Saturday, May 29, 2010

Externality taxes should be large enough to be an effective enough deterrent

A tax on substances producing negative externalities is a well-established strategy to control its adverse effects. Accordingly, cigarettes and alcohol, have for long been the focus of attention of fiscal authorities, albeit more as a soft source of raising revenues than as an effort to curb adverse health and social externalities.

Amidst this, one of the less discussed issues have been the extent of taxes required to exercise a sufficient enough deterrent against their excess consumption. Econ 101 teaches us that if the price elasticity of demand for the product is low, then taxation will do little to reduce consumption and will only increase the prices paid by the consumers (since the incidence of taxation is higher on the price inelastic consumer). In the circumstances, for taxes to make a substantial dent on consumption, they need to be raised by a large enough percentage.

In this context, a recent RAND study that estimated the potential effect of soft drink taxes on 7300 children's individual-level consumption and weight by examining differences in existing sales taxes on soft drinks between states, and explored whether small or large taxes were more effective, comes to similar conclusions. They find that "existing taxes on soda, which are typically not much higher than 4 percent in grocery stores, do not substantially affect overall levels of soda consumption or obesity rates". They also find that "reducing consumption for all children would require larger taxes". The authors conculde that "Soda taxes do have the potential to help reduce children's consumption of empty calories and have an impact on obesity, but both their size and how they are structured are key to whether they create measurable impact."

Therefore as David Leonhardt writes in a Times article, "So a small soda tax could actually have a worse impact on some families’ budgets than a substantial one — by raising the price of soda without affecting consumption." He also has this superb graphic, which shows that soda prices have been declining since 1978 relative to overall inflation, as measured by the Consumer Price Index, with prices of carbonated drinks falling 34% relative to all other prices, largely because its cost of manufacturing has fallen dramatically. In contrast, the prices of the average real cost of fruits and vegetables has risen more than 30%.

This finding could have echoes in India too. Have prices of the median variety of cigarettes and alcohol risen slower than that of foodstuffs? Have the costs of producing the former fallen faster than that of producing food? If either are true, and my guess is that they are, then taxes on cigarettes and alcohol should be raised even more so as to exercise a large enough deterrent impact on its regular consumers.

Update 1 (6/6/2010)
Greg Mankiw does not support soda taxes, citing the slippery slope arguement (that such paternalism that seeks to protect us from ourselves can lead to undesirable outcomes).

Update 2 (18/6/2010)
David Leonhardt points to a study published in the American Journal of Public Health which finds sales of sugary soft drinks declined by 26 percent following a price increase of 45 cents — or 35 percent of the baseline price, a clear indication that when the price of soda goes up, consumption goes down. The same has been found true for both tobacco and alcohol.

Update 3 (23/6/2010)
Freakonomics points to a study by Tammo H.A. Bijmolt, Harald J. van Heerde, and Rik G.M. Pieters that have found that consumption of all goods in general drops by about 2.6 percent for every 1 percent increase in price. However, in view of its addictive power, alcohol use is much less responsive to prices, as shown by this review of 132 papers on the topic by Craig A. Gallet, who reported the average study showed that alcohol consumption, over the long term, drops only 0.82 percent for every 1 percent increase in prices. Cigarettes sales are even more insensitive to price hikes.

Update 4 (24/8/2012)

Kevin Callison and Robert Kaestner examined recent, large tax changes, which provide the best opportunity to empirically observe a response in cigarette consumption, and employed a novel paired difference-in-differences technique to estimate the association between tax increases and cigarette consumption. They find,
Estimates indicate that, for adults, the association between cigarette taxes and either smoking participation or smoking intensity is negative, small and not usually statistically significant. Our evidence suggests that increases in cigarette taxes are associated with small decreases in cigarette consumption and that it will take sizable tax increases, on the order of 100%, to decrease adult smoking by as much as 5%.

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