Vapor products, harm reduction, and taxation: More questions than answers for a young and dynamic product market

Eric Fruits —  3 October 2018 — 2 Comments

ICLE has released a white paper entitled Vapor products, harm reduction, and taxation: Principles, evidence and a research agenda, authored by ICLE Chief Economist, Eric Fruits.

More than 20 countries have introduced taxation on e-cigarettes and other vapor products. In the United States, several states and local jurisdictions have enacted e-cigarette taxes.

The concept of tobacco harm reduction began in 1976 when Michael Russell, a psychiatrist and lecturer at the Addiction Research Unit of Maudsley Hospital in London, wrote: “People smoke for nicotine but they die from the tar.”  Russell hypothesized that reducing the ratio of tar to nicotine could be the key to safer smoking.

Since then, much of the harm from smoking has been well-established as caused almost exclusively by toxicants released through the combustion of tobacco. Public Health England and the American Cancer Society have concluded non-combustible tobacco products as well as pure nicotine products are considerably less harmful than combustible products. Earlier this year, the American Cancer Society shifted its position on e-cigarettes, recommending that individuals who do not quit smoking, “… should be encouraged to switch to the least harmful form of tobacco product possible; switching to the exclusive use of e-cigarettes is preferable to continuing to smoke combustible products.”

In contrast, some public health advocates urge a precautionary approach in which the introduction and sale of e-cigarettes be limited or halted until the products are demonstrably safe.

Policymakers face a wide range of strategies regarding the taxation of vapor products. On the one hand, principles of harm reduction suggest vapor products should face no taxes or low taxes relative to conventional cigarettes, to guide consumers toward a safer alternative to smoking. the U.K. House of Commons Science and Technology Committee concludes:

The level of taxation on smoking-related products should directly correspond to the health risks that they present, to encourage less harmful consumption. Applying that logic, e-cigarettes should remain the least-taxed and conventional cigarettes the most, with heat-not-burn products falling between the two.

In contrast, the precautionary principle as well as principles of tax equity point toward the taxation of vapor products at rates similar to conventional cigarettes.

Analysis of tax policy issues is complicated by divergent—and sometimes obscured—intentions of such policies. Some policymakers claim that the objective of taxing nicotine products is to reduce nicotine consumption. Other policymakers indicate the objective is to raise revenues to support government spending. Often missed in the policy discussion is the effect of fiscal policies on innovation and the development and commercialization of harm-reducing products. Also, often missed are the consequences for current consumers of nicotine products, including smokers seeking to quit using harmful conventional cigarettes.

Policy decisions regarding taxation of vapor products should take into account both long-term fiscal effects, as well as broader economic and welfare effects. These effects might (or might not) suggest very different tax policies to those that have been enacted or are under consideration.

Apart from being a significant source of revenue, the cigarette taxes have been promoted as “sin” taxes to discourage consumption either because of externalities caused by smoking (increased costs for third-party health payers and health consequences) or paternalism. According to Centers for Disease Control and Prevention in U.S., smoking-related illness in the U.S. costs more than $300 billion each year, including; (1) nearly $170 billion for direct medical care for adults and (2) more than $156 billion in lost productivity, including $5.6 billion in lost productivity due to secondhand smoke exposure.

The CDC’s cost estimates raise important questions regarding who bears the burden of smoking related illness. Much of the cost is borne by private insurance, which charges steeper premiums for customers who smoke. In addition, the CDC estimates reflect costs imposed by people who have smoked for decades—many of whom have now quit. A proper accounting of the costs vis-à-vis tax policy would measure the incremental discounted costs imposed by today’s smokers.

According to Levy et al. (2017), a strategy of replacing cigarette smoking with e-cigarettes would yield substantial life year gains, even under pessimistic assumptions regarding cessation, initiation, and relative harm. Increased longevity does not simply extend the individual’s years of retirement and reliance on government transfers but has impact on greater work effort and productivity together with higher tax payments on consumption.

Vapor products that cause less direct harm or have lower externalities (e.g., the absence of “second hand smoke”) should be subject to a lower “sin” tax. A cost-benefit analysis of the desired excise tax rate on vapor products would include reduced health spending as an offset against excise tax revenue that was foregone by putting a lesser rate on those products.

State and local governments in the U.S. collect more than $18 billion a year in tobacco taxes. While some jurisdictions earmark a portion of tobacco taxes for prevention and cessation efforts, in practice most tobacco taxes are treated by policymakers as general revenues to be spent in whatever way the legislative body determines.

In the long-run, the goals of reducing or eliminating consumption of the taxed good and generating revenues are in conflict. If the tax is successful in reducing consumption, it falls short in generating revenue. Similarly, if the tax succeeds in generating revenues, it falls short in reducing or eliminating consumption.

Substitutability is another consideration. An increase in the tax on spirits will result in an increase in beer and wine purchases. A high toll on a road will divert traffic to untolled streets that may not be designed for increased traffic volumes. Evidence from the U.S. and Europe indicate high or rising tobacco taxes in one jurisdiction will result in increased sales in bordering jurisdictions as well as increase illegal cross-jurisdiction sales or smuggling.

As of March 2018, nine U.S. states have enacted taxes on e-cigarettes:

California 65.08% on wholesale price
Delaware 0.05 USD/ml
DC 70% on wholesale price
Kansas 0.05 USD/ml
Louisiana 0.05 USD/ml
Minnesota 95% of wholesale price
North Carolina 0.05 USD/ml
Pennsylvania 40% of wholesaler price
West Virginia 0.075 USD/ml

In addition, 22 countries outside of the U.S. have introduced taxation on e-cigarettes.

The effects of different types of taxation on usage and thus economic outcomes varies. Research to date finds a wide range of own price and cross price elasticities for e-cigarettes. While most researchers conclude that the demand for e-cigarettes is more elastic than the demand for combustible cigarettes, some studies find inelastic demand and some studies find highly elastic demand. Economic theory would point to e-cigarettes as a substitute for combustible cigarettes. Some empirical research supports this hypothesis, while others conclude the two products are complements.

In addition to e-cigarettes, little cigars and smokeless tobacco are also potential substitutes for cigarettes. The results from Zheng, et al. (2016) suggest increases in sales of little cigars and smokeless tobacco products would account for about 14 percent of the decline in cigarette sales associated with a hypothetical 10 percent increase in the price of cigarettes. On the other hand, another study using a seemingly identical data set (Zheng, et al., 2017), suggests that sales of little cigars and smokeless tobacco would decrease in the face of an increase in cigarette prices.

The wide range of estimated elasticities calls into question the reliability of published estimates. As a nascent area of research, the policy debate would benefit from additional research that involves larger samples with better statistical power, reflects the dynamic nature of this relatively new product category, and accounts for the wide variety of vapor products.

More importantly, demand and supply conditions for e-cigarettes, heated tobacco products and other electronic nicotine delivery products have been changing rapidly over the past few years—and are expected for rapidly change into the foreseeable future. Thus, estimates of demand parameters, such as elasticity and cross-price elasticity estimates, are almost certain to vary over time as users gain knowledge and experience and as products and suppliers enter the market.

Because the market for e-cigarettes and other vapor products is small and developing, the tax bearing capacity of these new product segments are untested and unknown. Moreover, current tax levels and prices could be also misleading based on the relatively sparse empirical data, in which case more data points and evaluation is needed. One can argue, given the slow growth rates of these segments in many markets, that current prices of e-cigarettes and heat-not-burn products are relatively high when compared to cigarettes and a tax or an increase on existing tax would slow down the segment growth or even lead to a decline.

Separately, the challenges in assessing a tax on electronic nicotine delivery products indicate the costs of collecting the tax, especially an excise tax, may be much higher than similar taxes levied on combustible cigarettes. In addition, as discussed above, heavy taxation of this relatively new industry would likely stifle innovation in a way that is contrary to the goal harm reduction.

Principles of harm reduction recognize that every proposal has uncertain outcomes as well as potential spillovers and unforeseen consequences. Nevertheless, the basic principle of harm reduction is a focus on safer rather than safe. Policymakers must make their decisions weighing the expected benefits and expected costs. With such high risks and costs associated with cigarette and other combustible use, taxes and regulations must be developed in an environment of uncertainty and with an eye toward a net reduction in harm, rather than an unattainable goal of zero harm.

Read the full report.

Eric Fruits

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Eric Fruits, Ph.D. is Chief Economist at the International Center for Law & Economics and Economics International Corp. He is the Oregon Association of Realtors Faculty Fellow at Portland State University. He has written peer-reviewed articles on initial public offerings (IPOs), the municipal bond market, real estate markets, and the formation and operation of cartels. His economic analysis has been widely cited and has been published in The Economist and the Wall Street Journal. Dr. Fruits is an antitrust expert who has written articles on price fixing and cartels for the top-tier Journal of Law and Economics. He has assisted in the review of several mergers including Sysco-US Foods, Exxon-Mobil, BP-Arco, and Nestle-Ralston. He has worked on many antitrust lawsuits, including Weyerhaeuser v. Ross-Simmons, a predatory bidding case that was ultimately decided by the United States Supreme Court. As an expert in statistics, he has provided expert opinions and testimony regarding market manipulation, real estate transactions, profit projections, agricultural commodities, and war crimes allegations. His expert testimony has been submitted to state courts, federal courts, and an international court.

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