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The Economics of Smoking: Getting It Right Robert D. Tollison and Richard E. Wagner George Mason University CONFIDENTIAL: TOBACCO LITIGATION TlTX 0036852 ~

TABLE OF CONTENTS 1. SMOKING AND THE STATE: AN OVERVIEW 1-1 A Battlefield Tour 1-1 American Principles, Public Policy, and Tobacco Warfare 1-6 Organization of this Book 1-8 2. WELFARE ECONOMICS, PUBLIC POLICY, AND SMOKING 2-1 Smoking, The Market Process, and a Free Society 2-2 Taxation and Regulation in a Market Economy 2-6 ' Taxation in a Market Economy 2-7 Regulation in a Market Economy 2-12 Welfare Economics and Tobacco Policy 2-14 Tobacco Taxation as Corrective Taxation 2-18 Tobacco Taxation: An Overview 2-20 3. THE TAXATION AND REGULATION OF SMOKING: PRINCIPLE VS. EXPEDIENCY? 3-1 Realistic Politics and Tobacco Policy 3-2 Knowledge and the Improbability of Corrective Taxation 3-7 Political Incentive and Actual Tobacco Taxation 3-12 Rationale, Reality, and Tobacco Regulation 3-19 Tobacco Policy in Constitutional Perspective 3-20 4. SMOKING AND THE ECONOMIC COST OF LOST PRODUCTION 4-1 Smoking and Health: The Method of "Attributable Risk" 4-2 How Accurate are Measures of Attributable Risk 4-4 Economic Measurement of Indirect Costs 4-10 Joint Costs and Improper Cost Attribution 4-13 Who Loses Lost Production: Smokers or Nonsmokers? 4-15 What about the Benefits of Smoking 4-20 5. MARKETS, INSURANCE, AND THE MEDICAL COSTS OF SMOKERS 5-1 Attribution of "Medical Costs" to Smoking 5-2 Medical Costs, Personal Responsibility, and Insurance 5-6 Life Insurance and Nonsmoker Discounts 5-9 Health Insurance and Smoker-Nonsmoker Parity 5-11 Smoking and Fire Costs 5-14 Moral Hazard and Insurance Costs 5-17 6. MEDICARE, MEDICAID, AND THE SOCIAL COST OF SMOKING 6-1 Smokers and the Cost of Medicare 6-1 Transfers and Social Costs: A Clarification 6-7 Proposals for Earmarked Cigarette Taxes 6-12 Principle, Expediency, and Wealth Transfers 6-19 CONFIDENTIAL: TOBACCO LITIGATION TITX 0036853

7. SMOKING, BUSINESS COSTSn AND SOCIAL COST 7-1 Smoking and the Efficiency of Team Production 7-2 Smoking and Workplace Efficiency 7-5 Workplace Costs: A Further Consideration 7-11 Smoking and Economic Productivity: A Conceptual Framework 7-15 Smoking and Productivity: Discussion of the Data 7-18 8. ETS AND GOVERNMENTAL PROTECTION OF CONSUMERS AND WORKERS 8-1 The Economics of Clean Indoor Air Acts 8-3 The Coase Theorem, Ownership Rights, and Markets 8-11 An Alternative Explanation 8-15 Tobacco and "Public Health" 8-18 9. ADVERTISING, "ADDICTION," AND THE DENIAL OF TRUE CHOICE 9-1 Separating Advertising Myth from Advertising Reality 9-1 Cigarette Advertising has no Significant Impact on Smoking by Youth 9-4 Cigarette Advertising is a Firm-Specific Investment ` 9-6 International Evidence: Cigarette Advertising Bans do not Work 9-8 The Constitution and the Protection of Commercial Speech 9-10 Advertising and Addiction 9-17 The New Economics of Addiction 9-19 Consumer Sovereignty or Health Fascism? 9-23 10. SELF INTEREST, PUBLIC INTEREST, AND LEGISLATION 10-1 Corrective Cigarette Taxation:. An Analytical Unicorn 10-1 An Economic Approach to Legisllation and Regulation 10-5 Democratic Politics and Tax Policy 10-10 Rent Seeking, Tax Resistance, and Social Waste 10-12 The Social Cost of Tobacco Taxation: A Recalculation 10-19 Economic Principles and the Anti-Cancer Bureaucracy 10-20 Tobacco Taxation and Regulation: A Realistic Approach 10-26 11. INTEREST GROUPS AND THE PUBLIC'S HEALTH 11-1 Overview 11-1 Market Processes and Personal Health 11-3 Is Health Research a Public Good? 11-8 Public Health and the Collective Interests of Physicians 11-16 Self Interest in Public Interest Organizations 11-21 12. PRINCIPLE AND EXPEDIENCY IN PUBLIC POLICY 12-1 Principles of Constitutional Political Economy 12-3 The Self-Ownership Foundations of a Democratic Polity 12-7 Considerations from the Economic Theory of Legislation 12-9 Implications for Public Policy Toward Tobacco 12-11 Implications for Public Policy More Broadly Considered 12-14 CONFIDENTIAL: TOBACCO LITIGATION TITX 0036854

PREFACE Cigarettes are under political attack at all levels of government in the United States. From Washington, D.C. to state capitals to local governments, proposals abound to increase the cigarette excise tax, to impose smoking bans, to prevent cigarette adver- tising, to restrict the sale of cigarettes through vending machines, to cut off the export of cigarettes, to earmark the cigarette excise tax for health programs, to divest the stock of cigarette companies, and so on. And all of these are purportedly being advocated in the name of health. Undergirding and abetting the health argument is an economic theory which claims to place a value of up to $100 billion per year on the alleged health costs of smoking to the American economy, which is more than $3 per pack of cigarettes smoked. As our title suggests, our interest lies in the economics of smoking and not in the health issues surrounding smoking. We are professional economists and not medical scientists. We will focus on what, if any, economic consequences arise for nonsmokers when smokers smoke. For purposes of our discussion, we simply accept the premise that smoking damages health and proceed with our analysis. Since we have not studied the issue ourselves, we have no way of knowing whether such a premise is true. But it really does not matter for getting the economics of smoking right. The important point resides in who pays for whatever costs may be attributable to smoking. If smokers bear all such costs, including any health risks, then surely no issue of public policy or taxa- tion arises, at least within the setting of a free society. But if nonsmokers pay part of the costs of smoking, there would. be a clear rationale for the intervention of government in taxing and regulating smoking behavior. Resolving this important issue represents the primary focus of this book. CONFIDENTIAL: TOBACCO LITIGATION 2 TITX 0036855

Unlike our previous book on the subject (Tollison and Wagner 1988), our inten- tion in this book is to be comprehensive. We seek to cover all of the economic issues that have been raised with respect to cigarette smoking. In addition to a careful considera- tion of the argument that smokers impose costs on nonsmokers, we examine the issues surrounding the regulation of environmental tobacco smoke, the advertising of tobacco products, the public health bureaucracy and its associated interest groups, the health- promotion "industry," the earmarking of tobacco taxes, and various other issues related to smoking. Most of these issues, however, derive from the social cost argument. For example, the argument that tobacco advertising should be banned or regulated is based on the proposition that smoking should not be promoted, especially to young people, because it impares health and imposes costs to society. So the root issue remains whether smokers pay their own way in society: For if they do, issues such as the above should become moot, at least when judged against the traditional standards of American democracy, where adults are presumed generally to be free to pursue whatever activities and interests they choose, provided only that they do not interfere with the similar liberties of others in the process. We will also try to set the issue of smoking in a larger context. If, in fact, smoking is taxed and regulated on strictly majoritarian and unprincipled grounds (smokers equal about one-third and nonsmokers two-thirds of the adult population in the United States), then the arguments that are being used to provide the intellectual basis for such programs are quite dangerous and insidious and can be quite easily applied to virtually every facet of people's everyday lives. Thus, while smoking may be the issue of note today, to allow a faulty economics of smoking to prevail is an open invitation to tomor- row's arguments about the social costs of sugar, sunbathing, saturated fat, recreational CONFIDENTIAL: TOBACCO LITIGATION 3 TITX 0036856

injuries, obesity, and on and on and on. Down this road lies not a free society but a totally regulated society with only one acceptable lifestyle as prescribed by the health paternalists. In a world of busybodies it is only a matter of time before something even the busybodies themselves like will come under scrutiny. Getting the economics of smoking right is therefore important. Although we are economists, we have written this book not just for economists but for everyone who is interested in possible public policy measures concerning smoking. In so doing we have, tried to limit our use of technical economic argumenta- tion and concepts, and where we could not avoid such usage, to present it in an under- standable fashion. This manuscript was produced under a grant from The Tobacco Institute. The views expressed are those of the authors and not necessarily those of the Institute or its member companies. CONFIDENTIAL: TOBACCO LITIGATION 4 TITX 0036857

CHAPTER 1 TOBACCO WARFARE IN AMERICA: AN OVERVIEW There can be no doubt that tobacco has become an object of civil warfare in the United States over the past 20 years or so. Smokers and nonsmokers have been waging pitched battles on many fronts throughout the land. Former Surgeon General C. Everett Koop articulated a vision of a "smoke-free America," where if any smoking at all were to take place it would be in the privacy of smokers' homes and only in the company of other smokers. Perhaps inspired by this vision, a Hawaii State Senator introduced, in February 1990, legislation that would have banned the sale of tobacco products throughout Hawaii. While this proposal failed to be enacted, its mere introduction into Hawaii's legislative process surely attests to the ferocity with which the Great American Tobacco War is being waged. Indeed, there are several universities, including West Virginia University and Texas A&M University, that have banned all smoking on campus. A Battle field Tour This image of warfare is conveyed throughout the nation's news media. For instance, an article in the Wall Street Journal (24 May 1990) carried the headline: "Tobacco Is Facing New Attacks." That article went on to describe several fronts along which fighting is taking place. One front is epitomized by the organization of the Boston-based Tobacco Divestment Project. Amid much fanfare Harvard University announced that, starting in June 1990, it would sell off its holdings of tobacco stocks, which were valued at over $60 million.1 The City University of New York has done the same thing, only the value of its holdings are less than $4 million. Proponents of divest- CONFIDENTIAL: TOBACCO LITIGATION 1-1 TITX 0036858

ment seek to multiply Harvard's action by pressuring pension funds, insurance com- panies, and other large-scale owners of tobacco stock to sell their holdings. Economically, it is unlikely that divestment would exert any significant economic impact on the value of tobacco companies. For the value of tobacco stock depends on the returns investors believe they can receive relative to other investments. At first glance, successful pressures for divestment might seem to be a way of depressing the value of tobacco stocks by dumping large amounts of such stock onto the market. However, this will make tobacco stocks more attractive to those investors who are immune to the divestment bug. All that will happen, ultimately, is; that people will rearrange their investment portfolios: divestors will own no tobacco stock and will own correspondingly more of other kinds of stock; non-divestors will have increased their ownership of tobacco relative to other-stock in an offsetting fashion.2 Economically speaking, divestment would seem to be merely symbolic and devoid of economic significanc.e. But even at the level of symbolism, divestment carries the odor of war. Over what else are calls for divestment heard in America? Over South Africa, of course. In this case divestment is advocated as a means of bringing pressure to bear upon whites in South Africa to support the abolition of Apartheid. To be sure, many scholars have argued that divestment from South Africa would primarily harm blacks in South Africa, and that the best way to promote the elimination of Apartheid would be to promote even greater investment in South Africa, because it is the competi- tion for labor and the search for profits that would do the most to undermine Apart- heid.3 While the subject of this book is smoking in America and not Apartheid in South Africa, divestment links the two subjects and illustrates the warfare mentality surround- CONFIDENTIAL: TOBACCO LITIGATION 1-2 i ITx 0036859

ing tobacco. While there is considerable controversy over the economic properties of divestment in South Africa, the pressure for divestment is doubtlessly fueled to a substantial extent by a belief in the evil nature of the South African regime. The exten- sion of divestment to tobacco is to place tobacco in the same normative position as Apartheid in South Africa. By this logic decent people should do their best to eradicate both Apartheid and smoking, and divestment reflects and symbolizes this common belief, the cogency of arguments about the ineffectiveness of such policies notwithstand- ing. Vending machines are coming to provide another arena for warfare. Cigarettes have long been widely available for purchase through vending machines, just as have soft drinks and candy. Anti-smoking activists are increasingly seeking to restrict the availability of cigarettes through vending machines. Much of the argument in support of these restrictions has been couched in terms of reducing the ability of minors to buy cigarettes. While most states have minimum age requirements for the purchase of cigarettes, it is more difficult to enforce those requirements with vending machine sales than with over-the-counter sales. For this reason it has been advocated that the availability of vending machines be restricted to such places as bars and offices, where minors would rarely be found in the first place 4 Alaska, Indiana, and Minnesota enacted such legislation in 1990, while similar legislation was defeated in 21 states. ° Legislation to ban or to restrict vending machine sales is currently under consideration in about 20 states. Those smokers who do not frequent bars or work in offices, and who would perhaps constitute a majority among smokers, would be casualties in the vending machine wars. The alleged reason for opening battle along this front is to reduce oppor- CONFIDENTIAL: TOBACCO LITIGATION 1-3 ~ TITX 0036860

tunities for minors to smoke. Whether this claim is reasonable is something we will explore in depth later; we would only note here that it is implausible that vending machine restrictions would have anything approaching the impact implied by the figures cited above. Eighty percent or so of vending machine purchases take place in such places like bars, factories, and military bases, which are not readily accessible to minors. For minors who want to try smoking will find other sources available: older classmates and brothers and sisters being perhaps at the forefront of these other sources. Furthermore, while it has been reported that most adults who smoke began smoking as minors, it is nevertheless true that most minors who try smoking do not continue to smoke as adults. In short, it is unlikely that the vending machine wars will do much by way of restricting cigarette experimentation by minors. But it will clearly further restrict the ability of adult smokers to buy cigarettes. Starting in the early 1980s, each year around five to ten state legislatures have considered legislation to mandate the development of a "fire-safe" cigarette. Such legislation would require a cigarette to be so constructed that it would not cause an ignition if it were carelessly dropped on bedding and upholstered furniture. There are currently some significant unanswered questions about how even to produce such a cigarette. The federal government's Cigarette Safety Act of 1984 created a Technical Study Group on Cigarette and Little Cigar Fire Safety to examine the technical and commercial feasibility of developing cigarettes that would not ignite such objects as bedding and upholstered furniture. After three years of study, its report issued in October 1987 noted that substantial additional work would be needed to determine if such a product is feasible. Federal legislation was passed in 1990 which authorizes a continued examination of this issue by the Consumer Product Safety Commission. CONFIDENTIAL: TOBACCO LITIGATION 1-4 TITX 0036861