When Governor DeWine announced his budget proposal earlier this year, there were a lot of major changes that were fascinating for policy analysts. At Scioto Analysis, we’ve written about things like stadium subsidies, library funding, and especially the Child Tax Credit.
Another important part of the Governor’s budget was an increase in taxes on cigarettes, marijuana, and gambling, collectively referred to as “sin taxes.” My colleague Rob Moore wrote about the benefits of taxing these goods from an economic perspective, but he also acknowledged the most frequently cited downside: sin taxes are regressive. On average, lower-income people spend a larger percentage of their income on these goods, and as a result they bear most of the burden of these increased taxes.
When faced with higher prices, people will usually consume less of a good. From a theoretical perspective, we often ignore the actual mechanism of people participating less in a market. The effect of one out of 100 people quitting smoking is the same as all smokers reducing their smoking by 1%.
In practice though, people have different responses to increased prices. Some people who have a low willingness to pay for these goods will stop consuming them altogether, people with a moderate willingness to pay may adjust their consumption by a little, and people with a high willingness to pay will not change their consumption and instead just manage the higher prices.
The third group is the one I want to highlight today.
A new working paper released this month looks into the question of how households change their consumption habits when faced with higher cigarette taxes. They use two approaches to answer this question. First, they surveyed current smokers and asked them how they would respond to a hypothetical price increase. Then they looked at actual consumption data and quantitatively assessed how people responded when taxes went up.
The survey responses aligned with what we expect to happen in practice. Some people said that if faced with higher prices they would try to quit, some people said they would try to reduce their smoking habits, and some people said they would just deal with the higher prices.
The most interesting findings came from the quantitative analysis. When households (particularly low-income households) are faced with higher cigarette prices, they tend to reallocate their spending away from what the authors describe as “human capital forming expenditures.” These authors suggest that households offset nearly 70% of the increased cost of cigarettes with reduced human capital expenditures.
Previous research on cigarette taxes has shown that higher taxes lead to better human capital outcomes, such as better health and higher education, despite lower spending on these goods by households. This seems to suggest that the benefits of overall reduced consumption of cigarettes outweighs the increased cost and resulting reduction in human capital investment.
One commonly suggested policy option for reducing the regressivity of taxes is to take the additional revenue and rebate it back to the households that bear the burden. In this case, the state could use the revenue generated from a tobacco tax and use it to subsidize the human capital-developing goods that people consume less of as a result. Think financing college scholarships for low-income households with tobacco tax revenue.
Regressive sales taxes present challenges for policymakers and families. This paper highlights undesirable consequences that come from increasing the costs of goods that have negative externalities. However, benefits still may outweigh the costs depending on the exact structure of the tax, and with some careful planning many of the downsides can be offset.