An Immodest Proposal:
Internalizing the External Costs
Of Cigarette Smoking
Bryon Tilley-Rovira
WEMBA 17
ABSTRACT:
I will examine first the extent of cigarette smoking in the United States population,
the amount of tobacco consumed, and the present pricing of cigarettes. Next, I
will examine the related medical and social costs due to the negative health
effects of smoking. These facts will indicate in incomplete but quantifiable way
part of the true costs of cigarette smoking. An examination of the economic
principles of underlying internalization of cost externalities predicts a strong
decrease in tobacco smoking. Lastly, I will propose taxation as a possible tool to
internalize these cost externalities. I conclude with some additional comments on
the feasibility of such taxes.
In the United States, cigarette smoking remains a relatively common addiction, in
part, because the price of cigarettes reflects the private cost of production, not
the social or personal costs, of the consequences of this habit. If these cost
externalities were explicitly internalized, that is, included in the retail price,
smoking would decrease dramatically.
I will examine first the extent of cigarette smoking in the United States population,
the amount of tobacco consumed, and the present pricing of cigarettes. Next, I
will examine the related medical and social costs due to the negative health
effects of smoking. These facts will indicate in incomplete but quantifiable way
part of the true costs of cigarette smoking. An examination of the economic
principles of underlying internalization of cost externalities predicts a strong
decrease in tobacco smoking. Lastly, I will propose taxation as a possible tool to
internalize these cost externalities. I conclude with some additional comments on
the feasibility of such taxes.
How many United States adults smoke cigarettes, and who are they?
Although the number of US adults who smoke has declined perceptibly over the
last several decades, nevertheless, as of 2005, “an estimated 20.9% of all adults
(45.1 million people) smoke cigarettes in the United States; of these, 80.8% (36.5
million) smoked every day.” 1
Cigarette smoking is most prominent in young to pre-retirement adults, and
declines with age: “Cigarette smoking estimates by age are as follows: 18–24
years (24.4%), 25–44 years (24.1%), 45–64 years (21.9%), and 65 years or older
(8.6%).”1 Note the sharp decline of the number of smokers among the retired
population. This is due in part to deaths (significantly decreased life-spans; see
below) and disease-enforced cessation among senior citizens.
The propensity to smoke cigarettes is inversely correlated with degree of
education: “Cigarette smoking estimates are highest for adults with a General
Education Development (GED) diploma (43.2%) or 9–11 years of education
(32.6%), and lowest for adults with an undergraduate college degree (10.7%) or
a graduate college degree (7.1%).”1
Cigarette smoking correlates inversely to economic class: “Cigarette smoking is
more common among adults who live below the poverty level (29.9%) than
among those living at or above the poverty level (20.6%).”1 This may indicate the
cigarettes are in some sense an inferior good. Consider as well the strong
correlation between degree of education and earning power.
Cigarette smoking is unevenly distributed by race and ethnicity: “Prevalence of
cigarette smoking is highest among American Indians/Alaska Natives (32.0%),
followed by whites (21.9%), African Americans (21.5%), Hispanics (16.2%), and
Asians [excluding Native Hawaiians and other Pacific Islanders](13.3%).”1
How much do they smoke, and how is this induced or reinforced?
“An estimated 371 billion cigarettes were consumed in the United States in
2006,”2 “and cigarettes account for more than 90 percent of expenditures on all
tobacco products in this country.”3 “The total United States expenditures on
tobacco were estimated to be $88.8 billion in 2005, of which $82 billion were
spent on cigarettes.”3 This averages to 8,226 cigarettes per year per smoker, or
~22 cigarettes per day, or slightly more than a pack a day. The number of
cigarettes smoked is specific to the individual, of course, but the average is a
useful index of typical smoking behavior.
“In 2005, cigarette companies spent $13.11 billion on advertising and promotion,
down from $15.12 billion in 2003,4 but nearly double what was spent in 1998.5
This amounted to more than $36 million per day,4 more than $45 for every
person in the United States,4,5 and more than $290 for each U.S. adult smoker
annually.”5,6
What are the personal and social costs of smoking, both monetarily and nonmonetarily?
The most tragic cost is the high loss of life directly due to cigarette smoking.
“Cigarette smoking remains the leading preventable cause of death in the United
States, accounting for approximately 1 of every 5 deaths (438,000 people) each
year.”1 “Based on data collected in the late 1990s, the US Centers for Disease
Control (CDC) estimated that adult male smokers lost an average of 13.2 years
of life and female smokers lost 14.5 years of life” because of cigarette smoking
alone.7
The monetary costs include medical and productivity losses. “For 1997–2001,
cigarette smoking was estimated to be responsible for $167 billion in annual
health-related economic losses in the United States ($75 billion in direct medical
costs, and $92 billion in lost productivity),”13 “or about $3,702 per adult
smoker,”7,8 annually, a staggering figure!
“The total economic costs associated with cigarette smoking are estimated at
$7.18 per pack of cigarettes sold in the United States.”9 These, then, are the
external costs which largely do not become evident until after many years of
indulgence.
How do these costs compare to the retail price of cigarettes?
“As of 2006, the average retail price of a pack of cigarettes in the United States
was $4.26, but ranges widely across states.”11 This wide variability in the retail
price is based chiefly on how much state penal tax is levied. “The federal excise
tax is 39 cents per pack of cigarettes.”10 “The median state cigarette excise tax
rate, as of January 1, 2007, was 80 cents, but varied from 7 cents in South
Carolina to $2.58 in New Jersey.”12
Nevertheless, it is quite clear that the external costs are not levied to any
appreciable degree. The combined federal and average state excise taxes
amount to $1.19 added to the retail price of a pack of cigarettes. Deducting these
taxes from the average retail price, we deduce an average un-taxed retail price of
$3.07 per pack. Taxes add a 39% premium to the retail price on average.
However, even if we considered all the taxes levied ($1.19) as an attempt to
internalize the external medical and productivity costs ($7.18), they would
amount to only 17% or one-sixth of the external costs per pack.
What happens to cigarette smoking behavior when these external costs are
internalized, at least in part?
Contrary to prior expectation, it has been shown that addictive consumption is
susceptible to standard economic analysis. The demand for tobacco products
follows the basic laws of economics when constraints (such as cost) are raised
against use. Numerous studies of cigarette smoking, including several recent
studies that explicitly account for tobacco’s addictive nature, find a strong inverse
relationship between price and consumption.
Thus, “increases in cigarette prices lead to significant reductions in cigarette
smoking.13 A 10 percent increase in price has been estimated to reduce overall
cigarette consumption by about 3 to 5 percent.”13 Increases in cigarette prices
can lead to significant reductions in smoking prevalence by increasing cessation
among smokers and reducing smoking initiation among potential young
smokers.13
“Price elasticity (the percentage change in the quantity demanded resulting from
a 1-percent increase in price) estimates obtained from recent studies using
aggregate data fall in the overall wide range of –0.14 to –1.12, but most of these
estimates are between –0.3 and –0.5.”13 “Almost all of the estimates obtained
from time series methods based on alternative economic theories and applied to
various data produced estimates of the price elasticity of demand in a relatively
narrow range, which was centered on –0.4.”13
However, it must be noted that maximum range of price increase for which data
was collected was between $1.00 and $1.20. The price elasticity estimates may
be valid only for price changes within the studied range of price increases.
What effects would be predicted, if the full quantifiable external costs were
internalized through taxes as part of the retail price of cigarettes?
Let us look at the demand curve based upon the effect of price changes on the
overall demand for cigarettes. For the purpose of constructing a demand curve,
let us use a figure of -0.4 for the price elasticity, and assume that the price
elasticity remains constant throughout this price range. Below is the (theoretical)
demand curve for cigarettes.
Demand Curve for Cigarettes
$14.00
$12.00
$10.00
Price
$8.00
$6.00
$4.00
$2.00
$0.00
0
1000
2000
3000
4000
5000
6000
7000
8000
Quantity
Net Price =
Tax
change
Tax
Price %
change
$3.07
Price
Quantity
Quantity
% change
$8.52
$9.71
200
$12.78
1645
-80
$8.09
$9.28
190
$12.35
1974
-76
$7.67
$8.86
180
$11.93
2303
-72
$7.24
$8.43
170
$11.50
2632
-68
$6.82
$8.01
160
$11.08
2961
-64
$6.39
$7.58
150
$10.65
3290
-60
$5.96
$7.15
140
$10.22
3619
-56
$5.54
$6.73
130
$9.80
3948
-52
$5.11
$6.30
120
$9.37
4278
-48
$4.69
$5.88
110
$8.95
4607
-44
$4.26
$5.45
100
$8.52
4936
-40
$3.83
$5.02
90
$8.09
5265
-36
9000
10000
$3.41
$4.60
80
$7.67
5594
-32
$2.98
$4.17
70
$7.24
5923
-28
$2.56
$3.75
60
$6.82
6252
-24
$2.13
$1.70
$1.28
$0.85
$0.43
$0.00
-$0.43
-$0.85
-$1.28
$3.32
$2.89
$2.47
$2.04
$1.62
$1.19
$0.76
$0.34
-$0.09
50
40
30
20
10
0
-10
-20
-30
$6.39
$5.96
$5.54
$5.11
$4.69
$4.26
$3.83
$3.41
$2.98
6581
6910
7239
7568
7897
8226
8555
8884
9213
-20
-16
-12
-8
-4
0
4
8
12
Based upon this demand curve, we may predict that a tax increase to $7.15,
(close to the estimated $7.18 in external costs), will reduce overall cigarette
consumption by a predicted 56%. However, as the price increases from a staple
good to a luxury good, the fall in consumption may be more rapid. That is, the
price elasticity may have an increasing magnitude as the total price increases.
Note that an overall reduction in cigarette smoking encompasses both a
decrease in the prevalence of smoking, and in the number of cigarettes smoked
by those continuing the habit. The decrease in prevalence is due to smokers
quitting and fewer people taking up the habit.13
It should be noted that there are distinct short-run and long-run effects to be seen
due to price increases. The short-run effect represents the slow decrease in
cigarette consumption among currently addicted smokers. The long-run effect
represents the decrease in demand long-term due to potential smokers who
never start. The long-run price elasticity is up to double the short-run effect.13 As
one might intuit, those people living below the poverty level are especially
sensitive to price increases.13
Are steep excise taxes a realistic mechanism to reduce cigarette smoking?
The use of significant excise taxes to curb consumption would ordinarily be quite
effective in the case of ordinary goods. However, here we have a good which is
highly addictive, suggesting active resistance by consumers to steep, rapid price
increases. Nevertheless, the cases of California and Canada, which increased
prices $1.00 and $1.20, respectively, in a single increment, showed the predicted
sharp declines in consumption.13 Of political importance, neither government
suffered serious consequence for the sharp tax increase.
If the price increase on cigarettes could not be avoided by smokers, then
alternative strategies would emerge. Cigarette smokers could switch to substitute
goods, such a generic or discount-brand cigarettes, hand-rolled cigarettes, pipes
and cigars, and smokeless tobacco products. Alternative tobacco products would
need to have tax increases comparable to those of cigarettes, in order to block
this consumption strategy.
How do we implement a higher excise tax on tobacco?
I propose a “Social and Medical Equity Tobacco Tax.” The rationale for the tax is
that cigarette smokers need to pay the full cost of their habit as they consume
cigarettes; otherwise, the market in tobacco is highly distorted by passing on only
the very deficient private costs of production. This results in an inequitable
deferment of social (productivity/mortality) and medical costs to the future, and
this impacts tobacco producers not at all.
In return for smokers paying the higher excise tax, they would not be charged
more for health insurance than non-smokers. Instead, health insurers will collect
indirectly a supplemental “smokers’ premium” paid by the excise tax. As a
priority, the excise tax will fund smoking cessation products and programs
without charge to participants. Payment for products and programs will be on a
performance-based scale, proportional to the effectiveness and duration of
abstinence.
This tax would be phased-in over a ten year period, with proportionate tax
increases of about 36-cents (in real dollars) on a semi-annual basis. Cigarettes
smoking would be the major target, but all tobacco products would sustain similar
price increases. The taxes raised would be directed to tax enforcement,
subsidies for smoking cessation programs, and “smokers’ premiums” to health
insurers. One exception to the excise tax would be nicotine gums and patches.
Although subject to abuse by desperate smokers (nicotine addicts!), their hazard
is much less than regular forms of tobacco consumption, and they are
“gateways” to cessation.
We also can anticipate a brisk business in smuggled or contraband tobacco.
(Such smuggling exists today in order to evade state excise taxes.) An expanded
Department of Alcohol, Tobacco, and Firearms will be needed to police such
illegal activities. Organized crime likely will take an interest in supplying black
market cigarettes. However, unlike alcohol under Prohibition, cigarettes would
still remain a legal product, albeit an expensive luxury good. This should blunt the
appeal of contraband tobacco to some degree. It would be rather like the present
case of the very high penal taxes levied on alcohol. (Despite the high tax, not
many people drink moonshine or bathtub gin.)
Such steep price increases would undoubtedly involve political tests, with strong
resistance from addicted smokers, the tobacco industry, and vested economic
interests (such as Big-Tobacco state governments). I think that this tax might
only be implemented by counter-balancing vested interests with other competing
interests and formation of a new social compact.
For example, big businesses, in the form of pharmaceutical firms, health
maintenance organizations, health insurers, et cetera, could be promised a
portion of the tax revenues as reimbursement for smoking-cessation products
and services, and reduced insurance payouts.
A new social compact would be needed whereby any person might use tobacco
as he will, but he must pay the full monetary price for such indulgence. The new
excise tax should be used to assist the smoker to quit, to reward effective
cessation products and programs, and to reimburse health care expenses for
smokers.
What can we conclude?
Approximately one adult in five in the U.S. smokes cigarettes. Of those smokers,
an estimated 70% of want to quit.13 However, so long as only the private cost of
tobacco production is passed on the consumer, the cost of this highly addictive
product is priced at an unrealistically low price. When prices increase to reflect
the external costs as well, economics lends an effective hand to motivate
smoking cessation.
Initially, I was skeptical there could be enough political will in the U.S. to enact
increasingly higher excise taxes on tobacco. (Images of the Boston Tea Party
came to mind.) Yet I recall a recent trip I made to Spain where, as in all of
Europe, the government charges an excise tax on gasoline and diesel fuel that is
several times the cost of these goods. All citizens, not just a minority, pay these
taxes without revolting against the government. The citizens may complain
occasionally, but they almost all drive highly fuel-efficient cars and use public
transportation regularly. Conservation and alternative energy are by-words in
these countries.
Perhaps the Spanish possess a certain level of political maturity that allows them
to formulate worthy social goals and use the “visible hand” of government to
implement the tough measures needed to bend economic principles (the
“invisible hand”) to our purposes.
When it comes to reducing cigarette smoking and its ill effects, maybe it is time
we Americans grew up too.
References:
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United States, 2005. Morbidity and Mortality Weekly Report [serial online].
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http://www.cdc.gov/mmwr/preview/mmwrhtml/mm5542a1.htm.
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Report of the Surgeon General. Atlanta, GA: U.S. Department of Health and
Human Services, Centers for Disease Control and Prevention; 2000.
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