Monday, August 13, 2007

Cigarette demand and Taxes

Two of the propositions on the ballot last fall raised cigarette taxes. The state tax went from $1.18 per pack to $2. This was passed along to consumers and they responded as predicted (by economists) with a reduction in the quantity of cigarettes demanded.

State officials say it's too early to tell whether the recent state tax hike and the new statewide smoking ban have curbed per capita smoking rates in Arizona. But tax officials say sales were down 23 percent in May and 15 percent in June from a year earlier. And a Web-based survey by the University of Arizona and Northern Arizona University found that 84 percent of smokers considered quitting after the tax hike and 28 percent quit for a day or more.

Another interesting, but entirely predictable impact was the significant increase in cigarette tax stamp sales prior to the new tax rate going into effect. The graph isn't availble in the on-line edition of the paper, but it shows a huge increase in October, November and December, with a corresponding decrease in the first quarter of this year. This is a classic example of an expected price increase (tax increase) triggering an increase in demand.

The price elasticity of demand is also interesting. The demand for cigarettes has long been thought to be inelastic. However, if you raise the price high enough, eventually you get into the elastic region of the demand curve. The 82 cent increase represents about a 20% increase in the price of a pack of cigarettes. If volumes stay down by a similar amount, we're getting to the point on the demand curve where we transition from an inelastic demand to an elastic demand.

That means further tax increases would likely result in revenue decreases. There are hints of other problems.

Industry groups predict increased black-market sales and thefts. They also warn that tax increases can backfire. If smoking declines, programs that depend on tax revenue could lose money.

As I like to point out, just because something is illegal doesn't mean there still isn't a market for it. It just raises the opportunity cost.

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