The Failure of Pigou's Taxes

Once upon a time, economist Arthur C. Pigou proposed that by imposing taxes upon things that might create excess social costs, those costs could be reduced.

Called a "Pigovian Tax", a classic example of this kind of tax in action would be the special excise taxes that many states impose upon tobacco products, where the excess social costs might be the increased spending for health care to deal with smoking-related ailments.

Here, if Pigou's taxes really work, we should see the consumption of tobacco products fall as the taxes imposed on them are raised substantially enough to affect the purchasing decisions of those who might consume them.

Let's use the state of Hawaii as a case study here, because Hawaii has been greatly increasing their taxes on tobacco products over the last several years. Here, the typical excise tax imposed by the upon a pack of cigarettes has increased from $1.00 in 2000 to $3.20 per pack in 2011, with 60% of that increase having taken place since 2008. During that same time, the federal excise tax on tobacco has increased from $0.34 per pack to $1.01 per pack, and the typical retail price of a pack of cigarettes in Hawaii has risen from $4.05 in 2000 to $9.27 in 2011.

But unlike every other state in the U.S., Hawaiians can't just jump in their cars and make a quick run for the border for the sake of buying bootleg tobacco products to avoid their state's very high tobacco taxes, which has risen to now rank fourth in the nation, behind only New York, Rhode Island and Connecticut.

That means that if Pigovian taxes can really work to significantly reduce the consumption of tobacco products anywhere, they're going to work in the islands in the middle of the Pacific Ocean that make up the state of Hawaii.

We've tapped the state's most recently issued report on its tax revenue collections from its excise tax on tobacco products for each of its fiscal years from 2000 through 2011. We then used that data, along with the state's tax on each 20-count pack of cigarettes, to calculate the equivalent quantity of packs of cigarettes consumed in the state for each of those years.

Our chart below reveals what we found:

Here, we see that the consumption of tobacco products actually rose in every year from 2000 through 2005, before beginning to fall in the years from 2005 through 2009.

But we see that 2009 really marked a bottom in consumption - the consumption of tobacco products has bounced back in 2010 from that low point and has held steady 2011, despite the state continuing to increase its taxes on tobacco products in each of those years.

What this data indicates is that whatever benefits that Pigovian taxes might be able to provide have diminishing returns. Past a certain point, they will fail to achieve their objectives of meaningfully reducing the excess social costs for the ails they are meant to fix. Instead, these kinds of taxes would appear to simply become a vehicle by which politicians may raise tax revenue by imposing a discriminatory tax policy aimed at an "undesirable" minority.

This outcome is quite different from what we anticipated might happen when we last looked at Hawaii's taxes on tobacco. We're definitely surprised.

References

State of Hawaii. Department of the Attorney General. Report on the Tobacco Enforcement Special Fund. Fiscal Year 2010-2011. [PDF document]. 9 January 2012.