The Effects of Cigarette Taxation

What is probably the fastest growth in taxation in the United States, cigarette excise taxes levied by both the Federal and state governments have shown a distinctive impact relative to supply and demand, equilibrium of price and quantity, and elasticity of the product. The intent of the tax is twofold; to reduce the rate of cigarette usage and to increase revenues for healthcare programs related to the effects of cigarette smoking, such as cardiopulmonary disease, respiratory disease, and illness related to second-hand smoke.

Cigarette excise taxes vary greatly from state to state, with rates as of 2004, New Jersey levied the highest rate ($2. 05 per pack) while Virginia had the lowest rate (2. 5 cents per pack) (Goel and Nelson, 2006). However significant increases have been realized with cigarette excise tax even in major tobacco producing states such as Kentucky, where historically they have been extremely low due to the economic influence of tobacco producers.

Tobacco excise taxes for cigarettes are levied on the producers of the product, usually in the form of tax stamps affixed to the individual packs of cigarettes. These taxes are then handed down to the consumer in the form of price increases for the product. According to Gustafson (2007) upon passage of substantial increases in cigarette taxes, a marked increase in the sale of tax stamps occur immediately before the enacting date of the new tax rate, followed by a dramatic decrease in the sale of tax stamps after the tax rate increases.

This is a classic case of increasing demand today because it is known that there will be a price increase in the (near) future. But what is the long-term impact on supply and demand relevant to these tax increases? As with any taxed product, the supply curve will shift upwards in direct relationship to the tax increase. So, if the government charges a $1 tax on every pack of cigarettes, and the cigarette sellers want to pass this tax on to the buyers, then the supply curve will shift upwards by $1.

The net result is that for any price, the stores will sell fewer packs of cigarettes, to make up for the extra cost of the tax. In effect, if consumers want to maintain their previous levels of consumption, cigarettes would now cost $1 more per pack. However, according to Gustafson (2007) there is a point at which the inelasticity of the cigarette market becomes elastic due to the pressures of an extremely high excise tax.

For example, Gustafson notes that when Arizona increased the cigarette tax to $2 a pack in 2006, the demand for cigarettes fell from a rate of 21 million packs per year to 17 million packs per year, or a 20% decrease in demand, which Gustafson calculates a price elasticity factor of one. In other words, the amount of the excise tax in Arizona has hit a point to where every increase in the price in cigarettes, you will realize a decrease in demand equivalent to the increase.

If for some reason Arizonans wanted to protect the consumer from a price too high, the legislature could enact a price ceiling on a pack of cigarettes. The price ceiling, in conjunction with the high excise taxes, could force the price ceiling to become binding, causing the tobacco companies to narrow their margins since they would be prohibited from reaching the equilibrium price point due to the price ceiling, and supply will decrease and demand increase as a result.

If the Arizona legislature decided to enact a price floor, and the equilibrium price is lower than the floor, causing the price floor to be binding, then a surplus of cigarettes would occur and demand would be reduced. Of course, these scenarios regarding price ceilings and floors do not take into consideration additional impacts to cigarette sales, such as non-pricing government regulations, such as advertising restrictions, labeling, and smoking bans in public places. In conclusion, government tax policies definitely have a distinctive impact relative to supply and demand, equilibrium of price and quantity, and elasticity of cigarettes.

However, as Gustafson (2006) points out is the case in Arizona, a certain price level will create an elasticity in the product market that will have the desired social effect, but a contrary revenue effect. References Goel, Rajeev K. & Nelson, Michael A. (2006). The effectiveness of anti-smoking legislation: a review. Journal of Economic Surveys 20(3), 325-355. Retrieved June 15, 2008 from EBSCOhost database. Gustafson, Scott (2007). Another look at cigarette taxes. Retrieved June 15, 2008, the World Wide Web at http://azecon. blogspot. com/2007/10/another-look-at-cigarette-taxes. html.