What-if Economics
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What-if Economics

Taxing Sugar, Rum, and Tobacco

Although sugary beverages, alcohol, and tobacco products negatively affect health, imposing a tax on these commodities seems arduous for governments across the world, primarily due to conflict of interest among big corporations, civil societies, and consumer sovereignty.

This piece is a follow-up to my previous article, An Economy Made of Tobacco, that provides context to the existing problem to which this article attempts to provide the solution.

“Sugar, rum, and tobacco are commodities which are nowhere necessaries of life, which have become objects of almost universal consumption, and which are therefore extremely proper subjects of taxation.” (Adam Smith, 1776)

As Adam Smith reasons the suitability of taxation in his well-known book, An Inquiry into the Nature and Causes of Wealth of Nations, why do nations hesitate and find it too hard to follow this philosophy?

Economists, and in general, free-market enthusiasts, argue against taxes as it creates distortionary effects in the market and interferes with consumer sovereignty. However, the notion of consumer sovereignty does not apply in practice as the strong background assumptions of rationality and perfect knowledge do not hold. Further, when the consumption of such habit-forming-products impacts health, in the long run, intervention is required.

Companies selling tobacco, alcohol, or sugary products capture a considerable share of the market, especially amongst the younger demographics, who are unaware of the potential health consequences, often due to extensive marketing campaigns shadowing the harm from consumption of these products. This phenomenon is that of information failure, which is quite evident in markets for such products.

The economic costs — direct as well as indirect — of consumption of sugary beverages, heavy drinking, and constant tobacco use are high as they not only deteriorate health but also affect productivity and lead to premature deaths. Thus, it is the responsibility of the state to enforce strict laws or regulate prices by either increasing them or using the tool of taxation policy. Both these methods are almost equivalent to the other; both increase the incidence of cost on the consumer.

Increasing prices, for one, would decrease quantity demanded, ceteris paribus, following the law of demand. It does depend on the elasticity of demand, a microeconomic concept implying flexible preferences leading to a fall in consumption as prices rise. If the consumer demand is elastic to prices, raising the price is an apt policy choice.

For a better understanding, refer to Figure 1. The demand is a flatter curve in Figure 1.2 as opposed to Figure 1.1, implying a more elastic demand. Comparing both these diagrams, one can see that with an equal rise in price, the quantity demanded decreases much more in the case of elastic demand.

Another way is to influence the consumers’ preferences by generating awareness through campaigns, health warnings, and prohibiting cigarette ads on television, and most importantly, on social media — which receives a mass audience at a much lower cost. This policy intervention does not lead to a change in prices but shifts the demand curve to the left, reducing the quantity demanded.

Figure 2 — Figures 2.1 and 2.2 — compares the decrease in quantity demanded (due to a price change) and a fall in demand (due to a change in preferences, keeping price constant).

From what we know, Europe had a rising alcohol consumption until a decade ago; America is facing the issue of obesity at its peak; China and Asia, in general, are victims of the big tobacco corporations dominating their tastes and preferences. Public announcements and anti-smoking or anti-drinking campaigns alone are not the solutions to this problem. A higher price does discourage smokers, especially teenagers, who lack a steady source of income and thus have a demand elastic to a price change.

Secondly, policymakers possess the tool of taxation. It would increase costs to the buyer and the producer, concurrently raising the tax revenue of the government. However, opponents of price rise or a tax opine that this would lead to rising black markets and encourage illicit trade of cigarettes or alcohol alike.

Imposing taxes is a tricky political decision. Economics theory and policy suggest an ad valorem tax would be best suited for situations of negative externalities — sugar, rum, tobacco — as they impose indirect costs to the consumer. The word ad valorem is Latin for according to value. Equivalently, ad valorem tax is the amount of tax levied on a good as a percentage of its value.

Accordingly, if tax is at 20%, the buyer has to pay $12 for a good priced at $10; $120 for a good priced at $100. The gap between the pre-tax and the post-tax supply of cigarettes or alcohol will rise, as shown in Figure 3.1.

Interestingly, it is not the only approach policymakers could follow. Another type of taxation in economic theory is that of Pigouvian tax, covering the social cost as well as the cost of externalities. (Refer, Figure 3.2) This concept, named after Arthur C. Pigou, internalizes externalities and corrects for inefficient markets. Theoretically, the size of the tax should be equal to the cost of the negative externality.

Figure 3.2 provides the theory behind this taxation policy. The supply curve — Supply1 — denotes the private marginal cost of the externality, whereas the demand curve denotes the marginal benefit.

The pre-tax market operating equilibrium lies at E1, where the marginal benefit cuts private marginal cost. After applying a Pigouvian tax, the marginal cost rises by the tax amount to Supply2.

This supply curve denotes the new private marginal cost and is equal to the social marginal cost. Thus, at the post-tax equilibrium, E2, the outcome is socially efficient. Taxation is good for society as it eliminates negative externality by costing more to the producers.

If one dives deeper into microeconomic theory, one will find that it costs the consumers as well. The share of incidence of the tax burden on the consumer and producer depends on the extent of elasticity of demand and supply curve. Although it is interesting to know that, it does not much concern the scope of this article.

However, it is rather difficult to accurately measure the extent of negative externality due to its subjective nature, making it less effective as a policy tool. The indirect costs of smoking, drinking, or other health concerns might vary by person, culture, or location.

Taxation is a taxing choice to make for the policymakers and governments, who remain in a power-sharing paradigm with the big corporations seeking profits out of negative externalities. Myriad of options apart from taxation are available to reduce consumption of sugar, rum, and tobacco. Still, tax policy has proved to be a powerful tool amongst them — in theory, and practice.

This article was originally published on What-if Economics. View and subscribe to my newsletter to get insights right in your mailbox.

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Shereein Saraf

Shereein Saraf

An economist in the making, interested in ideas of development economics and political economy. Subscribe to my insights at whatifeconomics.substack.com

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