Why high taxes on alcohol and tobacco are counterproductive?

The one constant in every Indian budget have been the fiscal proposals on ever higher taxes on tobacco and alcohol products. The taxes on these products are today many times more than the actual price of the product. Have you ever wondered who among the customer and the tobacco company pays what share of the tax? Before we go on, let us examine the markets for tobacco and alcohol products.

Tobacco and alcohol generally have a captive or "addicted" group of consumers. Though there are also those occassional users, they are a small minority and are not the focus of our attention. The major category consists of the former, whose demand for these products is relatively invariant with respect to changes in price, or thier price elasticity of demand is very low. In other words, the demand for these products among this former category, is inelastic. Eco 101 (or a simple graphical illustration would show) says that for products with inelastic demand, the incidence of taxation is much higher on the consumers than on the sellers.

Further, a large share of those chronically addicted are likely to be those with difficult social and even crime backgrounds. They are also more likely to be the economically weaker sections. As we have seen, under the circumstances, there is a very strong chance that the higher prices forces these socially challenged addicts to become more desperate and resort to more crime and other anti-social activities to finance their purchases. This is surely going to impact crime rates.

There is another interesting dimension to raising prices on cigarettes, brought out in an NBER article Do Higher Cigarette Prices Encourage Youth to Use Marijuana? by Frank J Chaloupka et al. It is conventionally thought that higher cigarette prices results in marijuana substitution. The article argues that marijuana and cigarettes are not substitutes, and also claims that any reduction in cigarette smoking (due to higher prices) also results in a fall in the use of similar substance abuse like drinking, marijuana and other illicit drug use.

Interestingly, in the US, adjusted for inflation, taxes on alcoholic drinks have been falling, because taxes on them have hardly budged since early 1990s. Arguing in favor of higher taxes on products like tobacco and alcohol, David Leonhardt has highlighted this.

Update 1 (13/3/2010)
Deliana Kostova, Hana Ross, Evan Blecher, and Sara Markowitz used individual-level data from 20 developing countries, and estimated that the price elasticity of cigarette demand among youth is -1.83. They tehrefore argue that policymakers in developing countries could reduce cigarette consumption by youths by raising taxes. A 10% increase in the price will reduce youth cigarette demand by 18.3%.