An Economic Assessment of Proposed Cigarette Excise Tax Hikes in the State of West Virginia

Diplomarbeit von Nils Guhl

Abstract:

Many states in the U.S., including West Virginia, are recently contemplating increasing the state cigarette excise tax rate in order to alleviate their tense budgetary situation.

Two groups have dominated the political process of cigarette tax legislation. The health community contents that smokers impose costs on the society by excessively using the health care system and damaging the health of non-smokers through second hand smoke. Also, youth are unaware of the full risks of smoking and therefore unable to make fully informed decisions. Therefore, the health community demands higher cigarette taxes to deter youth smoking and make smokers bear the costs they impose on the public.

The tobacco industry, lobbying for low cigarette taxes, argues that the current cigarette tax is sufficient to compensate for the excess health care costs of smokers. Higher taxes are also said to disturb the free market mechanism by depriving consumers of making free consumption decisions. Most importantly, rising tax differentials between states would lead to a large smuggling problem. In fact, West Virginia’s border states Kentucky and Virginia and nearby North Carolina levy the lowest cigarette excise tax rates in the nation, currently being 3, 2.5, and 5 cents per pack, respectively. A tax hike on top of West Virginia’s current 17 cents per pack may promote tax evasion and thus counteract the fund-raising efforts of the West Virginia State Government.

This study carefully examines the economic validity of both lobby groups’ arguments and aids the legislative decision making process by providing a scientific framework for the appropriate taxation of cigarettes in West Virginia.

Part I determines the efficient cigarette excise tax rate based on economic efficiency theory. Three potential market failures associated with cigarette consumption are examined: (1) External costs, (2) incorrect risk perception, and (3) addictive behavior. Criteria for the estimation procedure of the economic costs and the cost estimation of those market failures are presented and comprehensively discussed. The study particularly embeds the application of different addiction models to smoking decisions and assesses their fundamentally different impact on the efficient tax rate. For this purpose, the standard model of rational addictive behavior and the recent approach of time-inconsistent addictive behavior are reviewed. Based on most recent evidence, this study concludes that the approach of time-inconsistent addictive behavior provides a more compelling picture of real-life cigarette smoking decisions and finds that the efficient tax rate is at least 35 to 52 cents higher than the 17 cents currently levied.

Part II analyzes how consumption, sales, and cigarette tax revenues are going to be affected by a tax hike that raises the cigarette tax to the efficient level by developing and assessing a comprehensive econometric model of cigarette demand for West Virginia. Among other things, the model carefully takes into account cross-border activities, such as private and criminal smuggling.

Evaluated in conjunction with the results from Part I, the conclusion leads to the recommendation of the range for a cigarette excise tax rate in West Virginia.

Table of Contents:

	List of Contents	I
	List of Figures	V
	List of Tables	VI
	List of Abbreviations	VII
A.	Introduction	1
B.	Problem Statement and Solution Structure	3
I.	Determining the Efficient Cigarette Excise Tax Rate in West Virginia	4
I.1	Introduction	4
I.2	Cigarette Tax Rates in West Virginia as of 08/01/2002	4
I.3	Definition and Differentiation of Economic Efficiency	4
I.3.1	Introduction	4
I.3.2	The Pareto-Efficient Criterion	5
I.3.3	Economic Efficiency and Social Welfare	6
I.4	Market Failures in the Cigarette Market and Public Policy Response	9
I.4.1	Introduction	9
I.4.2	Externalities	10
I.4.2.1	Description	10
I.4.2.2	Public Policy Response	13
I.4.3	Incorrect Risk Perception	15
I.4.3.1	Description	15
I.4.3.2	Public Policy Response	15
I.4.4	Addictive Behavior	16
I.4.4.1	Introduction	16
I.4.4.2	Definition of Addiction in the Realms of Economics	17
I.4.4.3	Brief Review of Addictive Behavior Modeling	17
I.4.4.4	Rational Addiction Model by Becker and Murphy	17
I.4.4.5	Time-Inconsistent Addictive Behavior by Gruber and Koszegi	19
I.4.4.6	Conclusion	22
I.4.5	Conclusion	23
I.5	Efficient Cigarette Excise Tax Rate based on the Rational Addiction Model by Becker and Murphy	24
I.5.1	Introduction	24
I.5.2	Cost Classification	24
I.5.3	Criteria for Social Cost-of-Smoking Studies	24
I.5.4	Procedure of the Manning Study	26
I.5.5	Assumptions for Manning Study Transferability to West Virginia	26
I.5.6	Identifying and Valuing External Costs	27
I.5.6.1	Introduction	27
I.5.6.2	Medical Costs	27
I.5.6.3	Retirement Pension and Disability	28
I.5.6.4	Sick Leave	28
I.5.6.5	Group Life Insurance	28
I.5.6.6	Nursing Home	29
I.5.6.7	Taxes on Earnings	29
I.5.6.8	Fires	29
I.5.6.9	Environmental Tobacco Smoke (ETS)	30
I.5.6.10	Pain and Suffering	32
I.5.7	Identifying and Valuing Internal Costs due to Incorrect Risk Perception	32
I.5.8	Summary and Discussion of Taxable Costs	33
I.5.9	Translating Taxable Costs into the Efficient Cigarette Excise Tax Rate	35
I.5.9.1	Introduction	35
I.5.9.2	Perfectly Elastic Supply Curve	35
I.5.9.3	Cost Structure of Taxable Costs of Smoking	36
I.5.9.4	Conclusion	40
I.5.10	Conclusion	40
I.6	Efficient Cigarette Excise Tax Rate Based on the Approach of Time-Inconsistent Addictive Behavior by Gruber and Koszegi	41
I.6.1	Introduction	41
I.6.2	Taxing Market Failure due to Addictive Behavior	41
I.6.3	Conclusion	42
I.7	Proposed Excise Tax Hike in West Virginia	43
II.	Potential Effects of Proposed Cigarette Excise Tax Hikes on Resident Cigarette Consumption and Cigarette Tax Revenues in West Virginia	44
II. 1	Introduction	44
II. 2	Cross-Border Activities	45
II. 2.1	Introduction	45
II. 2.2	Casual Cigarette Smuggling	45
II. 2.3	Organized Cigarette Smuggling	45
II. 2.4	Effects of Cross-Border Activities	46
II. 2.5	Historical Overview of Cross-Border Activities in the U.S.	46
II. 3	A Model of Cigarette Demand in West Virginia	49
II. 3.1	Introduction	49
II. 3.2	Developing the Model	49
II. 3.3	Results of Regression	56
II. 4	Potential Effects of Proposed Tax Hikes on Cigarette Consumption of West Virginia Residents	59
II. 5	Potential Effects of Proposed Tax Hikes on State Cigarette Excise Tax Revenues	62
C.	Conclusion and Outlook	64
	References	66
	Appendix	72
Appendix 1	Map: Overview of West Virginia borders
Appendix 2	Map West Virginia: Bootlegging from West Virginia into border states, assignment of bootlegging counties to border states
Appendix 3	Map Kenntucky: Bootlegging from Kentucky into West Virginia, assignment of bootlegging counties to West Virginia (does not apply in any year 1970-2000)
Appendix 4	Map Maryland: Bootlegging from Maryland into West Virginia, assignment of bootlegging counties to West Virginia
Appendix 5	Map Ohio: Bootlegging from Ohio into West Virginia, assignment of bootlegging counties to West Virginia
Appendix 6	Map Pennsylvania: Bootlegging from Pennsylvania into West Virginia, assignment of bootlegging counties to West Virginia
Appendix 7	Map Virginia: Bootlegging from Virginia into West Virginia, assignment of bootlegging counties to West Virginia
Appendix 8	An example: Calculation of bootlegging variables for 1970
Appendix 9	Time series data for West Virginia 1970-2000
Appendix 10	Correlation matrix for regression results
Appendix 11	Analysis of stability of results