On reason economic theory suggests selective excise taxes generally are not desirable is that they distort individual choices among goods and services in the market and impede efficient resource allocation. Circumstances may exist, however, in which the efficiency case against selective excise taxes is stood on its heed: should market failure be present, such taxes may actually be the preferred policy instrument to achieve economic efficiency.

This section discusses two conditions that, if present, make a selective excise tax on cigarettes and other tobacco products a correction for market failure and consistent with economic efficiency: spillover effects and imperfect information. First, cigarette smoking might impose a financial burden on the rest of society (spillover effects). Second, people might make their smoking decision without complete information about the negative consequences of these products; that is, they may make a rational decision based on imperfect information that would be irrational given complete information.

SPILLOVER EFFECTS

It is a generally accepted fact that smoking damages the smoker's health. The term "health costs" is a broadly defined measure which includes medical expenditures, lost productivity from sickness and disability, and early death. These health costs are divided into two types those that burden the smoker himself (internal costs) and those that burden society (external costs). ² If the smoker possesses complete information about the relationship between smoking and his own health, he already takes internal health costs into account in making a decision, and no tax is justified to obtain economic efficiency. It is, therefore, the external health costs that might justify cigarette taxation. This section deals with the magnitude of external costs, or spillover effects. The following section deals with the issue of whether imperfect information about internal costs justifies a tax.

To the extent that others in society must pay part of these health costs --increased medical expenditures (which are largely pooled through insurance), and increased job absences covered by sick leave payments a tax may be justified because the cigarette price does not cover the true economic cost of smoking. And the external costs of smoking are not limited to the health costs of smokers. For example, smoking contributes to fires whose costs may be borne by others if premiums on fire insurance are raised for everyone.

This brief discussion suggests two conclusions from standard economic theory. First, smoking related costs that are incurred by the smoker

2. These issues are also discussed in Michael Gross, Jody L. Sindelar, John Mullahy, and Richard Anderson, "Policy Watch: Alcohol and Cigarette Taxes," Journal of Economic Perspectives, Vol. 7, Fall 1993, pp. 211222.

directly--such as his share of medical expenditures or actual lost wages from sick days--are internal costs that do not justify a tax on spillover grounds. Second, costs imposed on the nonsmoking population (external costs) can justify a tax on spillover grounds. This conceptual case for cigarette taxation does not, however, provide information about how large the tax must be to compensate for the external costs. For that, it is necessary to review the literature that measures the magnitude of these external costs.

The Manning Study

A thorough analysis of spillover effects from smoking must include a lifetime profile of both the external costs smokers impose on nonsmokers and the external savings smokers provide to nonsmokers. While there has been considerable research on the overall health costs of smoking (medical expenditures, lost productivity from sickness and disability, and early death), only the study by Manning, Keeler, Newhouse, Sloss, and Wasserman (hereafter referred to as the Manning study) measures both the lifetime external costs and savings that are needed to gauge the efficient excise tax. ³ Their study uses data on health costs of smokers (both current and former) and lifetime nonsmokers (referred to as neversmokers) to develop the estimates.

The Manning study found that the net external costs (external costs minus external savings) of smoking are small--smaller than the current combined Federal and State taxes on cigarettes. Part of the reason for this finding is that the external costs smokers impose on society (primarily because their larger lifetime medical expenditures are not reflected in the insurance premiums they pay or in contributions to programs such as Medicare) are substantially offset by the external savings they provide to society: their earlier death reduces their payout from the pension plans (including social security) to which they

3. See Willard G. Manning, Emmett B. Keeler, Joseph P. Newhouse, Elizabeth M. Sloss, and Jeffrey Wasserman, The Costs of Poor Health Habits, A RAND Study, Cambridge, Mass.: Harvard University Press, 1991. The results for alcohol and tobacco appear also in "The Taxes of Sin: Do Smolders and Drinkers Pay Their Way?", Journal of the American Medical Association v. 261, March 17, 1989, pp. 16041609. The basic data for the study are from the Health Insurance Experiment conducted by the RAND corporation for individuals under age 60 (collected from years 19721982), supplemented with data from the 1983 National Health Interview Survey for older individuals. Data are expressed in 1986 dollars.

contribute. ⁴ (These pension plan savings are smaller than they would otherwise be because smokers retire earlier than nonsmokers.)

In 1986 dollars, the Manning study found that the net external cost per pack of cigarettes is 15 cents for a new (young) smoker. This estimate includes 43 cents of external costs imposed on society: 26 cents of additional medical expenditures; one cent of sick leave costs; 5 cents of group life insurance costs; 2 cents of costs from fires; and 9 cents of lost tax revenue smokers would have paid to finance retirement and health programs had they not died early. Offset against these costs are external savings to society of 27 cents: 24 cents from reductions in retirement pensions; and 3 cents from reduced use of nursing homes. Rounding error accounts for the lost cent.

This 15 cents of net external costs equals 21 cents in 1995 dollars if the spillover effects are adjusted using the GNP deflator; and 33 cents if the medical expenditure and nursing home components of external costs are adjusted using the medical services price index. ⁵ (Unless otherwise stated, the 1995 estimate using this medical services price index will be used for all further perpack calculations in this report.) The 50cent current tax (Federal tax of 24 cents per pack and average State and local taxes of 26 cents per pack) is 1 1/2 times as high as the 33cent tax justified by the net external costs estimated in the Manning study. ⁶

Notably, the Manning study suggests a much stronger case can be made for taxing alcoholic beverages at a higher rate. It estimates net external costs of at least 68 cents per ounce of alcohol. ⁷ A large fraction of this cost is associated with loss of life, medical expenditures, and property damage in automobile accidents. Current Federal taxes on alcohol are $13.50 per proof gallon, or

4. Note that counting these reduced costs of pension plan payouts as transfers to the nonsmoking population does not mean that there is a gain to society from premature death--such premature deaths are costly. That is, transfers have no effect on the total cost (to smokers and nonsmokers combined) of premature death. Because transfers are made, the cost of premature death to the smoker (internal costs) has increased--the retirement income the smoker is losing is higher. Costs to nonsmokers (external costs) are decreased by the same amount. This accounting for transfers must be made in order to analyze separately the two potential market failures dentified in this report, spillover costs and imperfect information. Some have suggested that this treatment implies that society benefits from early death, and that, for example, early deaths from breast cancer would be treated as a savings when evaluating the desirability of breast cancer research. This analogy is not correct. In the case of breast cancer research, the reduction in premature death would obviously be treated as a benefit to society.

5. These adjustments use the GNP deflator as projected by the Congressional Budget Office. The medical services price index is taken from actual data for 19861992; for additional years, the assumption is made that these costs rise in excess of the GNP deflator by the difference observed from 19861992.

6. The average State and local tax of 26 cents per pack was reported in Tax Foundation, Tax Features, vol. 37, October 1993.

7. There was not enough division of costs to separate out the medical expenditures comport nt of traffic accidents, so the cost could be a few cents higher.

about 21 cents per ounce for distilled spirits; $18.00 per barrel of beer, or about ten cents per ounce; and $1.07 per gallon on table wine, or about eight cents per ounce. State taxes tend to be low (ranging from less than two cents to about ten cents per ounce for distilled spirits, generally less than one cent per ounce for leer, and from less than two cents to about 16 cents per ounce for wine). ⁸

These data suggest that much larger taxes would have to be imposed on all of these products if alcohol taxes were to reflect net external costs. ⁹ In short, based on the criterion of matching tax revenue to net external costs, the data indicate that cigarettes are overtaxed and alcohol is undertaxed. ¹⁰

Qualifications to the Manning Study

Because the Manning study is alone in its attempt to calculate all financial spillover effects (both costs and savings) as a basis for assessing the economically efficient level of tax, it is important to discuss thoroughly potential issues that may raise doubts about the results. This section considers a variety of such issues: the likelihood of estimation error from model specification; the sensitivity of the estimate to the choice of discount rate; the omission of passive smoking from the external cost estimate;the proper treatment of nonhealthrelaled external costs; some miscellaneous issues; and the consistency of the estimate with findings of related studies. Many of these issues and caveats are also discussed in the Manning study.

Much of this discussion is quite technical and is presented below. A brief summary of these issues is provided for those readers who may wish to skip the technical details and proceed directly to the information and addiction discussion in the next section.

8. These are rates as of September 1992, as reported in Tax Foundation, Facts and Figures on Government Finance, 1993, pp. 25657. Some States do not allow private sale and typically impose taxes as a percentage of price; note also that the higher tax rates on wine are imposed only in a very few States; most States impose taxes well below the Federal level.

9. Some argue that significant differences exist between alcohol and tobacco in that some alcohol is consumed in moderate amounts by individuals who do not drive while intoxicated. This nonabusive consumption does not generate external costs and should not be subject to an excise tax whose purpose is to correct for externalities. It is also true, however, that the magnitude of external effects from tobacco depends in part on the amount of exposure in packs per day and the number of years smoked. Those who smoke for a short period are more similar to nonsmokers than to smokers in their health and mortality characteristics. Obviously, use of an excise tax as an instrument to correct for external costs is imperfect for both alcohol and tobacco.

10. Some might ask why this report does not evaluate the other major selective excise revenue raiser, the gasoline tax, as a substitute revenue source for cigarette taxation. A primary rationale for both alcohol and cigarette excise taxation is control of socially undesirable (costly) behavior. The primary rationale for the gasoline tax is to require highway users to provide tax revenue in exchange for the benefits they receive from highway construction.

• Estimation error-The Manning study's lowerbound and upperbound estimates of spillover effects are designed to account for the possibility of estimation error. The lowerbound estimate produces net external savings of 14 cents per pack (recall that all estimates are adjusted to 1995 price levels). The upperbound estimate produces a net external cost of 53 cents. Neither of these estimates justify a 75cent increase in the cigarette tax which currently averages 50 cents per pack.

• Discount rate-- Any study whose results involve a comparison of costs and savings with significantly different time patterns can alter the relative magnitudes by changing the discount rate. Raising the discount rate from five to ten percent would increase net external costs of smoking to 42 cents per pack. Lowering the discount rate to just under four percent would produce net external costs of zero; below that rate net external savings would be generated. In neither case is a 75cent increase in the tax rate justified on spillover grounds.

• Passive smoking--Differences exist about whether passive smoking effects are largely internal or external costs. The link between passive smoking and disease is uncertain. The best available estimate of this link implies external costs of no more than a few cents per pack, not enough to justify a 75cent increase in the cigarette tax.

• Nonhealthrelated external costs--The Manning study does not incorporate effects such as general distaste and annoyance on the part of many for smoking. These effects cannot be quantified and may be best dealt with through regulation rather than taxation.

• Relationship of the Manning study to other studies--The Manning study is likely to be more accurate in its estimates of the economically efficient level of tax because it is the only study that uses the appropriate analytical framework and includes all financial spillover costs. Other studies, when considered in the appropriate framework, are generally consistent with the Manning study.

The Manning estimate uses a procedure that attributes variations in individuals' total lifetime health costs to smoking status, income, sex, and various other attributes. This is a standard estimation strategy--it attempts to control for the influence of nonsmoking factors on total health costs, thereby isolating the influence of smoking. This is referred to as the "base case" in the following discussion.

The Manning study estimates an upper limit for the external costs of smoking that arise from effects on smokers' health by attributing all the variation in total health costs among individuals to smoking status, in effect assuming that no other differences among individuals contribute to the observed

differences in health costs. This "upperbound" analysis produces net external costs of 53 cents. This cost is likely to be an overestimate since some of the deleted nonsmoking factors are found to be statistically significant and therefore are unlikely to have some influence on total health costs. With this upperbound cases the conceptually desirable tax (on efficiency grounds) would argue for only a threecent increase in selective cigarette excise taxes.

It also is possible that the 33cent net external cost estimate, based upon total health costs, is an overestimate. This would occur if omitted variables generate nonsmoking health costs that happen to be correlated with smoking. Consider risk. Smokers are found to be more likely to engage in risky activities and as a consequence are, for example, more likely to incur health costs from accidents. ¹¹ These nonsmoking health costs to some extent would be attributed to smoking status by the basecase methodology, even though they are caused by differences in risktaking rather than smoking status.

The Manning study's authors attempt to control for such bias by restricting health costs to those thought to be related to the smoking habit (e.g., certain cancers, respiratory illness, circulatory diseases, and ulcers). Using this approach, they construct a "lowerbound" estimate that also eliminates any effect of smoking on early retirement (which affects the level of pensions and foregone taxes). Attributing variations in these smokingrelated or habitrelated health coste to smoking status, income, sex, etc., and eliminating the retirement effect, produces net external savings (external savings exceed external costs) of 14 cents. Of course, if smoking produces net external savings rather than a net external cost, a cigarette tax justified as compensation for net external costs would not be appropriate.

If medical expenditures are adjusted only to reflect habit related disease, but unlike the case just discussed the effect on early retirement from the base case is retained, the result is a net external cost of 12 cents. If instead early retirement costs in the base case are reduced in the same proportion as the reduction in the change in medical expenditures moving from the base case to the lower bound, the result is net external savings of four cents.

What is one to make of these three cases and their permutations? The upperbound case seems unrealistic--it comes from a clearly misspecified model that attributes too many health costs to smoking, yet still produces estimates of net external costs that fall far short of justifying a 75cent tax increase. The lowerbound estimate (and estimates adjusted to various treatments of early retirement) could be a better estimate of spillover effects than the base case. If the basecase model were perfectly specified (no omitted variables), it would provide the same results for medical expenditures as the lowerbound case (provided the latter correctly identified smokingrelated health costs). Which model provides a better estimate of spillover effects depends upon one's belief about whether omitted variables in the base case are more of a problem than the

11. See W. Kip Viscusi, Smoking: Making the Risky Decision. NewYork: Oxford University Press, 1992.

measurement error incurred when separating smokingrelated health costs from total health costs. ¹² Neither justifies the current 50cent cigarette excise tax on the basis of spillover effects.

Any study whose results involve a comparison of costs and savings with significantly different time patterns can alter the relative magnitudes by changing the discount rate. Discounting provides a way to compare, at a given point in time, amounts that will be received at different points in the future. Discounting accounts for the fact that a dollar received or spent in the future is less valuable than a dollar received at present, since a dollar received now can be invested at interest. The higher the interest (discount) rate, the smaller the value of amounts paid or received in the future.

Discounting is important in the Manning study because the external costs of smoking accrue more quickly across time than do the offsetting external savings from smoking. Thus, the relative importance (dollar value) of external costs and external savings is affected by the choice of discount rate. Also, much of the tax is paid in advance of either the savings or the costs.

Raising the discount rate from the five percent used in the base case to ten percent increases the difference between the external costs and the offsetting external savings from 33 cents to 42 cents. A further increase in the discount rate has little effect on net external costs, because at a ten percent discount rate, future external savings are already so heavily discounted that further discounting has a minor effect. Also, all values are reduced relative to tax receipts, which occur earlier in time. Lowering the discount rate has a more powerfull effect: external costs equal external savings (net external costs become zero) at a discount rate of slightly under four percent (and at a zero discount rate, smoking produces external savings of $1.18 a pack).

A zero discount rate is not reasonable, but the ten percent rate is probably too high. A discount rate reflecting the pretax return on capital would probably be around seven percent, or about halfway between the five percent and ten percent levels. ¹³ Because of the way in which discounting affects net external savings, the seven percent discount rate produces results that are very close to

12. These measurement errors could arise from imperfect medical knowledge or from misdiagnosis of illness. The direction of such a measurement error is not clear. For example, some smokingrelated illnesses could be diagnosed as a nonsmokingrelated disease because smoking is a contributing rather than primary cause. At the same time, physicians may be more inclined to diagnose as smoking related the illnesses of smokers than those of nonsmokers. See Hans J. Eysenck, "Smoking and Health," in Smoking and Society, ed. Robert D. Tollison, Lexington: D.C. Heath, 1986 for a discussion of evidence on this latter effect.

13. This seven percent rate of return is consistent with two methods of derivation: dividing estimated net capital income by the estimated capital stock, and grossing up an estimated aftertax return by the estimated effective tax rate.

the ten percent rate. None of these discount rates generate net external costs that justify current excise tax rates.

Some suggest the Manning study underestimates net external costs from smoking because it does not include the external costs of passive smoking. The exclusion of these effects is not due to a failure to address the issue. These issues are addressed in a variety of ways in the Manning study. With respect to the data used to estimate costs for active smokers, the Manning study cuts its medical expenditure data eight ways in a search for evidence of passive smoking effects. It examines both total medical expenditures and the subset associated with illnesses related to smoking, for adults and children as outpatients and inpatients. The data analyzed indicate a statistically significant effect for habitrelated (smokingrelated) inpatient medical expenditures for adults; the data do not indicate an effect for the other categories.

Several reasons suggest it may be appropriate to omit passive smoking effects from the calculation of the corrective tax: first, there is much less certainty about the link between passive smoking and health than the link between direct smoking and health; second, to the extent that evidence does exist, it has been associated with effects within families and largely to spouses of smokers, thereby raising questions as to whether the effect should be considered an external or an internal cost; third, taxes may be a flawed instrument to correct for passive smoking effects; and finally, based on available evidence, these costs are quite small relative to current and proposed taxes. Each of these points is discussed.

First, the effects of passive smoking on health are far weaker and less certain than the effects of active smoking. There has been a debate about passive smoking's effect on health; much of the discussion about this issue is technical in nature and is discussed in Appendix A.

Second, if a passive smoking effect exists, the effect may be most likely to occur within families. ¹⁴ Reasons exist for considering a family, rather than an individual, to be the decisionmaking unit when designing externalitycorrecting taxes. One reason is that corrective governmental action often is not desirable for spillover effects that occur within groups that are small enough to negotiate with each other, since members of the group can come to a mutual agreement that maximizes welfare. Passive smoking effects that occur within a family unit may fit this description. This is a gray area where public policy might well consider these effects either as internal or as external costs depending upon the

14. Although the Environmental Protection Agency issued a risk assessment that classifies environmental tobacco smoke as a cancercausing agent, the epidemiological studies they use are based on studies of passive smoking within the home, not in the workplace or in public places. See United States Environmental Protection Agency, Respiratory Health Effects of Passive Smoking: Lung Cancer and Other Disorders, December 1992.

relative bargaining strengths of those affected. The findings of the Manning data, which tend to show that costs are more likely to be associated with adults (who I resumably have relatively comparable bargaining strengths) than with children (who presumably would operate from a relatively weak bargaining position) might argue for treatment as internal costs. In additions since smoking tends to be initiated at an earlier age than marriage, individuals generally know whether or not their spouses will be smokers.

If the smoker or the parents together make the decisions and there are effects on children, there is still a reason to treat costs as internal. Many, one hopes most, parents consider the welfare of each other as well as children in making decisions. Thus, many family smokers should already be taking into account, at least in part, any negative consequences of smoking for other family members, regardless of how decisions are made.

Third, if passive smoking effects are considered external costs, equity considerations suggest a tax remedy may not be desirable. The justification for a tax to correct externalities is made on efficiency grounds because it is possible to make all individuals better off. This "all win" scenario is accomplished (assurring a net external cost) by: (1) imposing the tax on cigarette smokers, thereby reducing their aftertax income; (2) altering smokers' behavior, thereby making nonsmokers better off; and (3) making lump sum payments to compensate smokers for their tax payments. In practice, the third step is omitted, which causes distributional effects--smokers lose and nonsmokers gain. Many people, however, perceive this distributional effect as fair, since smokers impose costs on nonsmokers in the first place. Were a tax used to correct spillover effects within families, however, nonsmoking family members in families with smokers who continue to smoke will be made worse off--they receive little or no reduction in passive smoking costs and their aftertax income is reduced by the amount of the family's tax payments. Thus, while a tax to reflect such passivesmoking costs might be efficient, these equity considerations may make it less desirable.

Finally, even if all costs of passive smoking are considered to be external and existing data are used to measure a per pack amount, the costs probably are small relative to current and proposed taxes. The Manning study calculates a total cost of smoking (both external and internal costs in excess of the price of the product) that includes medical expenditures, lost productivity due to illness, lost productivity due to early death, and costs from fires. This total cost equals $2.53 per pack (recall that these numbers are adjusted to 1995 levels). While the literature does not provide good data on the relationship between these active smoking costs and passivesmoking costs, and indeed does not really show for certain that a passivesmoking cost exists, these total activesmoking costs along with other data can be adjusted to make three rough estimates that are suggestive of the general magnitude of potential passivesmoking costs.

Estimate based upon EPA's estimate of deaths from lung cancer--Although the uncertainty of the epidemiological studies on passive smoking is discussed in Appendix A, these results can be used to generate possible passivesmoking

costs. Divide EPA's estimated 3000 deaths from lung cancer due to passive smoking by the lung cancer deaths attributed to active smoking, and multiply this 0.022 result by the per pack total cost. ¹⁵ This generates passivesmoking total costs of six cents per pack.

Estimate based upon EPA's estimate of child hospitalizations--A second epidemiologicalbased estimate can be made using EPA estimates that hospitalizations of young children due to respiratory disease from passive smoking range between 7,500 and 15,000. The average hospitalization is estimated to cost between $3,000 and $4,500. ¹⁶ If these amounts are converted into perpack costs they would range from onetenth to threetenths of a cent per pack. ^l7

Estimate based upon relative physical exposure to smoke--A third adjustment is to multiply the estimate of total activesmoking costs by the ratio of nonsmokerstosmokers' physical exposure to smoke and by the ratio of non smokers to smokers. ^l8 This calculation generates a passivesmoking total cost of 2.5 to 5 cents per pack.

The first and third estimate might understate passivesmoking costs if the $2.53 per pack total activesmoking cost is understated. First, if individuals are willing to pay more than expected lost earnings for the expected change in life expectancy (internal costs for active smokers, but external costs for passive smokers),the $2.53 perpack cost could rise by as much as $5 a pack, according to Manning. Stated in 1995 price levels, this increase could be as much as $6.84 per pack. Another difficult area to assess is the cost of low birthweight babies due to maternal smoking. Some have argued that these passivesmoking costs

15. Premature lung cancer deaths attributable to smoking are estimated at 137,000 in 1989. See United States Environmental Protection Agency (1992); and U.S. Library of Congress. Congressional Research Service. Mortality and Economic Costs Attributable to Smoking and Alcohol Abuse, Report 93426 SPR by C. Stephen Redhead, April 20, 1993. Note that this method assumes that the relationship between active and passive premature deaths for lung cancer holds for the overall ratio of health and mortality costs for all diseases.

16. Testimony of Alfred Munzer, American Lung Association, Before the Subcommittee on Specialty Crops and Natural Resources of the House Committee on Agriculture, July 21, 1993, stated that 15,000 hospitalizations would cost between $45 million and $68 million.

17. Current Federal taxes at 24 cents a pack account for $5.7 billion; thus each penny per pack is worth $238 million. The total cost of the hospitalizations would range from $23 million (7,500 at $3 000) to $68 million (15,100 at $4500). Thus, the amount per pack would be from less than onetenth of a cent to less than threetenths of a cent.

18. Kyle Steenland, "Passive Smoking and the Risk of Heart Disease," Journal of theAmerican Medical Association, January 1, 1992, Vol. 267, pp. 9499 reports urinary cotinine (a marker for nicotine) in nonsmokers to be less than one percent of that of smokers, and in nonsmokers living with smokers, two percent or less. Since there are roughly an equal number of neversmokers and former/current smokers, the passive cost would be one to two percent of active smoking. These estimates may actually be somewhat high: see the discussion of biological markers in Chapter 3 of the Environmental Protection Agency (1992). Note that this method assumes a linear relationship between exposure and disease.

are very high, but measurement is difficult and only a small group of smokers (pregnant women) impose these costs. ¹⁹

Adjusting for these higher total activesmoking costs gives passivesmoking costs of 21 cents per pack for the calculation based upon estimated lung cancer deaths and 9 to 18 cents for the calculations based upon physical exposure. These seem rather high for a few reasons. First, as stated above, the epidemiological evidence for passivesmokingrelated disease is weak. Second, the estimates based upon physical exposure assume a linear relationship between exposure and disease. In fact, strongly nonlinear relationships in which health effects rise with the square of exposure, and more, have been found with respect to active smoking (see Surgeon General's Report, 198'9, p. 44). For example, if health effects rise with the square of exposure, the effects would be onetenth to onefifth as large as with a linear relationship. Adjusting the nine to 18 cents per pack to allow for such a nonlinear relationship would reduce passivesmoking costs to a range of one to four cents per pack.

These calculations suggest that if a passivesmoking cost were to be considered appropriate for inclusion as an external cost, it would be quite small, and unlikely to raise the estimate of spillover effects above the level of the current tax. Thus, it would not justify the 75cent tax increase.

Some also suggest the Manning results are understated because they do not incorporate nonquantifiable external costs such as irritation from smoke, smell, nuisance, or general distaste. This is a complicated issue whose resolution requires more than economic analysis. The distaste some individuals have for smoking is difficult to quantify. The stance society should take--whether it should protect the observer's right to be free from the sights, sounds, and smells of others, or whether it should protect the individual's right to indulge in the offending habit when there is no way to measure damage--is not subject to clear guidelines. Individuals undertake many activities that others find distasteful, and many, perhaps most, of them are not subject to government control.

In any case, a tax might not be the best approach to correct for such behavior, for choosing the efficient level of tax relies on quantification of dollar value find is imposed whether or not repelled observers are present. Rather, regulations which separate smokers, allow specific smoking areas, or restrict the

19. See Joel W. Hay, "The Harm They Do Others: A Primer on the External Costs of Drug Abuse," in Searching for Alternatives: DrugControl Policy in the United States, ed. Melvyn B. Krauss and Edward P. Lazear, Stanford: Hoover Institution Press, 1991.

activity in close environments might be more appropriate. Such regulations have been shown to be effective in reducing the demand for cigarettes. ²⁰

Note, however, that an argument can be made that, to achieve efficiency, private businesses should be able to make their own decisions about allowing, disallowing, or separating smokers, since they must respond to the tastes of their customers and workers. For example, owners of restaurants and bars will modify their conditions to attract customers so that some will allow smoking, some will not allow smoking, and some might segregate smokers from nonsmokers. ^2l This is a fairly straightforward argument that holds up as long as s efficient choice is available and customers have adequate information. Some decisions would still have to be made about public facilities that are subject to monopoly provision. In practice, of course, many such regulations already exist, some affecting private businesses as well as public facilities.

Some argue these estimates of net external costs are not relevant because they do not account for the intangible costs of premature death (e.g. the grief of family and friends). On the efficiency grounds being discussed here, the relevance of this issue depends upon whether the individual accurately values the effect of this risk on his family and friends (presumably relatively few individuals ignore these risks). There is no compelling reason to believe the individual undervalues this risk. In any case, a policy that assigned an arbitrary value for the underassessment of intangible cost of premature death would have farreaching implications. It would imply imposition of the rights and preferences of groups relative to those of individuals, a policy that could be viewed as inconsistent with certain basic political and economic values of society. Pleasure driving, many recreational activities, some dietary practices, and some occupations, to name just a few activities, involve the same actuariallyvalidated risk of premature death and grief. In fact, we do not impose taxes on these activities. Taxing such activities involves value judgments that are beyond the scope of economic analysis.

Several other issues suggest viewing the estimates in the Manning study with some uncertainty.

(1) The estimates indicate the appropriate tax only for a new (young) smoker, not for the current mix of smokers. Ideally one might wish to tax each

20. Two recent studies include a "regulation index" as a determinant of the demand for cigarettes. See Theodore E. Keeler, TehWei Hu, Paul G. Barnett, and Willard G. Manning. "Taxation, Regulation, and Addiction: A Demand Function for Cigarettes Based on Timeseries Evid~ nce," Journal of Health Economics. Vol. 12, 1993, pp. 118; and Jeffrey Wasserman, Willard G. Manning, Joseph P. Newhouse, and John D. Winkler. "The Effects of Excise Taxes and Regulations on Cigarette Smoking, " Journal of Health Economics. Vol. 10, 1991, pp. 4364.

21. This argument is made by Robert D. Tollison and Richard E. Wagner, The Economics of Smoking, Boston: Kluwer Academic Publishers, 1991.

cigarette based on its marginal net external cost; such estimates do not exist and such an approach is impossible to translate into an excise tax, which cannot be varied by the age and characteristics of the purchaser. Moreover, the fact that existing smokers have already paid taxes and had their smoking decisions influenced by these taxes would need to be considered. The lifetime perspective offers the only feasible method of calculating a net external cost and the associated corrective tax. The implications of a lifetime perspective for calculating the tax receive more attention in Appendix B.

(2) Changes in the tar and nicotine content of cigarettes may result in a decrease in net external costs for current new smokers as compared to the cross section of existing smokers.

(3) The share of cost borne privately may differ in the future from the assumptions in the Manning study. In the Manning study, approximately 28 percent of the present value of lifetime medical costs and half of nursinghome costs was paid by the smoker. If there were no cost sharing, the perpack amount would rise to 46 cents from 33 cents. The President's proposed health care plan will, however, also involve some cost sharing through deductibles and copayments. If cost sharing were 15 percent, the perpack amount would be 37 cents; if cost sharing were ten percent, the perpack amount would be 40 cents.

(4 ) The estimates include only the foregone tax revenue from early death that is used to finance transfer payments. Exclusion is clearly an appropriate decision for the remaining taxes that finance benefit type goods, since the demand for these goods is also reduced. Exclusion may be less appropriate for those ; taxes that finance collectivelyconsumed goods (such as defense) where a reduction in the number of consumers provides no cost savings. At the same time, there are other collective nonmarket benefits (e.g. reduction in congestion) that are not accounted for. Their exclusion raises an interesting conceptual issue which would require subjective judgments to quantify.

(5) Interview surveys, on which some of the data are based, may be subject to considerable errors in recall. The Manning study also prepared an estimate based on the National Health Interview Survey for all ages. The 39cent net external cost is higher due to higher sick leave costs.

(6) When comparing the spillover effects with the proposed tax at 1995 price levels, the likelihood that average State taxes would increase during that time period is ignored.

There are other studies of the costs of smoking, particularly of the medical expenditures component of these costs, and there are other estimates of perpack medical expenditures or total health costs. The Manning study is likely to be more accurate in its estimates of the appropriate level of tax because it is the

only study that uses the appropriate analytical framework and seeks to include all spillover costs.

Five other studies/calculations are discussed in Appendix B. Of these, two studies provide evidence on the magnitude of excess lifetime medical expenditures of smokers; the Manning study's estimate of excess lifetime medical expenditures falls between these two estimates. Others of these studies provide calculations of perpack medical expenditures or total health costs that are: Consistent with the Manning results. The Appendix discussion illustrates the conceptual deficiencies of these estimates as an indicator of net external costs and the corrective tax. ²²

This section states and explains the general characteristics of the Manning study that make it conceptually correct. First, the Manning study attempts to identify all financial costs and savings of smoking that are external to the smoker. Thus, it includes medical expenditures and costs of lost productivity, but adjusts these costs to exclude amounts that are paid out of pocket by the smoker; that is, external costs are distinguished from internal costs. As a consequence of this procedure, it includes changes in the smoker's payments to society and society's payments to the smoker that result from the smoker's early death.

Second, the Manning study controls statistically for many other attributes that might affect observed differences in health care expenditures for smokers and nonsmokers, such as education, income, and other health habits. (This control does not necessarily, of course, capture all of these other factors.)

Third, the Manning study calculates the tax from a lifetime perspective, where costs and savings of smoking are discounted over a lifetime and used to generate a tax of equal present value. This lifetime perspective is important because of the timedependent nature of the smoking/health phenomenon. Typically, individuals smoke for many years before smokingrelated disease appears; taxes are collected well in advance of additional medical expenditures, and as a result taxes and medical expenditures have different present values. Also when individuals die early as a result of smoking, health and other costs (e.g. pensions) are foregone (and thus reduced). These external savings (fore gone medical expenditures and pension savings) occur even later in (expected) life and are even more heavily discounted than are smokers' additional medical expenditures.

22. It is important to note that the discussion of these studies here and in Appendix B is not mean; to imply that these five studies are done incorrectly. In general, the studies are not intended to generate information suitable to estimate the efficient tax, but are simply explorations of the available data to increase knowledge about the relationship between smoking and medical expenditures. The afterthefact comparison in this report is necessary, however, because the result, of these studies are used by others to draw inferences about the efficient tax, and these inferences cast doubt upon the validity of the Manning study estimates.

Although the five studies discussed in Appendix B are useful for a variety of policy issues, they all omit at least one of these three characteristics, which renders their results for calculating the optimal tax somewhat deficient.

The detailed discussion of the qualifications to the Manning study suggests reasons may exist to increase and to decrease its estimates of net external costs. If all the adjustments that might suggest an increase in net external costs--a higher discount rate, passive smoking effects, a smaller share of costs borne privately, and higher lifetime excess costs found in one of the studies reviewed in Appendix B--were assumed to be appropriate, the measured external cost could be large enough to justify the 75cent proposed tax addition.

But such an upperlimit measure does not appear to be the most reasonable choice to make. Indeed, there are adjustments that also suggest the net external cost is very small, or perhaps even net external savings--restriction of the costs to habitrelated diseases, a lower discount rate, lower lifetime excess costs found in another of the studies reviewed in Appendix B. The range of reduction is at least as large as the range of increase in the numbers. The 33 cent number represents a central position between the upper and lower bounds.

Given the current state of information, Manning's basecase estimate appeals to be the one that best informs the policy decision regarding the spillover effects of smoking.

Aside from spillover effects, standard economic theory holds that a tax is justified on efficiency grounds if individuals are unable to recognize the full costs of smoking to themselves (internal costs). Thus, a second argument for imposing a tax on cigarettes is that people are not informed of the hazards of smoking and do not recognize the full cost to themselves. Or, they are not able to make sensible choices because the consumption of the commodity is habitformirg and they do not fully understand the difficulties of altering future behavior.

Before discussing these two issues, it is important to understand an important observation from economic theory: the fact that individuals engage in hazardous or dangerous activities does not mean that they are making bad choices. Individuals are presumed to choose activities, in accordance with their subjective tastes and preferences, that make them the happiest. This choice does not necessarily mean that they will maximize their health or their lifespan. Individuals engage in all sorts of behaviors that impose some danger in exchange for benefit (driving small cars or riding motorcycles, working in risky jobs, eating unhealthy diets, engaging in risky sports). Thus, nothing in economic theory precludes the notion that individuals smoke because their enjoyment of

the activity outweighs the sum of the actual costs of purchasing cigarettes and the internal health costs.

Some studies have found that both teenage and adult smokers tend to be risk takers in a variety of ways (e.g., they are willing to work at riskier jobs and they are less likely to wear seat belts). ²³ Thus the average smoker, in continuing a behavior that involves a health hazard, seems to be behaving in a way consistent with other decisions he makes.

From an economist's perspective, if there is a market failure, it is not in making a choice to engage in a dangerous or risky activity, but rather in making that choice with incorrect information. Two aspects of this information problem are considered in turn: whether the individual is knowledgeable about the health hazards; and whether the individual understands the cost of changing behavior in the future. The final subsection discusses the policy implications of these findings.

Information on Health Hazards

An argument is frequently made that smokers may not be correctly informed about the risks of smoking. The Congressional Budget Office, for example, cited statistics indicating some smokers are not aware of the linkage between cigarette smoking and various diseases. ²⁴

In a recent study, Viscusi uses two surveys of the general population--his own and one provided by the tobacco industry--to quantify smokers' and nonsmokers' perceptions of the health risks of smoking. ²⁵ The two surveys yield similar results. Survey respondents were asked how many of 100 smokers are likely to die from smokingrelated diseases.

According to Viscusi, mortality statistics on smokingrelated deaths indicate the total lifetime mortality risk to smokers ranges from 0.18 to 0.36 (18 to 36 of each 100 smokers are likely to die from disease caused by smoking). ²⁶

23. Viscusi (1992)

24. Congressional Budget Office. Federal Taxation of Tobacco, Alcoholic Beverages, and Motor Fuels. Washington, D.C.: U.S. Government Printing Office, August 1990.

25. Viscusi (1992). Portions of his book also appear in "Do Smokers Underestimate Risks?" Journal of Political Economy, vol. 98, 1990, pp. 12531269, and "Age Variations in Risk Perceptions and Smoking Decisions," Review of Economics and Statistics, vol. 73, no. 4, 1991, pp. 577588.

26. These lifetime estimates must be derived from annual estimates of smokingrelated disease. The technique for preparing this estimate is discussed in some detail by Viscusi. It begins, howe~ er, with the basic data on annual deaths attributed to smoking. See U.S. Library of Congt ess. Congressional Research Service. Mortality and Economic Costs Attributable to Smoking and Alcohol Abuse, Report 93426 SPR by C. Stephen Redhead, April 20, 1993 for further information on attributable deaths.

Survey respondents perceive this risk to be 0.54. ²⁷ This perceived risk differs somewhat depending on smoking habits 0.47 for current smokers, 0.50 for former smokers, and 0.59 for those who have never smoked. The perceived risk is higher for younger ages than for older ages, probably because the young have been more heavily exposed to information on smoking and health risks. Viscusi also finds a tendency among respondents to overstate the expected number of years of life lost because of smoking.

To summarize, Viscusi finds that while smokers perceive smaller risks than nonsmokers, smokers also perceive risks to be higher than indicated by scientific evidence. Thus, while some individuals may not be aware of or may reject the evidence on the health cost of smoking, this does not appear to be the case overall . These results should not be surprising, as it is common for individuals to overestimate the risk of a highly publicized discrete event that is reported without reference to the event's frequency of occurrence in the population to whom such an event may occur (common examples are the risks of being killed by tornadoes or struck by lightning).

If individuals overestimate the health hazards of smoking, a tax would not correct for imperfect information. ²⁸

Information on Habit-Formation and Addiction

In addition to inaccurate risk assessment, market failure also could result if individuals incorrectly assess the impact the addictive properties of tobacco will have on any future attempt to quit.

According to the economic theories applied to addictive behavior, simply because individuals engage in behavior that involves habit formation or addiction does not mean they are making a mistake, as long as the individual recognizes the difficulty of modifying behavior in the future and the possibility of a need for such modification. ²⁹ Individuals make many decisions that are difficult to change (and that they are probably aware are difficult to change)--marriage, job, purchasing a home, locating in a given area-- without those decisions being seen as bad choices and appropriate targets for government intervention.

27. Much of this overestimation of risk is due to overestimation of the risk of lung cancer.

28. Some argue that an individual's perception of risk differs when considering the risk for people as a group versus the risk for him or herself. Unfortunately, no quantitative measure exists lo ascertain the extent, if any, of this difference. See U.S. Department of Health and Human Services. Reducing the Health Consequences of Smoking: 25 Years of Progress. A Report of the Surgeon General 1989, DHHS Publication No. (CDC) 898411, p. 216, hereafter Surgeon General's Report, Chapter 4 for a discussion of this issue.

29. For a model of rational addiction, see Frank Chaloupka, "Rational Addictive Behavior and Cigarette Smoking," Journal of Political Economy, Vol. 99, no. 4, August 1991, pp. 722-742.

From this perspective, when smokers make a mistake it is due to a failure of information--a failure to understand either the difficulty of altering future behavior or the likelihood that alteration will be desired. It is not easy to assess the extent to which this problem occurs. A variety of observations support both the view that incomplete information is a serious problem and the view that it is a less important problem.

Two types of evidence might shed some light on the severity of this information problem. The first is evidence of the strength of the addiction problem. The less pronounced the addiction problem, the less serious is any failure to understand the problem. Second, if the addiction problem is serious, is there evidence that individuals are aware of the problem?

1. Evidence on habit formation and addiction

The evidence supporting the problem of habit formation is straightforward. That smoking is habit forming is essentially beyond dispute. There is also a substance in tobacco, nicotine, that is physically addictive to some degree. ³⁰ A very large number of smokers say they would like to quit or have tried to quit at Least once, ³¹ and quitters experience a high rate of recidivism. ³² Individuals also continue to spend money on smoking cessation programs.

Other observations suggest, however, that addiction is not serious enough to make smoking decisions significantly different from many other decisions in which the government does not intervene. For example, although many smokers have tried to quit and failed, many also have tried and succeeded, the vast majority without help. ³³ The number of former smokers is now as large as the number of current smokers.

Smoking decisions also respond to changes in prices in a way that is consistent with consumption decisions about many other products, and increased publicity about health risks did reduce smoking substantially. Thus, individuals appear to be able to cease smoking when the price (either in actual cost or in implicit, perceived health costs) increases substantially.

30. This issue is discussed in U.S. Department of Health and Human Services, The Health Consequences of Smoking: Nicotine Addiction, 1988, Surgeon General Report, DHHS Publication No. (CDC) 888406. Another discussion that takes the position that there is a serious problem with

physical addiction and that is written for the general public is in the chapter on smoking in Jeffr My Harris, Deadly Choices: Coping with Health Risks in Eueryday Life, Basic Books, Nest York HarperCollins Publishers, 1993, p. 167.

31. Seventy percent of current smokers have made at least one serious attempt to quit. See Congressional Budget Office. Federal Taxation of Tobacco, Alcoholic Beverages, and Motor Fuels. Washington, D.C.: U.S. Government Printing Office, August 1990.

32. For data on relapses after quitting attempts, see Harris (1993), p. 167.

33. Surgeon General's Report (1989).

The fact that many individuals say they would like to quit is indicative of the difficulty of breaking pleasurable habits but does not necessarily prove a serious addiction problem. As an illustration of how one might interpret discrepancies between statements of preferences and action, Viscusi notes that half of the people who live in Los Angeles say they would like to leave. The fact that they do not leave does not mean that they have no control over the decision, but rather that they perceive the benefits of staying to be greater than the benefits of leaving. Similarly, individuals may say they would like to quit, but when dealing with the actual decision continue to smoke because they enjoy it and cessation is a deprivation of an accustomed pleasure.

Indeed, some of the arguments used to support the case that smoking, addiction, and the difficulty of changing behavior is a serious problem are applicable to many other activities. Individuals not only engage in risky activities, but they also fail to initiate or persist in many behaviors that would contribute to their health (e.g. diet and exercise). When they do initiate changes, they exhibit a high rate of failure to follow through even when considerable money is spent on programs to attain these ends. Many overweight individuals have made a serious attempt to lose weight and failed; many sedentary individuals have made an effort to initiate and maintain a regular exercise program and failed. Few suggest these behaviors justify government intervention.

2. Evidence on information regarding addiction

Even if addiction is a serious problem, there is no market failure if individuals are aware of it when they make the initial smoking decision.

The argument that incomplete information is a serious problem begins with the observation that most smokers begin early in life, typically in the teenage years, when a lack of information or understanding may be more severe. A survey of teenagers showed that half expect not to be smoking in five years, ³⁴ where as data show that smoking participation generally does not decrease until much later in life. This evidence suggests that teenagers may well have incorrect perceptions about their ability to stop smoking.

On the other hand, some data indicate that even the very young are aware that it is difficult to quit smoking. About 75 percent of those 14 and younger, when queried about the difficulty of stopping smoking, identified as true the statement "It is very hard to stop smoking." ³⁵

34. Surgeon General's Report, 1989.

35. Viscusi (1992). It is possible that young teenagers who smoke may have different perceptions from the average, however.

Policy Responses

The fundamental tax policy issue is twofold. If smoking decisions are assumed to be reasonably informed, then the government should not intervene beyond correcting for spillover effects. If, however, the decision is assumed not to be informed, then intervention may be appropriate and a tax might make smokers better off in the long run if it led them to quit or fail to take up the habit.

The preceding discussion suggests uncertainty about the degree to which the smoking decision is a wrong decision when it is placed in the context of individual preferences. The evidence presented suggests that there is not much of a case for a market failure with respect to information on the health hazards of smoking. Indeed, it is possible that individuals overestimate these health costs, on average. Whether individuals are informed about the difficulties of changing future smoking behavior is much less certain.

As a correction to information problems regarding addiction, a tax has certain shortcomings. First, use of a tax that is set properly requires a quantification of the degree to which information is incorrect, a measure that cannot be made based on current information and that would presumably vary widely across individuals.

Second, the tax would be an effective deterrent to smoking primarily for those who have not yet begun and for those smokers who are least addicted. This is not an inconsequential step, but the tax would not be an effective remedy for correcting behavior for those who have already made an uninformed choice.

Finally, as in the case of spillover effects within the family, a tax aimed at "helping the smoker" produces distributional or equity effects that blur the desirability of the policy overall. Consider, for example, a tax of the magnitude proposed by the health care plan. Based on the elasticities used in section II, the shortrun participation elasticity of tobacco consumption (percentage change in share of individuals smoking divided by the percentage change in price) is about 0.3 and the long run elasticity is about 1.2. Assuming a constant elastic function with a 75cent tax, about ten percent of individual smokers will quit smoking in the short run. In the long run, the reduction will be about a third. This is troubling because the tax makes worse off the majority of those it is intended to help, and is particularly burdensome to lowerincome individuals.

On the whole, therefore, a tax may not be the most appropriate policy instrument to deal with the information problem. It is true that some estimates of behavioral response suggest that taxes can elicit a large response from teenage smokers (a reduction for the 75cent tax increase up to a third). But

adolescent smokers account for only six percent of all smokers. ³⁶ Nontax alternatives may be better targeted. If lack of information about addiction is the primary problem, perhaps a better response is to disseminate information to the young about the dangers of addiction through educational programs in the schools, general advertising, and perhaps through warning labels. If the age of initiating smoking and immaturity of decisionmaking by young smokers seems to be the primary problem, an approach might be to introduce stricter laws limiting the sale of cigarettes to minors and to enforce those laws. ³⁷ To help currert smokers who will constitute the great majority of smokers in the near and medium term, more assistance for quitting (including information and better nicotine replacement devices) may be a desirable public policy. ³⁸ Indeed, one feature that may be desirable in a health care plan is to provide coverage for expenditures on smoking cessation. Finally, a policy option that might help all individuals would be the development of a less dangerous cigarette. ³⁹

36. Calculated from data in National Cancer Institute, The Impact of Cigarette Excise Taxes on Smoking Among Children and Adults, Summary Report of a National Cancer Institute Expert Panel, August 1993.

37. It has been argued that laws barring sales of cigarettes to minors are enforced in only two of the 47 states with such laws. See "U.S. Urged to Escalate Tobacco War," Washington Post, Januar y 12, p. A16. See also the discussion in the 1989 Surgeon General's Report, pp. 587588 and 596608 regarding smoking policies in public schools, State laws regarding sale and possession by minors, and enforcement issues.

38. Jeffrey Harris, Deadly Choices: Coping with Health Risks in Everyday Life, New York: HarpelCollins Publishers, 1993, suggests that nicotine replacement devices might be improved.

39. Viscusi (1992) indicates that public health officials have not encouraged such improvements such as a "smokeless" cigarette that would continue to deliver nicotine and mimic actual smoking without many other adverse effects.

The proposed health care program is to be permanent, and the cigarette tax has been presented as a permanent feature of its financing. One standard for evaluating the tax might be whether it will generate revenue sufficient to finance a constant share of the program's costs over time. If it does not, policy discussions of the proposed health care program ought to consider what financing source will replace cigarette tax revenue beyond the budget window. ⁴⁰

This section demonstrates that longrun cigarette tax collections, although increasing over time, will be a diminishing share of longterm health care costs. First, the impact of failure to index the proposed perunit cigarette tax is discussed. While real spending is likely either to grow (if the health care "price index" increases faster than the rate of inflation) or to remain constant (if the health care "price index" rises at the rate of inflation), the real value of every dollar of tax revenue will decline as the price level rises. Second, it is demonstrated that, even were the tax indexed and income growth zero, health care costs will grow at the rate of population growth while revenue will grow at less than the rate of population growth. This discrepancy occurs because the sensitivity of smoking participation rates to price changes will increase over time, vhich in turn will generate larger reductions in cigarette consumption and tax revenue. The net effect on the Government's budget from reduced cigarette consumption--the possibility that the Government's reduced medical expenses due to smoking will offset its reduced cigarette tax revenue--is discussed. Third, the effect of per capita income growth on health care spending and cigarette tax revenue is discussed. Finally, an estimate is made of the proposed tax's effect on State tax revenue.

INDEXING

To simplify exposition of the consequences of adopting an unindexed cigarette tax, assume that the price level rises at an annual rate of four percent and that health care costs also rise at this rate of inflation (an underestimate given the current rate of increase in medical care prices). The absence of indexing affects cigarette tax revenue in two ways.

Were the cigarette tax indexed such that the tax rate on a pack of cigarettes always generated 75 cents in real 1994 dollars, the tax revenue collected on each pack of cigarettes would purchase the same amount of health care at any point in time, 75 cents worth in 1994 dollars. Why? Because both health care costs

40. Although some might argue that anticipated longterm administrative cost savings will compensate for the longterm decline in cigarette tax revenue identified in this report, two factors suggest this is far from certain. First, experience shows administrative cost savings to be easy to conceptualize but difficult to achieve. The Reagan budget projections of savings from elimination of "waste, fraud, and abuse" are instructive in this regard. Second, the estimates of longterm cigarette tax revenue decreases in this report do not account for continuance of the longterm downward trend in cigarette consumption, and the decrease therefore is understated.

and revenue would increase at a four percent rate. This is not true for an unindexed tax. After six years, the 75cent tax on a pack of cigarettes will purchase only 62 cents of health care; after 14 years, 45 cents; after 40 years, 16 cents; and after 53 years, 10 cents. The growing discrepancy between nominal and real tax collections is illustrated by the solid lines in figure 1.

These calculations apply to the tax collected on each pack of cigarettes. The number of packs will be responsive to the price change the topic of the next section. Any reduction in the quantity smoked will eventually dissipate as the real price effect declines over time. The average pretax price of a pack of cigarettes is currently $1.30 ($1.80 minus 24 cents of Federal tax and 26 cents of State/local tax). Assume this pretax price of $1.30 is allowed to increase at the rate of inflation and add the 50 cents of existing cigarette taxes to this inflated price. The dashed line in figure 1 is the 75cent tax divided by this adjusted nominal cigarette price. This percentage change in real price declines from 42 percent today to 28 percent in 14 years, 11.5 percent in 40 years, and 7 percent in 53 years.

SHORT RUN VERSUS LONGRUN PARTICIPATION RATE

Even if the tax were to be indexed or if there were zero inflation, cigarette tax revenue would reasonably be expected to finance a decreasing share of health care program cost over time due to behavioral responses of smokers. The response of cigarette consumption to price changes is summarized by estimates of the price elasticity of smoking participation rates and the price elasticity of the quantity of cigarettes smoked per smoker. The participation rate elasticity measures the percentage change in smokers divided by the percentage change

in the price of cigarettes. The quantity elasticity measures the percentage change in quantity of cigarettes purchased per smoker divided by the percentage change in the price of cigarettes.

Two facts are discernible from table 1: the smoking participation rate (column 2) is much more sensitive to price than is the average consumption of smoking participants (column 3); and the smoking participation rate of the young is much more sensitive to price (1.2 elasticity for 1217s) than is the participation rate of other age groups (0.15 elasticity for 3674s).

Table 1. Price Elasticity of Smoking Participation Rate and Quantity per Smoker, by Age
Age			Participation Rate			Quantity per smoker
12-17			-1.20			-0.25
20-25			-0.74			-0.20
26-35			-0.44			-0.04
36-74			-0.15			-0.15
All ages			-0.31			-0.11
Source: Department of Health and Human Services, Reducing Health Consequences of Smoking: 25 Years of Smoking, 1989. Surgeon GeneralReport, Table 13, p.537. These estimates represent a synthesis of numerous econometric studies. See the Surgeon General's report for a summary.

The difference in participation rate elasticity among age groups is consistent with expectations about demand for an addictive or habitrelated product. Since one's addiction or habit dependence presumably increases the longer one consumes a product, the ability to quit in response to a price increase is likely to decrease with age.

These elasticity differences have important consequences for longterm revenue collections. The 1217s' elasticity of 1.2 suggests that a one percent price increase would reduce smoking participation by 1.2 percent. In contrast, the 3674s' elasticity of 0.15 suggests a one percent price increase would reduce smoking participation by 0.15 percent. As a result, the reduction in smoking participants in response to the 75 cent tax would not be great in the short run--note the weighted price elasticity of participation rates for all ages is 0.31 (53 percent of current smokers in 1992 were 36 or older). Since the 75 cent cigarette tax represents a 42 percent increase in the average $1.80 price of a pack of cigarettes, the number of smokers will decline in the short run by 10.2

percent. ^4l When the response of quantity per smoker is incorporated, a reduction in cigarette consumption of 15.1 percent becomes the base for the shortrun revenue estimate.

As the years march on, the population of smokers comes to be dominated by new cohorts of 1217s whose initial smoking participation decision will be made in response to a 1.2 elasticity rather than the 0.15 elasticity. This process will generate a substantial decrease in the longrun aggregate participation rate relative to the rate in effect in the first five or six years of the tax. The expected longrun reduction in consumption of cigarettes will be much greater than in the short run.

As is true with econometric estimation of any behavioral parameter, the precise magnitude of these price elasticities is the subject of considerable debate. The estimates in table 1 are from the "traditional" framework, in which quantity demanded is a function of current price. The longrun price elasticity is inferred from the differences in elasticities by age group, as described above. Recent research has investigated the possibility that an addictive good such as cigarettes is subject to a much more complex demand relationship. This "rational addiction" framework suggests that today's consumption is dependent upon both past and future consumption. ⁴² This framework estimates shortrun and longrun elasticities directly, and finds the longrun elasticity to be higher than the shortrun elasticity, a result consistent with this report's use of the elasticities in table 1. The rational addiction estimates, however, tend to find a somewhat smaller difference between the shortrun and longrun elasticities than is implied by the estimates in table 1. These smaller differences masr be less accurate than the differences from the traditional literature for two reasons: the estimates represent a time period considerably shorter than probably is necessary to capture the full response to price; and the specification of tile rational addiction model creates serious econometric estimation problems.

The purpose of the longrun revenue projections presented in this section is to illustrate the existence of a growing revenue shortfall over time. This phenomenon would occur no matter which estimating framework's elasticities are used. Obviously, numerous other factors affecting revenue and not taken into account here would change over the lifetime span of these revenue estimates.

41. A simple linear calculation suggests a reduction of 13.2 percent, the product of 0.31 and the price change of 0.42, converted into a percentage. A constant elasticity demand function is used in this report, which produces a participation rate reduction equal to [1 {(1.80 + .75)/1.80}0.31], or 0.102.

42. See Becker, Gary S., Michael Grossman, and Kevin M. Murphy. An Empirical Analysis of Cigarette Addiction. National Bureau of Economic Research Working Paper No. 3322. March 1993; Keeler, Hu, Barnett, and Manning (1993); and Chaloupka (1991).

Federal Revenues

CRS's estimates of gross and net Federal revenue generated by the proposed cigarette tax for the next 69 years are presented in figure 2. These revenue estimates assume the tax is indexed and passed forward in a higher price. The estimates incorporate: zero per capita income growth; population growth; and a changing aggregate participation rate elasticity as today's population is aged for 69 years. This allows the entire population (age 12 to 80, an age range that includes almost all smokers) to have its initial smoking participation response to the proposed 75cents tax be made as a member of the 1217 age group The details of these calculations are provided in Appendix C.

Gross Federal revenue in figure 2 is 75 cents times the number of packs of cigarettes sold. Net Federal revenue reflects two adjustments: a reduction of 24 cents per pack for the existing cigarette tax that s not collected on consumption discouraged by the 75cent tax (the difference between beforetax and aftertax consumption); and a reduction of 25 cents per dollar of revenue (net of the 24cent per pack adjustment) for the lost Federal income tax collections attributable to reduced factor incomes (capital and labor income from cigarette sales revenue decreases by the amount of the increased Federal cigarette tax revenue). Net revenue grows over the 69 years from $11.466 billion to $12.353 billion.

The time path of revenue in figure 2 reflects the combined influence of population growth, which increases consumption and revenue, and the population's increasing participation rate sensitivity to the taxinduced price change, which decreases consumption and revenue. The effect of increasing participation rate sensitivity (fewer smokers) on longterm revenue collections

can be isolated in two ways. In figure 3, the upper revenue line is the first year's net cigarette tax revenue ($11.466 billion from figure 2) growing in response to increasing population. ⁴³ No adjustment is made for the increasing participation rate sensitivity--the first year's participation rate sensitivity is assumed to prevail through time. The second revenue line in figure 3 is the same as the lowest solid line in figure 2 that incorporates both population growth and increasing participation rate sensitivity. The difference between the two series is attributable to the changing participation rate sensitivity. As illustrated by the bottom line in figure 3, net tax revenue falls short of the revenue that would be required to finance a constant share of real health care costs (which are assumed to grow at the population growth rate). The shortfall becomes a constant 33 percent of the upper revenue line after 56 years.

An alternative view of this shortfall is presented in figure 4. Assume that the fiveyearbudget window revenue estimate of about $11.4 billion per year will prevail into the future. The resulting horizontal revenue line in figure 4 ignores the influence of both population growth and increasing participation rate sensitivity. The middle line in figure 4 is actual tax collections (lowest solid line in figure 2) "normalized" to remove the effect of population growth, but leaving the influence of increasing participation rate

43. Figure 2 net revenue in year X is multiplied by the ratio of beforetax consumption in year X to beforetax consumption in year 1. The 505.107 billion cigarettes subject to Federal tax in year 1 grows to 806.670 billion cigarettes in year 69.

sensitivity. ⁴⁴ In effect, this is the revenue from a tax had it been instituted many years ago; that is, a tax that had been instituted many years ago would provide longterm revenue of $7.7 billion, not $11.4 billion. The difference between the two revenue lines is attributable to increasing participation rate sensitivity. One might say that the shortfall is the amount by which one would overestimate longrun revenue collections if one assumed the budgetwindow revenue estimate would prevail into the future. Again, the percentage shortfall is 15 percent after 20 years, reaches 30 percent about year 43, and becomes a constant 33 percent of the upper revenue line after year 56.

Net Budgetary Effect

Some may argue that this estimate of a longrun revenue shortfall from an indexed cigarette tax is not an important policy issue because the reduction in smoking will lead to offsetting budgetary savings as the Government's medical expenditures decline.

Several factors suggest that reduced smoking will not improve the Government's budgetary position. First, the preceding section indicates that the net external cost of smoking is less than the tax per pack. For each pack that is not smoked there is a loss of 99 cents (the tax) and a gain of 33 cents (if all external costs are borne by the Government). Thus, the net budgetary effect could be an increase in the deficit of 66 cents.

Second, the 33cent per pack gain may be received by private sources rather than the Government. In fact, it seems likely that the Federal budget currently

44. Actual revenue is normalized by multiplying figure 2 revenue in year x by the ratio of beforetax consumption in year 1 to beforetax consumption in year x.

benefits from smoking because of the Government's heavy involvement in Social Security and Medicare, whose costs appear to be reduced due to early death of smokers. In that case, reduced smoking would add to the deficit. ⁴⁵

Finally, for purposes of the narrow issue of Government budgetary costs, the appropriate discount rate should be the Government's real borrowing rate, which is typically quite low, perhaps currently in the two percent range. ⁴⁶ As demonstrated in section I, a discount rate this low generates net external savings from smoking, which means reduced smoking probably would cause an increase in net budgetary costs.

This issue should be explored more carefully. This brief discussion suggests, however, that smoking reductions induced by the proposed tax will generate reductions in Government medical expenditures that are too small to offset the associated reductions in cigarette tax revenue.

INCOME GROWTH

An important determinant of demand for any good or service is income. A "normal good" is one for which consumption tends to increase as income increases. An "inferior good" is one for which consumption decreases as income increases. This relationship is summarized as the income elasticity of a good. A normal good will have an income elasticity greater than zero; an inferior good will have an income elasticity less than zero.

Research on the demand for consumer goods suggests that both health care and cigarette consumption are normal goods for which the income elasticity of demand is more than zero but considerably less than 1.0. At the moment, this literature does not provide strong grounds for suggesting that the demand for cigarettes will grow at a slower rate than will the demand for health care in response to income growth. ⁴⁷

45. The Government/private shares of medical costs for nonelderly workers might shift under the new system, depending on how binding the percentage caps are. Under the President's proposed health care plan, mandated payments will be limited to a cap as a percentage of earnings. If these caps were binding everywhere, reductions in medical expenditures would result in smaller Government subsidies. If the caps are binding nowhere, there will be no effect. Presumably, the effects will be binding in some cases and not in others.

46. Based on the WEFA Group forecast for 1992 through 1996 (U.S. Economic Outlook, January 1994), the average real rate of interest is less than one percent for 3month Tbills and slightly over three percent for tenyear bonds.

47. See Viscusi (1992) for a summary of the cigarette literature. Wasserman, Manning, Newhouse, and Winkler (1991) estimate the income elasticity of cigarette demand at different points in time (1970 through 1985). They find a smalI negative income elasticity beginning in 1983, which if correct would generate a somewhat larger revenue shortfalI than estimated above. For a summary of the medical care literature, see Feldstein, Paul J. Health Care Economics. Albany, New York: Delmar Publishers, 1993; and Folland, Sherman, Allen C. Goodman, and Miron Stano, The Economics of Health & Health Care, New York: Macmillan Publishing Company, 1993. Feldstein provides a discussion of the estimation issues that plague the income elasticity estimates for health care and leave its "true" value in a state of uncertainty.

STATE REVENUE LOSS

As noted earlier, the States levy an average 26-cent tax on a pack of cigarettes. The 75-cent proposed Federal tax will reduce consumption of cigarettes. As a result, States will lose 26 cents on every pack of reduced cigarette consumption. ⁴⁸ These State revenue losses over time are presented in figure 2 as the dashed line at the bottom of the figure. The State revenue loss grows from $1.0 billion to about $3.6 billion over the 69 year period.

48. Aftertax consumption is 85.4 percent of beforetax consumption of 505 billion cigarettes in year 1 of the tax and 65.5 percent of beforetax consumption of 806.7 billion cigarettes in year 69.

Questions have been raised about the effect of the tobacco industry in general, and its employment in particular, if a tax equal to 42 percent of price is imposed on cigarettes. The issue of job loss from any national policy needs to be discussed from the perspectives of the national economy and the local or regional economy.

JOB LOSS AS A NATIONAL ISSUE

The Tobacco Institute combines its own estimate of reduced demand with Price Waterhouse's estimate of jobs attributable to tobacco to produce an estimate of 273,000 jobs lost from a 75-cent tax. ⁴⁹

These job loss estimates are argued to be too high. Studies by the Coalition on Smoking OR Health and Arthur Andersen indicate that almost 90 percent of the jobs attributed to the tobacco industry by the Price Waterhouse study are either indirectly related to the industry (e.g., jobs in retail trade or suppliers to the industry) or are the result of multiplier or expenditure-induced jobs. ⁵⁰ The expenditure-induced effect accounts for about two-thirds of the job loss, and is based upon an assumption that reduced compensation (factor incomes) in the tobacco industry will in turn reduce demand in other sectors. Other criticisms by these groups of the job loss estimate include: a possible overstatement of effects due to use of a linear demand curve fro tobacco; a failure to adjust the estimate for already existing declines in employment and prices; and a failure to consider exports. ⁵¹

In evaluating the jobs issue, first note that the effect of tobacco taxes on total jobs is short-run. In the long run, workers will shift to new jobs; such a tax would not affect the overall long-run unemployment rate.

Even the short-run aggregate job loss estimate is overstated because the assumption of a zero spending offset is not realistic. Money not spent on tobacco by those who quit purchasing it will be spent on other commodities.

49. Tobacco Institute, Economic Impact of the Tobacco Industry and Economic Losses Due to a 75-Cents Per Pack Tax Increase. 1993; Price Waterhouse, The Economic Impact of the Tobacco Industry on the United States in 1990. October 1992.

50. Coalition on Smoking OR Health, Tobacco, Health and Jobs: Myths and Realities (undated); Arthur Andersen Economic Consulting, Tobacco Industry Employment: A Review of the Price Waterhouse Economic Impact Report and Tobacco Institute Estimates of "Economic Losses from Increasing the Federal Excise Tax", October 6, 1993.

51. Some of these criticisms are more valid than others. The elasticities applied by the Tobacco Institute are quite modest, and there is no reason that the tax-induced decline in employment in the tobacco industry will be influenced by any secular trend already occurring. Indeed, such an existing trend would make it less likely that such contractions could be absorbed by attrition. Similarly, the fact that prices have recently fallen has no obvious implication for a tax that is still two years from imposition.

Taxes collected by the Government will be used for other purposes (lower health insurance premiums). While it is true that a tax that reduces the deficit can induce shortrun nationwide unemployment, a tax that is offset by an increase in income and spending elsewhere is unlikely to have much effect. ⁵²

JOE LOSS AS A REGIONAL ISSUE

The jobs issue is a shortrun, regional issue. In those areas of the country where tobacco growing and manufacturing are concentrated, job losses would occur . Moreover, a local multiplier effect probably exists, although whether it is as large as that suggested by Price Waterhouse is not clear. The fact that these losses largely will be offset by gains in other areas, however, does not lessen the economic significance of the issue for the affected areas.

On the other hand, if a policy is judged to be beneficial to the Nation as a whole, it ought not necessarily be abandoned simply because it produces subsets of winners and losers. It may be preferable to cushion the blow by simultaneously adopting policies to both compensate losers and smooth their transition. For example, adjustment assistance to affected workers might be offered in the form of payments and training. The remainder of this section estimates the regional job loss for the major tobaccoproducing States, to provide some idea of the possible need for, and cost of, transition assistance.

Price Waterhouse estimated an overall nationwide employment of about 160,000 in tobacco growing and auctioning and about 50,000 in manufacturing. About 93 percent of these jobs are concentrated in six states (North Carolina, Kentucky, Virginia, Tennessee, Georgia, and South Carolina), with the lion's share located in the first three.

North Carolina has 40 percent of the growing/auctioning jobs (64,000) and 43 percent of the manufacturing jobs (22,000). Kentucky has 27 percent of growing/auctioning jobs (43,000) and about 14 percent of manufacturing jobs (7,000). Virginia accounts for 7 percent of growing/auctioning jobs (12,000) and a quarter of manufacturing jobs (12,000). The remaining three States are involved mostly in growing and auctioning; each of the three has about 12,000 tobaccorelated jobs. Tobaccorelated jobs account for slightlyunder three percent of total State employment in North Carolina and slightly over three percent in Kentucky, but less than one percent in the other States.

If the tax is fully passed on in price and if all production is directed to the domestic market, the expected shortrun consumption decrease would generate about a 15 percent reduction in tobaccorelated jobs. But all production is not

52. Some small effect might result from the time needed for adjustment. These issues are discussed in U.S. Library of Congress. Congressional Research Service. Is Job Creation A Meaningful Policy Justification?, Report 92697 E by Jane G. Gravelle, Donald W. Kiefer, and Dennis Zimmerman, September 8, 1992.

directed to the domestic market, and the job loss estimate must be reduced substantially to reflect the effect of exports, which are not subject to the tax.

Data for 1992 indicate that about 45 percent of fluecured tobacco production and 32 percent of burley tobacco production are exported as leaf tobacco . In addition, 26 percent of cigarette production (which uses most of the remaining 55 percent of fluecured leaf tobacco and 68 percent of burley leaf tobacco ) is exported. These numbers suggest that exports account for 50 percent of burley tobacco production, 59 percent of fluecured tobacco production, and 26 percent of cigarette production. Weighting by jobs in manufacturing and growing, and assuming that tobacco in Kentucky is burley and tobacco in the other States is fluecured, these export effects reduce the estimated tobacco related job loss by 51 percent in North Carolina, 47 percent in Kentucky, and 38 percent in Virginia. That is, demand for tobacco workers would be expected to fall, after adjusting for export demand, by 7 percent in North Carolina, 8 percent in Kentucky, and 9 percent in Virginia.

The importance of this job loss to each State's economy depends on both the percentage change in tobaccorelated employment and tobaccorelated employment's share of total employment. Multiplying these percentages indicates that total employment would fall by about three tenths of one percent in Kentucky, about two tenths of one percent in North Carolina, and less than one tenth of one percent in Virginia. Even a large regional multiplier would be unlikely to increase any effects beyond one percent. Of course, these effects are not evenly spread across each State, and would produce larger local effects.

Two factors might reduce the effect on jobs. The first is the possibility that the tax will not be immediately passed on in price. Tobacco manufacturers who are not able to alter instantaneously their capital stock may absorb some of the tax in the short run. Second, consumers may take some time to adjust to the higher prices.

Finally, one of the best forms of transition assistance for a major policy change such as the cigarette tax increase might be to phase it in over a few years. The proposed tax does just the opposite because it is not indexed, it begins as a large tax that declines in value over time.

Selective excise taxes often are not considered desirable revenue raisers because they disproportionately burden those who use the taxed products, thereby imposing horizontal inequities (unequal taxation of those with equal income). Excise taxes also may be considered undesirable because they tend to impose a heavier share of the burden on lowerincome individuals than does the traditional source of Federal revenue, the income tax.

These equity issues have always been important in evaluating excise taxes on tobacco, and have been discussed comprehensively in a recent Congressional Budget Office study. ⁵³ These equity issues are summarized below.

Cigarette taxes are especially likely to violate horizontal equity and are among the most burdensome taxes on lowerincome individuals. ⁵⁴ Only about a quarter of adults smoke, and less than half of families have expenditures on tobacco. Tobacco is more heavily used by lowerincome families than are other commodities, and is unusual in that actual dollars (in addition to the percent of income) spent on tobacco products decline in the highest income quintile. As a result, tobacco taxes impose a burden (as a percent of income) on the lowest fifth of families that is 3.6 times the average burden and 8.0 times the burden on the highest quintile. ⁵⁵ In contrast, the income tax burden on the lowest quintile is less than onetenth the average burden. ⁵⁶ However, these concerns about distribution across incomes may be ameliorated by the benefits of the health care program, which would constitute larger proportion of the income of lowerincome individuals.

53. Congressional Budget Office, Federal Taxation of Tobacco, Beverages, and Motor Fuels, August 1990, Washington, D.C., U.S. Government Printing Office, p. 34.

54 It is probably appropriate to focus on the amount of the tax imposed in excess of spillover costs, however, in assessing horizontal equity.

55 Congressional Budget Office (1990), p. 29.

56 Congressional Budget Offices Effects of Adopting a Value Added Tax, February 1992, Washington, D.C., U.S. Government Printing Office, p. 35.

An increased cigarette tax as a method of financing health care reform appears questionable on efficiency, budgetary, and equity grounds. The most straightforward justification for linking the two--that smokers impose financial costs on nonsmokers--probably has already been corrected by existing cigarette excise taxes. The revenue from the tax will be substantial but will decline over time relative to budget-window estimates and will finance an increasingly smaller share of health care costs. The cigarette tax will fall on a small share of the population and will disproportionately burden lower-income individuals of the population compared to almost any other revenue sourse. On the other hand, the tax does have considerable popular support and would help to deter the young from becoming smokers, although stricter enforcement of restrictions against sales to minors and prohibition of smoking in areas frequented by minors might accomplish the same goal.

If the Congress is interested in exploring alternatives to cigarette tax financing, several are available. First, other taxes that possess more desirable economic effects might be considered to replace all or part of the revenues to be derived from the tobacco tax. Second, some of the spending programs in the health plan might be adjusted or eliminated, thereby making tax increases unnecessary. Third, should all or part of the tobacco tax be retained, design improvements might be considered. Finally, alternative policies to target concerns about teenage smoking are discussed.

OTHER TAX SOURCES

An alternative revenue source that comes to mind in this context is an increase in the excise tax for alcoholic beverages. As with tobacco consumption, a link exists between alcohol consumption and health (both as a result of damage due to drinking and from traffic injuries). Evidence from the Manning study suggests that, unlike tobacco, spillover effects for alcohol substantially exceed current taxes. Thus, substitution of an alcohol tax for the tobacco tax would improve economic efficiency. Alcohol taxes are also regressive, but they are less regressive than tobacco taxes. About $8.0 billion is estimated to be collected from alcohol taxes in FY 1994 (compared to $5.7 billion for tobacco), so that the current taxes would have to be increased by a smaller percentage to yield the same amount of revenue. Taxes are currently lighter on beer and wine, per ounce of alcohol, than they are on distilled spirits.

Another alternative is to increase the rates or broaden the base of the traditional main source of Federal revenue, the income tax. Either rate increases or base broadening would be progressive compared to the regressive tobacco tax, and would fall broadly on all individuals rather than on a narrow group. Thus, the income tiax might be considered a more equitable source of revenue fro a national health care system. In addition, some base broadening options would seem to be natural for health care reform because they could also

promote economic efficiency in the health care market. A prime example is employerpaid health care premiums, which under current law and under the proposed plan distort consumer choices because they are excluded from the individual's income and are deductible by the employer.

PROGRAM REDUCTIONS

The health care proposal is a very large, complicated plan, and opportunities may exist to reduce spending. In general, tax revenues collected under the plan are dispensed either in benefit increases to public health programs (such as increased drug benefits for Medicare) or in a network of subsidies woven into the plan. One subsidy would prevent mandated employer premiums from exceeding a percentage of salaries; another would help lower income individuals pay for their share of program costs.

Within this network of subsidies, the set of subsidies for small businesses might deserve particular attention. Under the proposal, small businesses will receive special subsidies for their mandated premiums, with the subsidies based on a sliding scale that moves with business size and wage income. The argument for these subsidies is essentially a transitory one-concern that the imposition of these mandated payments on smaller firms that did not already have such plans will cause unemployment. As a permanent measure, such subsidies are likely to be inefficient-favoring workers of small firms may misalocate resources and generate less economic output. Due to the transitory nature of this problem, these subsidies could be phased out over a few years. ⁵⁷

MODIFICATIONS TO A CIGARETTE TAX

If a cigarette tax is to be used owing to its feasibility, shortrun revenue generating potential, impact on smoking reduction (particularly among the young), and ease of administration, policy makers are faced with a revenue source that declines in real terms and relative to the program expenditures.

A straightforward revision would be to index the tax. While one can debate the merits of imposing a tax in the first place, if the tax is to be imposed, indexation would ensure that the tax maintains its real value. A tax that is not indexed creates shortterm disruption in the industry for a revenue source that eventually will dissipate. In addition, because the erosion in real value due to failure to index occurs slowly, an unindexed tax looks better for budgetary purposes in the short run than in the long run. Of course, indexation could be achieved by periodic revisions on an ad hoc basis, but it is difficult to see the merits of such an ad hoc system as opposed to the certainty of an indexed tax if maintenanc