Cigarette Excise Tax Hike in WV

Arguments For and Against a Cigarette Excise Tax Hike in the State of West Virginia

Technical Report 15

March 2003

Nils Guhl
Diplom Wirtschaftsingenieur
Technische Universität Braunschweig

David W. Hughes
Associate Professor and Extension Specialist
Center for Agricultural, Natural Resource, and Economic Development
West Virginia University Extension Service

(Senior authorship is unassigned)

The appropriate level of tobacco product taxation has been a controversial issue for federal and state governments for many years. Consumption accelerated rapidly in the twentieth century due to the commercialization of the cigarette. More recently, discussions about the proper taxation of cigarettes have intensified as the adverse health consequences of tobacco use have become obvious. This debate is increasingly accompanied by discussions concerning regulations governing smoke tobacco product use in public facilities. Cigarette manufacturers have also experienced recent tort actions instigated by smokers and states attorney generals. Both groups have argued that tobacco companies are liable for pain and suffering, economic loss, and health care cost due to smoking induced diseases.

Cigarette excise tax rates have increased recently in many states. Such increases are a relatively painless way to ease widespread budget problems. West Virginia has not been immune to budget woes or to proposals to increase the state tax on cigarettes. Governor Wise recently proposed and the West Virginia Legislature has recently passed an increase in the state cigarette tax in West Virginia, which has remained unchanged since 1978, from $0.17 to $0.55 per pack (an increase of $0.38). The increase is expected to help meet what would have been a projected budget deficit in the 2003-2004 fiscal year of well over $200 million.

Discussed here are the arguments for and against increasing cigarette taxes in West Virginia. The health community and the tobacco industry lobbyists have dominated the political process of cigarette tax legislation. We will evaluate the legitimacy of arguments made by both sides in light of economic analysis. Most economists view taxes as a way to reduce use of goods that are "over-consumed". Views concerning whether cigarettes are "over-consumed" in West Virginia, that is, opinions concerning an increase in cigarette taxes largely hinge on how one views both the decision to smoke and the impact that smoking has on others. Higher cigarette taxes are much more justified if tobacco consumption constitutes what economists call a market failure, where private markets do not obtain the most desirable social outcome.

Current Situation in West Virginia

In 2000, an estimated 26 percent of all adults, (versus 22.6% nationally) and 39 percent of all high school students smoked in West Virginia. Between 1995 and 1999, 4,240 of 380,000 smokers died annually due to smoking related illnesses, meaning that more than one-fifth of the 21,000 annual deaths in the state were linked to smoking (West Virginia Department of Health and Human Resources, 2001).

Cigarettes are subject to federal excise tax, state excise tax, and state general sales tax in West Virginia. The cigarette excise tax is a fixed amount per pack of 20 cigarettes. The Federal Government charges a cigarette excise tax of $0.39 per pack. The state excise tax is $0.17 per pack versus a national average of state taxes of $0.61 per pack (Orzechowski and Walker, 2002). Taxes are charged when the manufacturers sell their cigarettes to wholesalers or large retailers. Cigarette excise taxes are included in the general sales tax base. General sales taxes are charged as ad valorem, that is, as a constant fraction of the wholesale or retail price. The State of West Virginia charges a rate of 6% on top of the retail price. Before the recent tax increase, the total cigarette-specific tax on every pack of cigarettes sold in West Virginia was $0.56 per pack, excluding the general sales tax.

Kentucky and Virginia share extensive borders with West Virginia. Both states (along with nearby North Carolina) have the lowest state cigarette excise taxes in the country. Kentucky's current cigarette tax rate is $0.03 per pack, Virginia's is $0.025 per pack, and North Carolina's is $0.05 cents per pack. Maryland, Pennsylvania and Ohio are border states with higher cigarette excise tax rates than West Virginia. All three states have undertaken substantial tax increases within recent years. Maryland increased its cigarette excise tax from $0.36 per pack in 1998 to $1.00 in 2002, Ohio increased its tax from $0.24 in 2001 to $0.55 in 2002, and Pennsylvania increased its tax from $0.31 in 2001 to $1.00 in 2002.

Tobacco farming and manufacturing in West Virginia are responsible for only 0.1% of gross state product (U.S. Department of Commerce, 2002). But cigarettes are sold through a diverse set of retail outlets including convenience stores, tobacco stores, eating and drinking establishments, grocery stores, and even pharmacies. Arguable, a tax increase could decrease retail activity in border counties and lead to a less than expected growth in tax revenue, because the inflow of consumers from high-tax neighbors could be reduced, while purchases by West Virginia residents in low-tax neighbors could increase. (1)

Differing Assumptions about Cigarette Consumption

Economic efficiency occurs when resources are allocated in a way that maximizes a society's welfare. Competitive markets are economically efficient if no one can be made better off without making someone else worse off (no consumer or producer can increase well being through further trade) and there is no market failure. For cigarette consumption, market failure could be due to externalities, to incorrect risk perception, or to addictive behavior (Jeanrenaud and Soguel, 1999).

Externalities are social (external) costs or benefits that production or consumption imposes on those not participating in the market. That is, individuals are negatively or positively affected by a market transaction without being compensated or charged. Negative externalities reduce overall social welfare. Second hand smoke is a potential negative externality created by a market transaction (cigarette consumption). Individuals who experience adverse health effects from second hand smoke are not compensated for this damage. If consumption creates externalities, economic efficiency may be improved by taxes that force consumers to account for extra-market impacts on others.

Participants must make rational decisions for markets to provide the greatest social benefit. To do so, consumers must possess and use adequate knowledge in making rational consumption decisions. If smokers are not fully informed about associated health risks, they underestimate personal costs (hence overestimate net benefits) and consume more than the economically efficient quantity. Firms usually have no interest in fully informing consumers about the adverse effects of their products, because full information would reduce sales.

Addiction exists when past use of a good raises the incremental pleasure of current use (resulting in past consumption raising present consumption). Cigarettes contain the addictive substance nicotine. Preventing nicotine withdrawal is a benefit of continued smoking. Therefore, past consumption encourages current use (Grossman, Chaloupka, and Anderson, 1998).

Addictive behavior may also hinder smokers from making rational decisions. The rational addiction model (Becker and Murphy, 1988) and the time-inconsistent addictive behavior approach (Gruber and Koszegi, 2001) provide contrasting views. Advocates of the former see smoking as a rational decision (i.e., not as addict-based market failure) while advocates of the latter hold to opposite conclusions. If smoking is rational, the case for an increase in cigarette taxes is weakened.
The rational addiction model is based on the idea that the act of smoking today builds a future addictive stock, which lowers the pleasure of smokers in the future because smoking is harmful. But, a higher addictive stock also increases the pleasure of smoking because it increases the future craving for cigarettes. Rational addicts are time-consistent, meaning their relative preference for well being at an earlier date over a later date is the same for any point in time (Gruber and Koszegi). That is, they follow through on their plans concerning their future cigarette consumption. Also, addicts are forward-looking in decisions concerning current versus future net benefits from smoking meaning current consumption depends on both past and future levels of use. They also trade off the current net utility (happiness or pleasure) gains from smoking against the future costs of doing so. Utility is derived from factors such as smoking pleasure and social group status while costs include the monetary price of cigarettes, current personal damage caused by smoking, and additional future damage caused by ongoing consumption. Smokers are fully aware of the possibility of becoming addicted. Addiction per se is not a market failure and self-imposed smoker costs are irrelevant for taxation, unless rooted in misperceptions regarding the harmfulness of smoking.

A sizeable empirical literature supports the key idea that addicts are forward-looking. But economic and psychological research suggests that addicts are not time consistent. Individuals instead tend to realize immediate rewards and to avoid immediate costs in a way that does not serve their long-run well being (O'Donoghue and Rabin, 1999).

Gruber and Koszegi base their approach on the same stock addiction framework as Becker and Murphy. However, as opposed to viewing smokers' preferences as time-consistent they assume that smokers make time-inconsistent decisions because they are impatient. Addicts would like to smoke less in the future than they actually end up doing. Their long-run preference suggests a lower level of consumption, but their immediate preference is to maintain consumption to derive instant pleasure. Although addicts wishing to smoke less in the future from today's standpoint, they end up making impatient decisions when the future arrives due to a lack of self-control. Time-inconsistent addicts maximize short-run well being by giving in to impatient decisions but fail to maximize well being in the long run because they are hooked (Gruber and Koszegi). Thus, addicts are not fully rationally consumers (i.e., addiction is a form of market failure).

Gruber and Koszegi further specify sophisticated versus naive time-inconsistent addicts. Sophisticated addicts are aware of their self-control problem and therefore know that they will change their preference in the future. They frequently try to quit or reduce smoking by using self-control devices, (which reduce the pleasure from smoking), such as telling others about their decision to quit and making it otherwise embarrassing to smoke. Taxes can serve as a self-control device for sophisticates to combat their own time-inconsistent tendencies by helping them realize their long-run preference of less smoking and increased long-run well being.

If naive addicts predominate, then increases in the level of cigarette taxes are even more easily justified. Naive addicts would also like to smoke less in the future, but do not recognize their lack of self-control. Hence, they do not use self-control devices. Naive smokers, expressing the desire to stop smoke at certain time in the future, are unaware that they will have changed their mind when that future time arrives. Taxes provide naïve smokers with a self-control device and help correct the misperception problem regarding their time-inconsistency behavior (Gruber and Koszegi).

There is clear evidence that youth usually underestimate the future likelihood that they will continue to smoke. Since 80% of all smokers adopt their habit before the age of 20 years (Evans, et al., 1999), the misperception problem is closely linked to underestimating the addictive potential of cigarette smoking. From a theoretical viewpoint, taxes are especially important for limiting cigarette consumption by young, usually naive, potential addicts. This logic is confirmed by numerous studies indicating that cigarette taxes are especially effective in reducing consumption and in preventing addiction by younger individuals (Chaloupka and Warner, 2001).

Laboratory experiments and other studies document that consumers are time-inconsistent (Gruber and Koszegi). Further, eight of ten U.S. smokers wish to quit but most do not. This indicates time-inconsistent smoking preferences because time-consistent smokers either voluntarily continue smoking or follow through on their decision to quit.

Pro and Con Arguments Concerning Increased Cigarette Excise Tax

The health community is pushing legislators to raise cigarette taxes to reduce smoking and promote the general health of West Virginia residents. The tobacco industry has promoted low cigarette taxes to keep cigarette prices down and stimulate consumption. Because state tobacco production and manufacturing is small, lobbyists rely on arguments concerning the demand side of the cigarette market.
Arguments on both sides contain a mixture of truths and fallacies. Disagreements center on evaluating the individual benefits of smoking, estimating impacts on health care cost, the level of damage caused by second hand smoke, impacts on low-income consumers, and impacts on retail activity and tax yield in border counties of the state.

Individual Benefits of Smoking

The health community pursues the goal of a smoke-free society based on the belief that cigarette smoking provides no individual benefits. Industry supporters argue that higher taxes disturb the free market mechanism by depriving consumers of making free consumption decisions. They argue that smoking is an individual choice and does provide benefits.

Proponents of the rational addict model would tend to accept the argument that smoking provides an individual with benefits. They see smokers as rational consumers, making an informed judgment about their own health and well being, and smoking if net personal benefits are positive. They point to the widespread belief that cigarette smoking leads to long-term health problems and argue that consumers are aware of the addict nature of tobacco products. Hence, tobacco consumption does not constitute market failure, thus weakening the case for an increase in cigarette taxes.

Proponents of the time-inconsistent addiction approach would be more sympathetic to the health care advocates' argument. They argue that many smokers would like to quit, but find it difficult to do so. That is, while providing benefits in the short-run, they would argue that in the long-run many smokers do not see cigarette smoking as a net benefit and only continue smoking because of their time-inconsistent behavior.

The impact on young, potential addicts is another important consideration in evaluating the impact of a cigarette tax. The health care community emphasizes that young smokers are unaware of the full risks of smoking in terms of both its health risks and its addictive nature. Hence, they demand higher cigarette taxes in part to deter youth smoking.

Again, proponents of the time-inconsistent addict approach would be sympathetic to the health care industry argument. They would especially agree that younger smokers inaccurately assess the addict nature of cigarettes. They would accept the argument that cigarette taxes are an effective deterrent against young naive smokers becoming addicts.

We find the time-inconsistent approach to be better supported by the empirical evidence concerning the behavior of most but certainly not all smokers. The vast majority of smokers indicate a desire to cease, but are unable to do so. While youth usually do not underestimate the adverse health impacts of cigarette smoking, they often underestimate the addictive potential for themselves. Both of these observations indicate that most smokers and especially young smokers are time-inconsistent. This is a telling argument for supporting a reasonable cigarette tax increase in our view.

Health Care Cost

A major argument of the health care community is that smokers impose costs on the society through excessive use of the health care system. The West Virginia Department of Health and Human Resources (WVDHHR) attributed $670 million in health care costs in West Virginia to smoking in 2001. Tobacco industry supporters would argue that the current cigarette tax is sufficient to compensate for the excess health care costs of smokers.

Economists would challenge the $670 million as not reflecting the true health care costs of smoking. First, the estimated cost touted by WVDHHR is based on the prevalence-based model, which measures smoking related costs in a given year. Those costs reflect historical trends in smoking. Smoking costs are better assessed with the incidence-based approach, which determines the present value of the additional lifetime costs of cohorts of present smokers. This method correctly captures the long lags between smoking initiation and most smoking-related illnesses. Just as important, smokers' excess costs during lifetime must be set off against savings resulting from premature smoking-related death (e.g. lower pension payments), which represent, strictly speaking, external benefits. That is, health costs should be evaluated as a net not a gross cost.

Other attributes of individuals than smoking that influence external costs from health care, such as education, income, and other health habits, should be statistically controlled for to isolate the effect of smoking. Smoking related costs should be assessed by comparing the costs of smokers to the costs of very similar non-smokers (a control group) rather than to the costs of all non-smokers.

Economists would also point out that external costs must be distinguished from internal costs. In particular, health care costs should be divided between those borne by the public at large through Medicare and Medicaid and those imposed on the private sector.

Second Hand Smoke

A major argument made by the health care community is that second hand smoke threatens the health of non-smokers. Industry advocates might counter that the impacts of second hand smoke are questionable or even non-existent. To most economists, second hand smoke could provide a strong theoretical foundation for taxes to alleviate the over-consumption of cigarettes because taxes force those creating the externality to account for the damage that they impose on others.

The strength of the externality based argument rests on the empirical evidence concerning how much damage second-hand smoke does impose on others including considerations about "accounting stance". That is, smokers impose most damage from second hand smoke on fellow family members (Manning et al.). If families rather than individuals are considered as consumption units, much of the projected damage from second hand smoke would not constitute an externality. Smokers are either unaware or (much less likely) do not care about the adverse effects of smoking on family members.

Some past studies have questioned the link between second hand smoke and adverse health effects (Gravelle and Zimmerman, 1994). The current consensus among health experts is that second hand smoke does impose adverse health impacts on others (World Health Organization Europe, 2001) and that such costs must be seriously considered in determining the appropriateness of a cigarette tax increase. For example, the effects of second hand smoke include between 30,000 and 60,000 annual deaths from heart disease in the US (Chaloupka and Warner, 2001). Moreover, in 1994, an estimated 39,000 low birth weight infants of women who smoke during pregnancy required hospitalization and more than 2,000 of those low birth weight babies died (Evans et al., 1999).

Impact on Low Income Smokers

Industry supporters argue that cigarettes are already heavily taxed in West Virginia and that a tax increase would impose an excessive burden on lower income smokers. The perception that an increase in cigarette taxes will be regressive exists because lower income smokers do spend a greater percentage of their income on cigarette than do higher income cigarette consumers.

But empirical studies conducted at the national level in both the United States and the United Kingdom indicate that the burden of increases in cigarette taxes on low income smokers has been typically overestimated (Warner, 2000). Low-income smokers cut their consumption at a much greater rate than higher income smokers. Farrelly and Bray (1998) found the price response by low-income cigarette smokers to be 70 percent greater than that found for higher income smokers in the US.
If the regressive nature of the tax is an issue, one response would be to place an ad valorem (percent) tax on cigarettes rather than a per pack tax. Wealthier individuals would bear an increased share of the tax because they tend to smoke higher priced brands. Another solution would be to use some of the increase in tax revenues to assist low-income smokers in quitting (Warner, 2000). Such an approach would also help ease public supported health cost, because low-income smokers tend to make the greatest use of Medicaid and to a lesser extent Medicare.

Retail and Tax Yield Impacts in Border Counties

Industry advocates argue that the proposed tax increase would have a detrimental impact on retail activity and tax revenues in counties bordering other states. For areas in southern West Virginia, a tax increase could increase the flow of West Virginia smokers to neighboring low tax states. For the northern border counties, a tax increase could stem the flow of smokers coming into the state to purchase cigarettes.

We evaluated the possible impact of cigarette tax rates on cigarette consumption in West Virginia with an econometric model based on data from 1970 through 2001. Our analysis found that cigarette prices in both low tax and high tax neighboring states did not affect cigarette consumption in West Virginia during those years. While undoubtedly some casual smuggling does occur between West Virginia and borders states, this activity has in all likelihood not had a marked impact on cigarette sales or retail activity in border counties in the past. The implication is that an increase of reasonable size in the cigarette tax should not have a detrimental impact on state cigarette sales or state cigarette tax revenue. This analysis is confirmed by conversations with state tax officials in bordering states, who indicated that the increase in tax revenue due to increased tax rates has meet their expectations. They felt that the leakage of sales into West Virginia has not been large, but did not have any leakage estimates. Cigarette tax revenues in West Virginia showed modest growth ($2.5-$3.0 million on an annual basis (Kabler, 2003) or around 10%) during the period when bordering states increased their taxes and West Virginia's remained at the 1978 level.
State government expert have indicated that the next tax level will mean that cigarette sales contribute a projected $59.7 million to state government finances (Kabler, 2003). We believe that this conservative estimate of the increased tax yield will be easily obtained.

Summary and Conclusions

The West Virginia legislature recently passed an increase in the per pack cigarette excise tax from $0.17 to $0.55. Strong supporters of the tax increase include health care advocates while tobacco industry lobbyist and certain sectors of the retail sector were opposed.

We analyzed the arguments made by both sides concerning a tax increase. The health care community's arguments supporting a tax increase are generally the most persuasive in our view. Our research indicates that the impact on tax revenues and retail activity due to cross-border sales would be minor. The health care community overstates estimates of health care costs from smoking. But smoking does impose an unestimated cost on the health care system. The weight of the evidence also indicates that second hand smoke does impose externality-based cost on others. An increase in the excise tax would also serve to reduce consumption by naive and potential addicts, especially among youth. The increase that is current being requested is not extreme and would give West Virginia a state cigarette excise tax rate close to but still less than the national average.

References

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