Is Smoking a Positive Fiscal Externality?

In this post, I will examine the question of whether smoking is a positive fiscal externality in the UK. A person’s fiscal contribution is equal to the total taxes she pays minus the total public money that is spent on her during her lifetime. If taking-up smoking leads to an increase in the average person’s fiscal contribution, then smoking is a positive fiscal externality; if taking-up smoking leads to a decrease in her fiscal contribution, then it is a negative externality. Smoking affects a person’s fiscal contribution in a number of ways: it affects her income taxes (via its impact on her productivity in the labour market), it affects her consumption taxes, it affects her healthcare expenses, and it affects her pension contributions and benefits. In addition, it may affect other people’s fiscal contributions via passive smoking.

Cigarettes are subject to very high tax rates in the U.K. Taxes account for 77% of the price of a pack of premium cigarettes and more than 90% of the price of a pack of cheap cigarettes (TMA, 2013a). Comparatively, VAT accounts for only 20% of the price of most consumer goods. Indeed, one of the main arguments for taxing cigarettes at such high rates is that smoking is an externality under the NHS (e.g., Reed, 2010). In particular, because the NHS is funded by the taxpayer and smoking increases a person’s lifetime healthcare expenses (or so it is assumed), someone who smokes is externalising the costs of his behaviour onto the taxpayer, and should therefore be taxed. In order to evaluate this argument and answer the more general question with which I began, I will briefly review the literature on the fiscal impact of smoking. My conclusion will be that smoking probably is a positive fiscal externality. This implies that efforts to curb smoking are likely to bring down tax revenues and push up public spending.

One effect of smoking is to reduce a person’s productivity in the labour market. Smokers may call in sick more often, take more cigarette breaks, or simply work less efficiently. What matters is whether taking-up smoking leads to a decrease in a person’s lifetime taxable output. If every smoker would earn substantially more during her lifetime if she didn’t smoke, then smoking reduces income tax revenues, all else being equal. However, it is possible that unobserved factors causing people to smoke make them less productive in the workplace, meaning that smokers wouldn’t be any more productive if they didn’t smoke. Furthermore, since in many professions output does not accumulate uniformly over time, a smoker’s cigarette breaks do not necessarily represent a loss of production. Sloan et al. (2004, p.255) attempt to estimate the external cost of smoking on worker productivity in the U.S, yet they calculate total wages lost (a partly private cost), rather than total income tax revenues lost. Using cohort data from Finland, Tiihonen et al. (2012) estimate a loss in income tax revenues due to smoking of €12,700 per smoker.

Another effect of smoking is to alter a person’s lifetime healthcare expenses. Although smoking increases the risk of some diseases that are expensive to treat (e.g., lung cancer), it reduces life expectancy and thereby lowers health expenditures at advanced ages. Consequently, it is not clear prima facie whether taking-up smoking increases or decreases a person’s lifetime healthcare expenses. Overall, the empirical literature on this question is quite mixed; some studies find that smokers’ lifetime healthcare expenses are higher than those of non-smokers, while others find that they are lower. However, more of the recent studies do seem to find that smokers incur lower lifetime healthcare expenses.

One reason to suspect that smokers incur lower lifetime healthcare expenses is that, counter to intuition, prophylactic medicine tends to increase healthcare costs. In a review paper, Cohen et al. (2008) obtained cost-effectiveness ratios of various medical interventions from 599 articles published between 2000 and 2005, and found that the great majority of preventative interventions were not cost-saving. Cohen et al.’s conclusions are reiterated by Russell (2009), Rappange et al. (2009) and Temple (2011). As Russell puts it, “Over the last four decades since cost-effectiveness analysis was first applied to health and medicine, hundreds of studies have shown that prevention usually adds to medical costs instead of reducing them.” Considering the healthcare costs of smoking itself, some early studies find that smokers’ lifetime healthcare expenses are higher than non-smokers’ (Hodgson, 1992; Miller et al., 1999), but others find that they are lower (Lippiat, 1990; Barendregt et al., 1997). Among more recent studies, Rasmussen et al. (2004) find that smokers’ incur higher lifetime healthcare expenses, whereas Van Baal et al. (2008) find the opposite. Two recent prospective studies, one conducted in Japan and one in Finland, both document lower lifetime healthcare expenses among smokers (Hayashida et al., 2010; Tiihonen et al., 2012).

Smoking affects not only a person’s healthcare expenses but also her pension contributions and benefits. Studies find that taking-up smoking reduces the total benefits a person receives to a much greater extent than it reduces the total contributions she makes. Because smokers tend to die younger than non-smokers, they receive pension benefits for fewer years. Indeed, from the perspective of the state pension system, the ideal situation is for a person to work as productively as possible during her lifetime and then to die immediately upon reaching retirement. That way, she pays into the system throughout her working life, but does not take anything from the system once she has retired. Sloan et al. estimate that, in the U.S., female smokers put in around $1,500 more to Social Security than they get out, while male smokers put in around $6,500 more than they get out (p.153). Tiihonen et al. estimate that, in Finland, smokers receive approximately €127,000 less in after-tax pension benefits than non-smokers. However, they do not differentiate between payouts from private pensions and those from the state pension.

Although taking-up smoking reduces the amount of income tax a person pays, it increases the amount of consumption tax he pays. A simple back-of-the-envelope calculation yields the amount of tax revenue that smoking generates per smoker. The U.K. government takes in about £6 in tax revenue each time a pack of 20 cigarettes is purchased (TMA, 2013b). Under the conservative assumption that the average smoker consumes 10 cigarettes per day, he pays approximately £1,100 in cigarette taxes every year. Assuming that if he didn’t smoke he would spend his money on goods taxed at only 20%, the government collects about £840 more in taxes from him than it would do if he didn’t smoke. Over a lifetime of smoking (i.e., 50 years), this adds up to an additional £42,000 in consumption taxes; assuming he smokes 20 cigarettes a day, the figure is closer to £84,000. Note that eliminating smoking from society lowers consumption tax revenues because (under reasonable assumptions) it is equivalent to reducing the average rate of consumption tax.

There have been a number of attempts to gauge the overall fiscal impact of smoking. Although the literature is, again, somewhat mixed, the evidence seems to suggest that smoking has a positive fiscal impact. Manning et al. (1989) estimate that, in the U.S., smokers confer an external benefit on society of $1 per pack at a zero discount rate, but confer an external cost of $0.15 per pack at a 5% discount rate. They conclude that “smokers probably pay their way at the current level of excise taxes on cigarettes”. Viscussi (1995) also analyses data from the U.S., and estimates that smokers save society $0.1–0.5 per pack, which translates into $900–4,600 over the lifetime of a smoker consuming 10 cigarettes per day. On the other hand, Sloan et al. estimate the external cost of smoking to be $1.44 per pack, which translates into $13,100 over a smoker’s lifetime (p.255).

An unpublished report produced by the U.K. government, which was leaked to The Guardian in 1980, estimated that a public anti-smoking campaign would cause a substantial fall in tax revenues and a substantial rise in pension outlays (Phillips, 1980; Temple, 2010). A report produced by Arthur D. Little for the Czech government in 2001, which was commissioned by Philip Morris, estimated that smoking has a moderate positive impact on public finances in the Czech Republic (Philip Morris, 2000; Tiihonen et al., 2012). Given that the report was commissioned by a tobacco company, its findings should obviously be interpreted with a fair amount of scepticism. Yang et al. (2011) estimate that smoking confers net costs on the Chinese economy, yet they do not attempt to quantify any of the potential benefits of smoking. Finally, Tiihonen et al. estimate that, in Finland, the average smoker’s fiscal contribution is around €133,000 greater than the average non-smoker’s.

In conclusion, the weight of the evidence suggests that smoking is a positive fiscal externality. Smokers pay less in income taxes than non-smokers, yet pay considerably more in consumption taxes. Their lifetime healthcare costs are probably slightly lower than those of non-smokers. And they take far less from the pension system than non-smokers, relative to what they pay in. There are several important caveats to my conclusion. First, it is tentative. At least one major study, namely Sloan et al., reaches the opposite conclusion. Second, it may only apply to the U.K. (and other similar countries), where healthcare and pensions are largely financed by the state, and taxes on cigarettes are very high. Third, as many authors have noted, the fact that smoking may have a positive fiscal impact does not imply that efforts to curtail smoking reduce social welfare. Indeed, if each QALY is assumed to be worth €14,600, then Tiihonen et al.’s finding reverses, and smoking becomes a net cost for society.

- Barendregt, J. et al. (1997). The health care costs of smoking. NEJM, 337:1052-1057.

- Bonneux, L. et al. (1998). Preventing fatal diseases increases healthcare costs: cause elimination life table approach. BMJ, 316:26-29.

- Cohen, J. (2008). Does preventative care save money? Health economics and the presidential candidates. NEJM, 358:661-663.

- Hayashida, K. et al. (2010). Difference in lifetime medical expenses between male smokers and non-smokers. Health Policy, 94:84-89.

- Hodgson, T. (1992). Cigarette smoking and lifetime medical expenditures. The Milbank Quarterly, 70:81- 125.

- Sloan, F. et al. (2004). Price of Smoking. MIT Press, Cambridge, MA.

- Lippiat, B. (1990). Measuring medical cost and life expectancy impacts of changes in cigarette sales. Preventative Medicine, 19:515-532.

- Manning, W. et al. (1989). The taxes of sin: do smokers and drinkers pay their way? JAMA, 261:1604-1609.

- Miller, V. et al. (1999). Smoking-attributable medical care costs in the USA. Social Science and Medicine, 48:375-391.

- Phillips, M. (1980). Why smoking, not health, wins the day: governments have failed to mount a public campaign against smoking. The Guardian, May 6th.

- Philip Morris. (2000). Public finance balance of smoking in the Czech Republic. Philip Morris CR.

- Rappange, D. et al. (2009). Lifestyle intervention: from cost savings to value for money. Journal of Public Health, 32:440-447.

- Rasmussen, S. et al. (2004). The total lifetime costs of smoking. European Journal of Public Health, 14:95- 100.

- Reed, H. (2010). The effects of increasing tobacco taxation: a cost benefit and public finances analysis. Action on Smoking and Health.

- Russell, L. (2009). Preventing chronic disease: an important investment but don’t count on cost savings. Health Affairs, 28:42-45.

- Temple, N. (2010). Governments, pay for smoking cessation. CMAJ, 182:1761-1762.

- Temple, N. (2011). Why prevention can increase healthcare spending. European Journal of Public Health, 22:618-619.

- Tiihonen, J. et al. (2012). The net effect of smoking on healthcare and welfare costs. A cohort study. BMJ Open, 2:1-5.

- TMA. (2013a). Tobacco taxation briefing. Tobacco Manufacturers Association.

- TMA. (2013b). UK cigarette prices. Tobacco Manufacturers Association.

- Van Baal, P. et al. (2008). Lifetime medical costs of obesity: prevention no cure for increasing health expenditure. PLOS Medicine, 5:e29.

- Viscussi, W. (1995). Cigarette taxes and the social consequences of smoking. Tax Policy and the Economy, 9:51-101.

- Yang, L. et al. (2011). Economic costs attributable to smoking in China: update and an 8-year comparison, 2000-2008. Tobacco Control, 20:266-272.


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Noah Carl

About Noah Carl

Noah is a doctoral candidate in Sociology at the University of Oxford. He was born and grew up in Cambridge, England. He received a BA in Human Sciences and an MSc in Sociology from the University of Oxford. His research focuses on the correlates of beliefs and attitudes.

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