIFICATION FOR TAXING TOBACCO One reason economic theory suggests selective excise taxes generally are not desirable is that they distort individual choices among goods and services in the market and impede efficient resource allocation. Circumstances may exist, however, in which the efficiency case against selective excise taxes is stood on its head: should market failure be present, such taxes may actually be the preferred policy instrument to achieve economic efficiency. This section discusses two conditions that, if present, make a selective excise tax on cigarettes and other tobacco products a correction for market failure and consistent with economic efficiency: spillover effects and imperfect information. First, cigarette smoking might impose a financial burden on the rest of society (spillover effects). Second, people might make their smoking decision without complete information about the negative consequences of these products; that is, they may make a rational decision based on imperfect information that would be irrational given complete information. SPILLOVER EFFECTS It is a generally accepted fact that smoking damages the smoker's health. The term "health costs" is a broadly defined measure which includes medical expenditures, 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 (external costs).2 If the smoker possesses complete information about the relationship between smoking and his own health, he already takes internal health costs into account in making a decision, and no tax is justified to obtain economic efficiency. It is, therefore, the external health costs that might justify cigarette taxation. This section deals with the magnitude of external costs, or spillover effects. The following section deals with the issue of whether imperfect information about internal costs justifies a tax. To the extent that others in society must pay part of these health costs-increased 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 smoking. And 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 insurance are raised for everyone. This brief discussion suggests two conclusions from standard economic t~. theory. First, smoking-related costs that are incurred by the smoker O CTt ~ F+ 2 These issues are also discussed in Michael Gross, Jody L. Sindelar, John Mullahy, and ~ Richard Anderson, "Policy Watch: Alcohol and Cigarette Taxes," Journal of Economic Perspectives, Vol. 7, Fall 1993, pp. 211-222. pp 2~