Economic Instruments for the Regulation Of Licit Drugs

Paper for the Perspectives for Change Conference, sponsored by the New Zealand Drug Foundation and the Alcohol Liquor Advisory Council, 25-27 November, 1991.

Keywords Health; Regulation & Taxation ;

This paper does not pursue the ‘why’ or ‘whether’ policy issues of the additional regulation of licit drugs such as alcohol and tobacco, except insofar as that is relevant to the ‘how’ of regulation. The paper focuses on only one aspect of the how, the use of ‘economic instruments’ of regulation.

The economic instruments of regulation could refer to such policy options as prohibitions and restriction. However in the current broad policy debate, economic instruments are confined to market instruments only, which includes taxes and subsidies, and property rights such as licences and private ownership. In recent years the main debate about the use of such market instruments has been for environmental regulation (Salmon 1991, Terra Nova 1991), but as this paper shows, their modem use for licit drugs precedes that for the environment.

An appreciation of why economists have advocated market instruments can be gained from the chapter heads of Roemer’s review of legislative action with regard to smoking (1982). They include such expressions as ‘control’ (four times), ‘restrictions’ (three times), ‘preventing, and ‘mandatory’. Whatever the civil liberties aspects of such interventions, economists would add that experience indicates that they tend to be less effective than the legislators’ intention, and they tend to generate a variety of economic inefficiencies.

In my view that does not mean a community should not use such direct interventions. If I see a child heading for a fire I am likely to warn and then grab her or him. But ideally there will be an education program, which helps the child make their own decisions, and there may well be a fireguard. In the same way the economic instruments aim to provide an environment in which control, restriction, and mandation are less necessary.

A feature of this paper is that it addresses both alcohol and tobacco. However the two licit drugs have different pharmacological and social impacts, and so the precise application of the market instruments will differ.

Fiscal Considerations

Excise duties on alcohol and tobacco were initially for revenue purposes. In 1839, the British Colonial Secretary, Lord Normandy, confidently advised putative Governor Hobson ‘Duties on the import of tobacco, spirits, wines and sugar, will probably supersede the necessity for other taxation …’, (McLintock 1958:90). Ordnance No.3 of 1841 imposed duties starting from 9d. a pound for unmanufactured tobacco, and 4s. 0d. a gallon for spirits (beer was no initially taxed). There was a brief period from 28 September 1844 to 8 April 1845 in which the duties were repealed, but since then excise duties on imports of tobacco and alcohol, and later on their domestic manufactures, have been an ongoing part of our fiscal reality (Taxation Review Committee 1967: 63).

Normandy’s prophesy proved unfounded however, as the revenue proved insufficient. Admittedly in 1875/76 customs and excise duty made up 91.6 percent of tax revenue, but since then the proportion has been diminishing. Today they are estimated to be 4.1 percent of total tax revenue (for the 1991/92 year). The decline is not so dramatic relative to total output. Customs and excise duties (including some other products) was about 4.1 percent of GNP in l875/76, and alcohol and tobacco taxation (excluding GST) is expected to be about 1.7 percent of GNP (excluding GST) this year. What Normandy under-estimated was the revenue demands of government.

As every first year economics student is taught, alcohol and tobacco are attractive targets for the tax. They are readily identified without easy substitutes, there are few manufacturers and importers,[1] and in each case the demand is price inelastic. This last concept is crucial to the subsequent discussion, so it needs to be explained.

In economics the term ‘elastic’ is virtually interchangeable with ‘sensitive’, so to say the demand for a product is price inelastic is to say that its demand is insensitive to a change in price. Thus if taxes go up, there is little change in demand for the product, and so the tax revenue gain is significant.

A counter-example from Britain in the 19th century may be helpful. There the Chancellor of the Exchequer put up the tax on bubbly wines, without appreciating that champagne was very price elastic, because consumers promptly switched to still wines, and the tax revenue went down. But while individual tobacco or alcohol products may be price elastic, collectively either product is price inelastic. (Easton & Kay 1982 for alcohol; Laugesen & Meads 1990, 1991 for tobacco)

This inelasticity means that when suppliers grump that about exceptional taxes on their products, they are told that the tax is not reducing their output or profit that much, in comparison to highly elastic products. In effect almost all the tax is being passed onto the consumer, and the producer is hardly suffering.

There is actually a deeper analysis in this, which I will not detail. But briefly if the government has to raise taxes then it can be shown that impositions on inelastic products are less ‘distorting’ in the economist’ s sense that they are less damaging to overall economic efficiency. Indeed there is a well established theory of the optimal level of taxation. That theory identifies a product with these characteristics alcohol as ideal for higher rate of excise tax relative to other products.[2]

There is one further characteristic of tobacco and alcohol, which makes them attractive in taxation terms. Consumption of either is thought to be indulgent, if not downright sinful. For this reason the excise duties on tobacco and alcohol are sometimes called ‘sin taxes’.[3]

The Aftermath of 1958

The most famous – or infamous – example of the imposition of sin taxes was the 1958 budget, which with hindsight now appears to be a case of superb fiscal management to a substantial external shock. At the time the ‘Black’ budget was seen as a betrayal of the promises in the 1957 election promise and the punishing of the working man’s pleasure in his ‘beer and baccy’, by a 30 percent rise in the price of alcoholic beverages and a 40 percent rise in the price of tobacco. So dramatic were these hikes that they perceptibly cut consumption despite each product’s price inelasticity of demand (Easton 1967).

The justifications for these hikes are surprisingly thin, given the furore they caused. The budget speech itself simply says there is a need for fiscal action and baldly – as baldly as the head delivering the budget -announced the additional impositions. In the subsequent customs and excise duty bill debate it was argued that even after the increases the duty rates would be lower than in the ‘Old Country’ (Walter Nash) and Australia (Phil Holloway). Arnold Nordmeyer quoted Professor Alan Danks of the University of Canterbury that we are smoking and drinking too cheaply for the times’. Nash hesitantly suggested ‘as for spirits, I do not know whether there are advocates on that side or this side of the House for more to be drunk’. Reading this debate today suggests the Opposition was easily scoring points against the Government right from the beginning. (NZPD 1958:291-5).

The politically traumatic experience of the 1958 budget meant that the subsequent government was loathe to raise the duties. An indication of the state of affairs is the 1967 Report of the Committee on Taxation which hardly discusses excise duties, proposed they be retained, concluding lamely it recognised
‘that excise duties are regressive [ i.e. impose more heavily on the poor] in their effect but in the nature of the commodities taxed, their importance in general to the revenue and the acceptability of excise in the public mind we do not consider that the mere fact of regression in this sector of the tax field is of itself sufficient reason for any change, provided the tax system as a whole is progressive.’ (p.372)

But even as they wrote tobacco duties were hiked, and again in 1970, and 1976. On the other hand alcohol duties were not significantly raised until 1977. It is unclear why the two were treated differently. The following comes from the October 1970 Economic Statement
‘Of all the products at present subject to indirect taxation, it is clear that cigarettes and tobacco can be subjected to additional tax without harming in any way the general welfare of the community. In fact it is increasingly argued that discouraging the consumption of these commodities is likely to make a positive contribution to our general health.’ (Muldoon 1970: 12)

There was no mention of alcohol. One practical political possibility is that smoking is more concentrated in low income groups, in comparison to drinking being more evenly spread across the community. Thus a National government was less constrained by the political impact of a tobacco excise duty hike on its supporters.[4]

The 1970 announcement raises an issue which amounts to a near deception. The purpose of the duty hike was to raise revenue. Insofar that people reduced their consumption of tobacco products as a result, that would reduce revenue. Thus it is not at all clear that the fiscal measure aimed to discourage consumption, despite the apparent meaning of the second sentence of the quotation.

The expression ‘without harming the general welfare of the community’, is probably a reference to the optimal theory of taxation, and the ‘in any way’ probably implicitly assumes the demand for tobacco is totally inelastic.

The 1977 Change

Holding the duty rates at the same nominal level, was becoming increasingly difficult in the 1970s, as inflation galloped along at double digit rates, and specific duties experienced a kind of negative fiscal drag.[5] The real value of the excise duty was diminishing, which reduced the real value of government revenue, and the real price which made the licit drug use cheaper. An interesting coalition evolved of those who merely wanted the government to control and reduce its deficit, and those who wanted the government to control and reduce the use of licit drugs, or perhaps merely punish the drug users. Different objectives, but a common policy prescription was to raise the excise duties.

Probably the 1970 tobacco duty hike was the first reluctant recognition, and in 1979 there was some linkage of specific taxes to inflation via the imposition of specific sales taxes.[6] However in the 1977 budget speech an apparent change in policy occurred. The first paragraph of the section entitled ‘Duty on Alcohol and Tobacco’ says
‘The Government is concerned at the high level of public expenditure caused directly by the consumption of tobacco and alcohol. The adverse effects on health of smoking and drinking have been well publicised. Alcohol is also a major cause of many road accidents. The cost of providing health care and treatment in public hospitals and elsewhere for those affected is very high. (Muldoon 1977:41)’

Having set the new higher duty rates the section concludes that the additional revenue ‘will help sustain the high level on health, including the extension of community health services’ (Muldoon 1977:42). Thus a new principle has been introduced. While the duties may remain primarily for revenue raising purposes their justification is now in terms of the costs that the activities impose on the public.[7]

The Externality Issue

The phenomenon recognised in the budget statement comes from standard economic theory . Usually the individual’s consumption covers all the costs to the community,[8] but for some consumption the costs to the individuals may differ substantially from the social costs.

For instance when I drink milk, I pay for the cost of the land, the farming, the treatment station, and the transport and delivery. In the jargon the costs to society are ‘intemalised’ to the consumer. In comparison while drinking the alcohol I pay for the farming, processing and distribution, I may (or may not) also incur social costs from the need for medical treatment, and perhaps for violence and or/accidents which are also precipitated from the drinking. These additional costs which I impose on society are called “externalities”. (Note there may be positive externalities, if society has its costs reduced, that is society benefits.) All consumption activities probably generate some externalities, sometimes positive, sometimes negative, but for a limited number of products the externalities are considered sufficiently large to require some government intervention. There are two broad reasons for these interventions.

First it might not be considered fair that a consumption activity should impose costs on other without the consumer paying for it. There is a sort of justice if costs are intemalised (and the distribution of spending power is fair) in that you pay for what the costs you incur to society. The tobacco smoker or alcohol drinker who ends up in hospital, or sends others to hospital, without paying for the costs incurred seems to be unjustly favoured.

The second reason is the price system also acts as a signalling device, which tells consumers how much of social resources they are using when they consume the product. Not only do prices signal resource usage, but they are self enforcing, because the consumption activity normally involves giving up income equal to the resources. Thus the consumer sacrifices income for the social resources used. However where there are externalities the self enforcing element no longer applies, and consumers will tend to overconsume the particular product, in the sense that they would use more of it than if they had to pay for it all themselves. In the economist’s jargon this generates inefficiency.

Each of these accounts can be seen in the two economic statements already quoted. In 1970 the duty (and hence prices) were hiked to discourage consumption (so we were told). In 1977 the purpose of the hike was to pay for the additional health costs the consumption was generating. Of course in each case revenue considerations were important.

This would appear to offer a golden opportunity to the tax enthusiast. If the commodity which generates bad externalities is price sensitive, slap on a tax to discourage people consuming it: if it is price inelastic you can still slap on a tax in order to recover the social costs that the consumption generates. There are, however, three caveats.

The first is that treasuries do not like earmarked taxes. They will lecture long on their reasons, (Treasury 1989a,b 1991) but briefly the grounds amount to the Treasury having less control over earmarked taxes and the resulting spending, and having approved one earmarked tax (no matter how justified) the door is opened for a myriad more as every minor externality is taxed (or subsidised in the case of good externalities).

Second, it is not always possible to hone a tax to match the externality. where consumption is directly proportional to public cost a fixed tax is appropriate. Probably for tobacco consumption and some medical costs generated by drinking (i.e. cirrhosis of the liver) that assumption is near enough. But if the social cost is from accidents it matters a lot whether the drink is at home or in the pub just before driving home, and it also matters a lot if it is the first and only drink of the evening or the umpteenth. The scenario for violence is even more complicated, but that raises the further problem that different drinkers generate different social costs in terms of accidents and violence.

One study showed that there was no simple solution to the fair tax problem, even if the community was merely grouped into heavy drinkers, moderate drinkers, and teetotallers. Any duty on alcohol which suited one group was unfair to the other two, and no compromise seemed possible. (Easton, Hunn, & Pryke 1985)

Third it proved quite difficult to measure what was the social cost. What costs do you charge to the individual and what to the community. For instance time off work is a loss of output to the community, but perhaps it is a part of the tradeoff for the pleasures of the drinking binge. How do we evaluate those pleasures?

Moreover consider the peculiar conclusion which arise from early death as a result of, say, smoking. While that may involve the health system in additional smoking related costs, but it saves the social security outlays and further medical costs of in old age.[9] It is possible that the savings to the state from early death may substantially exceed the costs of treating smoking. Should we then subsidise smoking rather than tax it?

The final problem is what do you do when, the revenue from special taxes exceeds the social costs that the activity generates.[12] If the demand is still price elastic the government may still wish to raise tax rates for revenue purposes. In the case of both commodities there appears to be still public pressure to raise taxation on each commodities, because consumption is still seen to be indulgent.[13]

In one sense the use of taxation to either control use of the licit drug or to reduce external social costs (and/or to intemalise them) has been a convenient excuse for the government to raise additional revenue while claiming to be acting in terms of some wider purpose. This is evident in the Minister of Finance 1991 claim ‘the Government is also moving to reduce costs on the health system by discouraging consumption of tobacco and alcohol’ (Richardson 1991: 12), while the main purpose of the hike was revenue. But in a crucial way the legitimation of these reasons in the fiscal debate became part of the leverage that the control lobbies used to justify other measures.

Airspace Rights

How far they progressed can be seen from the remark by the Minister of Health when she introduced the Smoke-free Environments Bill in 1990 she explicitly stated the Government had no ‘monetary self interest’ in the bill, and that ‘international tobacco consumption can be costly for governments, and show that the reduction in revenue from the tax on tobacco might well outweigh the savings in the health vote’ (NZPD 1990: 1635). From the papers released on discussion before the bill was introduced that Treasury did not strongly express these fiscal concerns either.

The bill (now act) is in three sections. The third part involves public education, an issue discussed in the penultimate section. The second involves direct (although partial) prohibition of advertising of tobacco use and sponsorship by tobacco companies, and so belongs to the direct control policy instruments that are not usually classified as an economic instrument. However while the first part also directly controlled smoking via the creation of smoke free zones, it can be thought of as an property right issue (that is the use of an economic instrument) as follows.

There are (at least) two property rights involved: on the one hand there is the right to breathe unpolluted air, a claim which was enhanced by the discovery of the health dangers of passive smoking; on the other there is the right to be able to smoke, and hence pollute the air, on demand. Economists cannot say which of these rights have priority, and the most obvious relevant economic analysis -the Coase theorem (Posner 1986)is inappropriate because the transaction costs of practical enforcement.

What happened was that as smoking penetrated wider social groups the pollution of airspace was accepted by law, since there was no alternative, and so it became increasingly widespread social practice that smoking was given priority over smoke free air. There were protestations, especially from those allergic to the smoke, and numerous practical courtesies, including some social segregation (as the smoking room for men after dinner). However as far is known there was no litigation in New Zealand, over the pollution of air space from tobacco smoking, and it seems likely if there had been the courts would have ruled there was a common law right to pollute other’s airspace. [12]

The effect of the first part of the Smoke Free Act was to give a statutory priority to the right to tobacco-smoke free air, over the right to smoke. Because transaction/enforcement costs of a system based on explicit private property rights would be high the rights are based on designated use. A full private property rights system would have been to give each person the right to smoke free air, which they could pursue in the courts by prosecuting the polluter . Not only would this have been horribly expensive, but it would not have dealt with lingering tobacco residues.

In summary the law change can be analyzed in terms of property rights, especially as it provides a good example of how transaction costs can make the Coase theorem, and its practical policy application infeasible. The change in priority of rights probably reflects the diminishing influence of smokers, plus increasing awareness of the health consequences of tobacco consumption (plus the public costs of smoking), and the recognition of passive smoking as a threat to non-smokers’ health.[13]

A New Right Application of Economic Instruments

The New Right objection to ‘selective’ interventions such as specific taxation, is pursued in a Centre For Independent Studies publication by Rob Cameron (1989). The paper appears to be a revised version of an anonymously authored paper submitted by Lion-Nathan (1989) to the 1989 Review of Excise Duties, which no doubt explains the omission of any reference to excise duties on tobacco in the paper, although one assumes there is a parallel objection by the New Right.[14]

The pamphlet’s one sided arguments include that tax is expensive to collect on alcohol, without noting all these defects apply to almost all other taxes. No attempt is made to provide any quantitative evidence for these costs. One extraordinary contribution in an extraordinary publication is the following item implying that prohibiting the lobbying would apparently result in a significant improvement in economic efficiency.
‘…battling the tax issue has meant a tradition of high public relations budgets. …[15] Further, the cost of lobbying or arguing the liquor industry’s case takes a disproportional large part of corporate budgets compared with other industries without the same burden.’ (1989: 18)[16]

The pamphlet also complains that ‘taxes on alcohol infringe the generally accepted principles of equity’ (1989: 17). It appears the equity ‘infringement’ occurs because people who drink pay more alcohol excise duty than those who do not.[17]

As an alternative to the present taxation arrangements the pamphlet proposes excise taxes should be replaced by a higher GST (that is a tax across all consumption,[18] and not just alcohol), but it does not note that because spending on alcohol rises more slowly than overall spending, so that the proposed switch would be regressive across income groups. There appears to be a certain selectivity of concern for equity.

Moreover there is no hint at all in the paper that the writer is aware of the theory of optimal taxation, which would recommend higher tax rates on price inelastic products such as alcoholic beverages, as a means of raising revenue with minimum loss of efficiency.

The pamphlet then deals with the social cost justification for taxing alcohol. It correctly points out that some of the social costs included in various calculations are not true net social costs, and also that the use of taxation is a clumsy means of differentiating between drinking which generates these externalities, and drinking which does not.[19]

But if taxation is a clumsy means of getting social costs to align more closely to private costs, what is the alternative? The pamphlet makes some brief desultory suggestions: civil remedies so that injured parties may take actions against the negligent; enabling the Accident Compensation Commission to make ‘standard deductions for self-injury through negligence’; charging for health services for any alcohol or accident related illnesses; and the Crimes Act imposing penalties for violent criminal behaviour which may result from drinking (1989: 1415).[22]

These proposals belong to two groups. One is to alter the law to place sanctions on social misbehaviour. Practicality and effectiveness is the issue here, and a matter which can be readily debated. The other is to abandon present policies for medical and related care, without any recognition of the reasons why they were put there in the first place, nor any consideration of the wider implications.

These recommendations involve certain types of economic instruments, typically private property rights which have been removed by the government. We shall not go through the specific analysis of each one, but leave the reader to ponder on to what extent the alternative in each case would be an effective means of resolving the problem, and what were the reasons for that public policy intervened in the first place. The visitor from Mars is likely to conclude on reading this pamphlet there was no alcohol induced negligence or illnesses (and certainly no alcohol induced unfairness) before the Accident Compensation Act and the introduction of the (mainly) free medical service.

In the end the Cameron paper indicated the limitations of using property rights and related instruments to regulate the externalities from alcohol, just as we saw the 1990 Smoke-Free Act was a response to limitations to its use for resolving tobacco issues.[21]

Revisiting the Tax Issue

While health/externality reasons have been used to raise the level of specific taxation of alcohol and tobacco in the last two decades such a justification may be coming to an end. Perhaps there is room for fine tuning, but it seems likely that tobacco duties now exceed the costs to the government of treating the health consequences of tobacco, and this is probably true for alcohol too. There are other externalities, but it is unlikely that they would significantly increase the funding needs.

Yet there remains a strong lobby for hiking these taxes for revenue reasons on the one hand, and because of various objections to the licit drugs on the other. But is it fair to punish users beyond the costs they incur to the state?

I want at this point to introduce a further reason for fiscal impositions, which in economic terms is fascinating because it involves working without one of the most fundamental assumptions economics uses: the rationality of economic behaviour. Abandoning such an assumption is not to be taken lightly but in the case of licit drugs there appears to be some case for doing so. Some work I did earlier this year for the Coalition against Advertising and Promotion illustrates the general phenomenon, although I shall have a little to say about alcohol at the end. (Easton 1991)

Normally economic assumes that the individual consumer has a set of well defined preferences about the options and is able to choose and act rationally to attain the highest preference available. The model works well in most situations, but its applicability when there is addiction is fraught with difficulties.

Addiction is not just a matter of getting hooked on a commodity (or act or event). I occasionally get hooked on international sporting spectacles that before I switched on I knew nothing about. While this change in preferences following on experience has some of the characteristics of addiction it lacks the element of preference inconsistency well illustrated by tobacco consumption.

The estimated proportions vary, but a significant proportion of current tobacco users regret their having formed the habit, and wish to give it up, but are unable to do so. A survey found that most smokers do know that smoking incurs serious health risks, and that 67.5 percent want to give it up. But a majority said they would find it difficult to give up smoking for even a week (N.Z. Cancer Society 1987).

It is difficult to describe this phenomenon in terms of the economic model of the opening paragraph to this section. What the addict seems to be saying is ‘tobacco usage is low among my preferences. I am sufficiently fully informed about tobacco and other issues to be say that among the options available to me, my optimal action excludes smoking. Nevertheless, I smoke.’ Becker and Murphy (1988) offer an account of how addictive like behaviour may occur. But when faced with this sort of behaviour they descend to an extraordinary non sequitur.[23]

There are two obvious points where intervention may be appropriate. The first is for the addict who wishes to cease. The policy prescription might be for government subsidised program to assist the addict to cease smoking. There would be some logic for the funding to be derived from an excise on the addictive product. (However, practically a part of the cost of the cessation program could be borne by the individual).

The second point of intervention is before the individual becomes addicted. There is a problem here. An adult who takes up smoking, aware that he or she may become addicted, may be said to be acting rationally. While retrospectively he or she may regret the decision, and the cessation program in the previous paragraph may be relevant, it is not obvious that intervention before the decision is appropriate, except in so far as to ensure the individual has accurate information about the effects of undertaking smoking.

However, suppose the person is not entirely rational. Economists are loathe to assume irrationality, but there are some exceptions, identified usually on pragmatic grounds. In the smoking case, an obvious exception is the young. Alternatively we might argue that it is more difficult to inform the young. In either case, it would seem sensible to provide measures, which are directly oriented towards the young taking up smoking, until they have reached an age where they may be judged ‘adult’ enough to make a rational decision, given sufficient information.

One already implemented policy is to restrict access of the young at the point of sale. But there would appear to be a need for other policies aimed at informing (including attitude changing) the young. In addition the case for a part user charge for smoking cessation pro~rams seems less appropriate for the young. They should not have been hooked in the first place.

It is at this point that excise duties appear to have a role. At first it might seem not appropriate to raise taxes further, because that would have very little impact on consumption. However, in recent years more detailed econometric studies suggested a more complex story of responsiveness of tobacco demand to price changes. For instance, different ages have different levels of responsiveness. In particular, the demand for tobacco products by the young is much more responsive than by those older.

The most widely quoted estimate from an American study is that the smoking participating elasticity for teenagers is 1.2, and the quantity smoked elasticity is 1.4 (Lewit Coate & Grossman 1981, Lewit & Coate 1982). That means a one percent rise in the price of tobacco products would reduce the number of teenagers who smoke by over one percent (i.e. 1.2%), and a smaller reduction in the amount of smoking per teenage smokers (i.e. 0.2%). More recent figures indicate a participation elasticity of. 76 may be more appropriate for 12 to 17 year olds, and this is the estimate used in the report of the US General Accounting Office (1989).

On the other hand a recent New Zealand study found an elasticity for 15 to 24 year olds of 1.13 (Laugesen & Meads 1990).[24] This figure possibly underestimates the elasticity for teenagers, since it includes the effect of those in their early twenties, who are likely to have a lower elasticity .That this elasticity appears higher than the US, one probably reflects New Zealand society being at an earlier stage in the tobacco usage cycle, more like that of the US of the 1960s.

The implication is that higher tobacco product prices are better at preventing people starting smoking, than at encouraging people to reduce or cease smoking. Indeed it would appear that once teenagers are captured into smoking, they find it as hard to give up as the adult does.

What this seems to suggest that for smoking there is a gate, beyond which smoking is addictive. I defer to the specialists to define the gate in behavioral terms, but practically for smoking it may the point at which the individual becomes a regular smoker. In any case before the gate, demand is very price elastic, after the gate it becomes inelastic. Because the most teenagers are coming up to the gate, their demand is – as the econometric evidence suggests – much more price elastic than the for the average smoker. Conversely they may be discouraged from going through the gate by higher prices. Thus the effect of increasing excise taxes may be small on smoking in the short run, but through the discouragement effect, may be much larger in the long run.

A similar effect probably applies for alcohol, where again teenager demand proves to be much more price sensitive than average (Choate & Grossman 1988). It is however harder to conceptualise the gate between the moderate drinker and the addicted one (a problem not peculiar to the economic analysis). The occasional smoker is quite a different beast from the moderate drink, since we may want to discourage the former, but merely keep in moderation the latter.[25]

Thus we have another reason for hiking the excise duty on licit drugs: in order to discourage individuals taking up addiction. This is fiscally tough on the addicted, who are likely to be with us for many years to come, and to be facing excise duties far above the external social costs they incur. That is why educational programs aiming to discourage the taking up of addiction are important, so as to take the weight of using the excise instrument. In my view there may also be a case in justice for the subsidisation of effective cessation or cure programs.[26]

One other use of the tax instrument which has been looked at, but does not seem promising is taxing advertising and sponsorship.[27] But the original paper for CATAP argues that if there is any relaxation of restrictions on advertising and sponsorship for reasons of – say public liberty, there should be a compensating rise in excise duty to offset the impact of youth who are pulled through the gate by the public displays.[28]


The use of economic instrument of taxation to regulate resource use is not new, but in the 1970s they became more consciously used to regulate the consumption of licit drugs. This was not simply a matter of public concern over the side effects (externalities and addiction) from licit drugs. The public concerns were convenient justifications for raising the excise duties to improve central government revenue.

Conversely, where the taxes are not benefiting its revenue, there is likely to be less enthusiasm from central government. For instance there may well be a justification for giving local authorities the powers to impose a throughput levy on taverns to compensate the neighbours for the noise and other local disturbances. But whatever the economic arguments, such a levy is not on the public agenda.

The next step may be to raise consciously excise duties on licit drugs above that justified by externality considerations. Again the driving force may be revenue needs, underpinned by the theory of optimal taxation which recommends higher taxes on more price inelastic products. There may be a side benefit, in that in each case teenagers and others may be discouraged from going through the gate of addiction.

However such tax increases will be penalising on those already addicted, which illustrates a general proposition that economic instruments may be very clumsy in their impact. We saw further evidence of this in the issue of airspace rights, while a New Right proposal to replace taxation by reduced state interventions which place greater, legally enforceable, obligations on the user of the licit drugs does not look promising.

So while economic instruments may be useful in regulating some features of licit drug use, they cannot efficiently replace entirely such measures as prohibition, restrictions, and controls, nor public education. Those in th~ green movements who advocate the greater use of economic instruments for environmental purposes are likely to come eventually to a similar conclusion .

1. This last point is less true in regard to wine
2. The optimal rate of taxation is inversely proportional to the elasticity of demand for the product. Alcoholic beverages (and tobacco) have a low price elasticity of demand. Thus their optimal tax rate would be higher than average. (e.g. K. W .Clements 1983).
3. As the Ernst & Young report for the Tobacco Institute delicately puts it:
‘It is also noteworthy that tagged taxes are often justified, or at least implicitly “sold” on subjective pseudo moral grounds. Thus for cultural reasons that are not well understood, certain acts or the consumption of certain substances, are widely considered to be a “bad” even when their consequences fall largely on those who choose to participate.’(1991: 9)
This paper takes a totally different approach. The justifications here are consequences of practical and identified characteristics of the commodities involved, and the behaviour they generate (especially as explained later, negative externalities and addiction). It is unnecessary, therefore, to coyly refer to ‘certain substances’. The topic here is licit drugs.
4. The 1976 announcement contains no justification for the hikes, but this time duties raised on spirits as well.
5. ‘Fiscal drag’ is when tax revenue rises faster than nominal GDP or inflation.
6. Another rationalisation of duties, still only partly achieved, has been to stop discrimination between beer, wine, and spirits, and tax on the quantity of absolute alcohol.
7. Although the story which follows has to be traced systematically, the following memoir may be useful. In early 1977 the Minister of Health proposed that a charge be placed on prescription drugs. This caused a political uproar, including objections from the medical and pharmaceutical professions. To mollify them the Minister explained the revenue would be used for spending on further community health services. Having committed himself the Minister found the powerful groups supported the additional spending but still opposed the prescription charges. Meanwhile in Christchurch I was publicly arguing that the Good Samaritan did not charge for his drugs, and that if the government wanted to place a tax on drugs – for that is what a prescription charge is – it should be placed on alcohol. Presumably this approach, perhaps from another source, shifted the government to imposing additional duties on tobacco and alcohol and using the funds for community health. (At the time I was aware that social costs of alcohol exceeded tax revenue, from talking to Dr Robert Crawford, superintendent of Hamner, but not about the social costs of tobacco. (Easton 1978) ) .
8. defined in a specific sense by economists.
9. A bizarre version of this point is that smoking prevents Alzheimer’s disease.
10. Ideally the tax level should be where marginal revenue equals marginal cost, but it is not at all obvious what such an objective means in practical terms. (Easton & Pryke 1985).
11. Non smokers and teetotallers and low drinkers may encourage higher taxes on smoking and drinking respectively because they benefit from the revenue, without bearing the costs.
12. See Ansley (1991) for an example of the difficulties of dealing with air pollution, in this case arising from mushroom farming.
13. This paper does not trace the ALAC levy, which is another example of a user charge.
14. The omission of any reference to the provenance of the paper in the Centre for Independent Studies’ publication is, to say the least, unusual in academic terms. The publication does however say the Centre is ‘independent of an political party or group’.
15. The omitted sentence is “Indeed, debunking some of the myths surrounding ‘the evils of drink’ is a lucrative business in itself”, a phenomenon independent of the level of taxation.
16. One wonders whether the writer had in mind any fee that Lion-Nathan may have paid for the preparation of the submission to the Review on Excise Duties.
17. The evidence is that amongst drinkers, excise taxes do relatively little to change the pre-tax and post-tax distribution of incomes. However, excise duties do subject significant numbers of low and middle income households to a 10 to 15 percent higher total tax burden than people in similar circumstance. (1989: 16)
18. Excluding the financial sector for whom Cameron works.
19. Because the pamphlet is making an emotional appeal it writes of ‘people’ rather than ‘drinking’, giving the impression that some people – no doubt the readers of the pamphlet never cause negative externalities when they drink.
20. Including ‘Offenders, for example, could be forbidden by law to drink’. One looks forward to the libertarian critique of such a proposal if it ever comes before parliament.
21. An aside – but it gives an insight into the bizarre approach of the paper – is the following paragraph, under the head ‘Costs to the Family’:
‘Domestic violence and other forms of social costs to the family cannot be dealt with through hefty taxes, either. When a family is considered as a unit, any costs of this type are not external social costs. They are ‘internal’ to the family. The proper question is whether the rights of the individual family can be identified and enforced against another family member. …’(1989:13)
What the third sentence seems to be saying is that domestic violence is an internal matter to the family, and only a social issue as far as rights are abrogated. It appears to be arguing that domestic violence is a different (and lesser) issue compared to violence between two strangers.
22. In addition there are those who favour duty hikes on products they do not consume.
23. ‘The claims of some heavy drinkers and smokers that they want to but cannot end their addictions seem to us no different from the claims of single persons that they want to but are unable to marry …’(p.693)
24. The 95 per cent confidence interval is (.73, 1.53)
25. On a minor research note, I originally conceived (or read about) ‘the gate’ when working on alcohol issues in the mid 1980s. however it was only when I was working on tobacco in 1991, was I able to see clearly how one might go about defining the gate.
26. Fairness might suggest that those defined as addicted to tobacco or alcohol might be entitled to a ration at a lower price. There would be a revenue loss though.
27. The idea is that the sponsorship generates bads such as additional teenage smoking, and a tax on sponsorship would bring the private decision of the tobacco company more in line with the public good. (But non-tobacco users may also benefit from the sponsorship.)
28. However whatever the theoretical reasons for taxing sponsorship, practically it is likely to be difficult. The Treasury is perhaps more pessimistic than necessary when it remarks that ‘such measures will be difficult to implement and audit. As sponsorship often involves nonmonetary transfers, there will be ample scope for evasion unless a very rigorous and correspondingly expensive auditing system is put in place.’(1991 :2) Nevertheless, its cautions are accepted, and given also that the imposition of an efficient tax system’ on sponsorship would take time and experience to construct, it is judged that a sponsorship tax is not viable at the moment and thus not available as a compensatory policy.

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