Tax 'em if you got 'em?

By Nicholas Goldberg

June 14, 2009 12 AM PT

Nicholas Goldberg is deputy editor of the editorial pages.

Raising taxes in California these days is extraordinarily difficult. In fact, in their effort to eliminate a $24-billion budget shortfall, the state’s politicians are discussing dismantling California’s main welfare program, eliminating the health insurance program for poor children and decimating education without any apparent debate on raising the income or sales tax.

One of the few state taxes that politicians have talked about raising is the tobacco tax. California’s is currently set at 87 cents a pack (and hasn’t been raised in a decade); this year, the Legislature will consider raising it to $2.97 a pack, which would bring the cost of a pack of cigarettes to more than $7.00. Sponsors of the bill estimate that the tax hike would raise about $2 billion.

How does the tobacco tax work? Who does it help and who does it harm? Below, some questions and answers to help frame the debate.

What’s the chief argument for hiking the tobacco tax?

That it’s a good tax. Business taxes have negative consequences: They drive companies and jobs out of the region. High income taxes make the state a less desirable place to live. Sales taxes can stifle commerce.

But tobacco taxes are different. They raise revenues and simultaneously serve the public good by reducing smoking, at least in theory. That’s not insignificant in a state where about 13.3% of residents smoke, where there are more than 30,000 smoking-related deaths each year, and annual smoking-related costs are estimated at more than $15 billion.

Can raising taxes really change behavior?

Yes. The tobacco tax is based on one of the most fundamental rules of microeconomics -- the law of demand -- which says that all else being equal, the more you raise the price of a product, the more demand for it will drop. Conversely, if you reduce the price, more people will buy, use or, in this case, smoke the product.

Taxing tobacco in order to discourage its use is a pretty clever idea. Who came up with it? Milton Friedman? Paul Krugman?

Actually, it goes back a bit further.

When Columbus first brought tobacco back from the New World, rulers were not quite sure what to do. In the 16th century, Murad IV, the sultan of Turkey, decided that tobacco was offensive, and he tried to control it the old-fashioned way, by declaring its sale or use punishable by death.

That wasn’t a great success. In 1604, James I, king of England, tried another approach. Calling smoking “a custom loathsome to the eye, hateful to the nose, harmful to the brain, dangerous to the lungs, and in the black stinking fume thereof, nearest resembling the horrible Stygian smoke of the pit that is bottomless,” he imposed a 400% tariff on tobacco.

What does “Stygian” mean?

Dark, gloomy, hellish -- like the river Styx. I had to look it up too.

But here’s the punch line: King James’ tariff had only minimal effects on consumption. Worse yet, according to some accounts, the enormous tax revenues that flowed in apparently converted James from an opponent of smoking to a supporter.

And today? Do many places have tobacco taxes?

Of course. Smoking is unpopular, and smokers are politically weak, so why not?

The United States instituted its first federal excise tax on tobacco in 1865 -- 2 cents per 20 cigarettes -- to help pay for the Civil War. In the 118 years that followed, it went up only slightly, to 8 cents a pack. But since 1983, the federal tax has been hiked repeatedly and now stands at $1.01 per pack.

Meanwhile, all 50 states have instituted tobacco taxes as well. They range from as low as 7 cents a pack in the tobacco-growing state of South Carolina to $2.75 a pack in New York, according to the Centers for Disease Control and Prevention. At 87 cents a pack, California’s tobacco tax is well below the national average of $1.20 a pack.

So this is a no-brainer, right? Raise the tax. Solve the budget crisis. End smoking. It’s that easy.

It’s not quite that simple.

For one thing, there’s a fundamental conflict in the tobacco tax: The more effective it is at discouraging smoking, the less revenue it brings in. Theoretically, if prices get pushed up high enough, so many people will stop smoking that revenues would decrease, eventually to zero if everyone were to quit.

Is it possible to predict what the effect of a price hike will be?

Surprisingly, it is.

What’s at work here is something economists call the “price elasticity of demand,” which measures how consumers respond to a change in price. Demand for a product, they say, is highly “elastic” if a slight change in price leads to a sharp change in consumption. If, by contrast, people are willing to continue paying for the product as the price goes up, the product is “inelastic.”

Demand for tobacco is relatively inelastic. Not because it is a necessary product but because it’s addictive. A 20-year, two-pack-a-day smoker is not all that likely to quit just because the price goes up by a dollar.

So people keep smoking no matter what?

No. Demand for tobacco is not perfectly inelastic, just relatively inelastic. Studies have shown that higher prices do persuade many smokers to stop. Especially poor people (who have more incentive to quit when prices go up) and younger smokers (who are both less addicted and more price-sensitive).

Now let’s get a little more technical. (If you don’t like numbers, you might want to skip the next few paragraphs.)

Economists have calculated, using data from real-world buying patterns, that in the developed world cigarettes have an elasticity of -.3 to -.4, according to Kenneth Warner, an economist who is dean of the School of Public Health at the University of Michigan. That means that if you raise the price of a pack by 10%, you will see a decline in the demand of 3% to 4%. (You calculate that by multiplying the elasticity by the price change.)

And what does that tell us?

Let’s work through a hypothetical. Imagine that a pack of cigarettes costs $6. Now assume that the tax on that is $2 out of the $6. If we were to double that tax to $4, the overall price would rise by $2 (from $6 to $8). That’s a 33% increase.

With me so far?

Cigarettes, you’ll recall, have a price elasticity of roughly -.4. So multiply the 33% price increase by -.4, and you learn that it will reduce the demand for cigarettes by 13.2%.

Wow. They can really tell that?

Obviously, it’s not exact. But the equation has proved, time after time, to be just about right. But we’re not done. We still want to know what the effect of that 13.2% drop will be on the revenue we were hoping to raise.

Let’s assume that we were initially selling 100,000 packs of cigarettes per week. We’re now going to lose 13.2% of those -- which is great, because that means that fewer cigarettes are being smoked -- bringing total sales down to 86,800 packs. That means that where we were initially bringing in $2 for each of 100,000 packs -- or $200,000 -- we’re now going to bring in 86,800 packs times $4, which comes to $347,200.

In other words, if Warner’s formula is accurate, not only will we reduce smoking by 13.2% in this hypothetical, we will also bring in $147,200 extra dollars in revenue.

Is there a price at which demand would fall so rapidly that there would no longer be any revenue increases?

Theoretically, yes. And yes, tobacco companies have often raised the specter of just that. But according to Warner, we’re nowhere near that point. He notes that cigarettes cost about $11 a pack in Ireland, yet every time the tobacco tax is raised there, it continues to bring in new revenue.

Surely there must be arguments against the tobacco tax.

Plenty of them. Some are made by tobacco companies, some by libertarians, some by economists.

One is that the government has no business using taxes to legislate personal choice. If people want to smoke and are fairly apprised of the risks, the government should not create financial impediments.

Another argument is that the government itself is now making a fortune from the cigarette business, and that’s immoral.

A third argument is that smokers are an unpopular minority with little political influence who are being asked to shoulder a disproportionate share of the burden of state budget problems.

This is particularly unfair, opponents say, because cigarette taxes are regressive -- meaning that because all people are taxed at the same rate regardless of their incomes, the taxes take a heavier toll on lower-income people. In fact, the tax is doubly punitive because not only does a $2 tax take a bigger share of a poor person’s income than it takes of a rich person’s income, but poor people are much more likely to smoke. According to the Centers for Disease Control and Prevention, about 30% of adults living below the poverty line smoke, compared with only about 20% of those above the poverty line.

Is that a reasonable objection?

It’s certainly true that tobacco taxes are regressive. On the other hand, poor smokers are also more likely to benefit, because they are more likely to quit as a result of the tax.

What if people are too addicted to quit?

In most cases, they’ll just pay the higher cost. But opponents warn that tobacco taxes create incentives for black markets, especially if there are large price differentials in nearby areas. In some cases, people will cross state borders, or even national borders, to buy or smuggle cheaper cigarettes. As taxes go up, it makes economic sense to purchase cigarettes on Indian reservations, where the taxes often do not apply.

So what’s the bottom line?

There aren’t that many taxes that do good while raising money. The gas tax, which discourages driving, is another example. Don’t rule them out!

ngoldberg@latimes.com