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DA3. Cigarette Tax

Statement

Suppose there is a bill to increase the tax on cigarettes by $1 per pack coupled with an income tax cut of $500. Suppose a person smokes an average of 500 packs of cigarettes per year—and would thus face a tax increase of about $500 per year from the cigarette tax at the person’s current level of consumption. The income tax measure would increase the person’s after-tax income by $500.

Would the combined measures be likely to have any effect on the person’s consumption of cigarettes? Why or why not?

Answer

Utility is the usefulness of a good. Consumer choice is the process of making decisions about goods in a way that maximizes overall utility within the limited amount of money available or budget (Rittenberg & Tregarthen, 2009). The utility of income tax is all public services available, while the utility of cigarettes is its psychological effects.

In this text, let’s think of the income tax as a good and its price is the amount of tax a person has to pay. Cigarettes are also another good and their price includes the tax on cigarettes. Each of these goods has a utility it provides to the person. Income tax price falls by 500$ per unit (1 annual unit), while cigarettes’s price rises 1$ per pack.

The person’s (aka, the smoker) spending is limited by there income. The reduce of income tax will increase the person’s income by 500$ implicitly according to the income-compensated price change which indicates that the fall in the price of a good boosts the consumer’s purchasing power by an amount equals the price fall multiplied by the quantity of the good consumed. In this case, 500$ * 1 annual unit = 500$.

The income effect tells us that the implicitly gained income from one good can be used to buy more of the same or other goods; it is not possible to buy more tax, so we will assume the income will be spent on other goods, including cigarettes. If the smoker did not change their quantities of cigarettes consumed, the person would spend 1$ * 500 packs = 500$ more on cigarettes; this would cancel out the gain from the income tax cut, and the person’s financial would break even.

However, the substitution effect tells us that the person will consume less of the good that has become relatively more expensive (cigarettes) and substitute it with cheaper alternatives; this should reduce the amount of cigarettes consumed. Alternatives to cigarettes may include nicotine gum, vaping, just consume less cigarettes, or quit smoking altogether.

One important matter in discussing consumer choice related to cigarettes is the addiction nature of cigarettes which means that demand would not drastically change, however, the consumer may look for cheaper cigarettes (say witching from Malboro to a cheaper brand). This little change in demand with the price change is called inelastic demand.

Putting everything together, the income effect indicates that cigarettes’s demand will stay the same, while the substitution effect indicates that the person will consume less cigarettes, and the addiction nature of cigarettes indicates that the demand will not change much. It is hard to predict the exact change in the quantity of cigarettes consumed within existing smokers due to the nature of the good; but the price increase will definitely decrease demand among new and young smokers.

We don’t know the original price of cigarettes; if the price increase was substantial enough (say +50%), this may decrease the quantity consumed in both existing and new smokers. However, if the price increase was not big enough (say 10%), the quantity consumed may stays the same for existing smokers, but it will decrease for new smokers.

To conclude, the combined effects will decrease quantity consumed for usual goods, but for cigarettes, the effects are not clear. For existing smokers, the quantity consumed may stay the same if the price rises moderately, and decrease if the price rises substantially. For new or young smokers, the quantity consumed will definitely decrease (Bader, Boisclair, & Ferrence, 2011).

References