Good Analysis by a Government Official

Next month, we California voters will get to vote on Proposition 29, an initiative to raise the cigarette tax by \$1.00 per pack. On Econlog, we are not allowed to advocate passage or defeat of a particular piece of legislation. But, if you have followed my posts, you can probably bet correctly about how I will vote on this.

My point here, though, is strictly about the economic analysis by the legislative analyst that’s printed in the Official Voter Information Guide. Here’s my bottom line: It’s a good analysis. I’ll put my comments under two headings: (1) effect of the tax increase on tax revenues, and (2) effect of the tax increase on health care spending.

Effect on Tax Revenues

In the tax part of a cost/benefit analysis course I teach, I often give the students a problem in which there’s an existing tax on cigarettes and the state government raises the tax. I use, as it turns out, an actual example from California in the late 1990s. One of the things I want my students to see is that the deadweight loss from raising the tax has two components: (1) the standard triangle loss from lower consumption of cigarettes, and (2) the reduced revenues from the tax (a rectangle) because that drop in consumption gives less revenue to the government from the previous lower level of the tax. [I could show you with a graph but I haven’t yet mastered doing graphs on this site.]

So when I heard in the advertising that the tax increase would generate \$735 million in additional tax revenue for the state government over its first full year, I thought, “I bet they didn’t take account of the fact that the drop in consumption will reduce the revenues from the existing tax.”

I was wrong. The Legislative Analyst explicitly took this into account and estimated the revenue loss at \$75 million. The proposition apparently takes this into account also and has a “backfill” proposition for making sure the new tax revenues spent on their favored items are net of this backfill.

The Legislative Analyst even gave enough data to allow you to “back out” what elasticity of demand he/she used. The estimated revenue from the current 87-cent tax per pack is \$905 million (for the 2010-11 fiscal year). That would imply sales of 1.04 billion packs. I don’t know what growth factor he [I’ll use “he” from now on] used: let’s assume 0.

Then the revenue raised from the \$1-per-pack tax increase, gross of backfill, is \$810 million for the 2013-2014 fiscal year. That implies sales of 810 million packs. So the reduction in packs bought due to the tax (assuming zero growth of sales absent the tax) is 194 million. That’s a 19-percent reduction in response to a \$1-per-pack price increase. [The analyst assumes that the whole tax is passed on to the buyer. That requires that the supply curve of cigarettes to California be horizontal, a reasonable assumption given that the cigarette companies have a very close substitute for selling cigarettes in California, namely, selling cigarettes to the other 49 states plus the District of Columbia, or, by President Obama’s reckoning, the other 57 states plus D.C. :-)]

We’re almost there. All we need now is to estimate the \$1 price increase as a percent of the old price. Let’s assume \$5.00. That’s a 20% increase. So the % reduction in consumption roughly equals the % increase in price. So the implied elasticity of demand is -1. [I don’t know whether that includes the analyst’s estimate of evasion of the tax, sales on Indian reservations, etc.]

Effect on Health Care Expenditures

One of the reasons advocates often give for higher taxes on cigarettes is that it will reduce health care spending. Of course, it will reduce health care spending on certain tobacco-related illnesses, but, by prolonging life, it will increase them on other things: the older you are, the more you spend on health care.

Did the legislative analyst catch this? Yes. Here’s what he said:

For example, as discussed earlier, this measure would result in a decrease in the consumption of tobacco products. The use of tobacco products has been linked to various adverse health effects by federal health authorities and numerous scientific studies. Thus, this measure would reduce state and local government health care spending on tobacco-related diseases over the long term. This measure would have other fiscal effects that offset these cost savings. For example, the state and local governments would incur future costs for the provision of health care and social services that otherwise would not have occurred as a result of individuals who avoid tobacco-related diseases living longer. Thus, the net fiscal impact of this measure on state and local government costs is unknown.

UPDATE: See my next blog post for the analysis done correctly.