Smoke and Mirrors
By Sam Wylie
Fall 1999

The States are the $200 billion winners from the tobacco settlement, so who are the big losers?

When the tobacco settlement was signed in December 1998, it was portrayed as a massive transfer of wealth from the large tobacco companies to the States. But in reality the agreement amounts to a lump sum annual tax on the tobacco industry.

The agreement stipulates, among other things, minimum annual payments to the States by the four large tobacco companies: Brown & Williamson, Lorillard Tobacco, Phillip Morris and R.J. Reynolds. The States get $205 billion by 2025 and then at least $9 billion per year in perpetuity. The tax is essentially collected by the tobacco companies and handed to the States, but who really pays the tax? How much of the burden of the tax is on the producers of cigarettes, and how much is born by consumers?

Because smoking is a habit so hard to kick, demand for cigarettes is highly inelastic - meaning that large price changes induce only small changes in the quantity demanded. Equivalently, only large price increases (decreases) will shrink (stretch) demand because the demand is inelastic to price changes. Social factors and education are often significant determinants of which people start smoking, but for those who do smoke the number of cigarettes smoked is not highly sensitive to price.

When a tax is imposed or increased, its burden falls on those consumers or producers who cannot move to a substitute product to avoid the tax. For consumers that means that there is no substitute product that becomes more attractive relative to the newly taxed product that can be consumed instead. For producers it means that the resources used in producing the product cannot easily be deployed in the production of something else.

Recall that the availability of substitutes determines the steepness of the demand curves of consumers or the supply curves of producers (steep curves are inelastic). Cigarette demand is inelastic because nothing else is a close substitute for cigarettes. The supply of landing spots at an airport is inelastic because if the price of landing slots falls, Logan airport cannot easily start producing something else with its runways and terminal buildings.

The point is that inelasticity and the burden of tax go hand in hand. If demand is elastic and supply inelastic (hotels rooms at a vacation resort) then the burden of a tax falls on the producers. In this case most of the revenue from a new tax comes out of the hotel's producer surplus. Alternatively, if the demand is inelastic and the supply is elastic (the cigarette industry) the burden of a new tax falls very largely on the consumers, with most of the tax revenue coming out of consumer surplus.

The diagrams here illustrate the idea. Diagram 1 shows the demand curve for tobacco companies before the imposition of the tax. The price that consumers pay, $2 per packet, is the price that the producers receive (ignoring distribution costs) for the 15 billion packs consumed. There is a single price - the price per pack that consumers pay is the revenue per pack that producers receive. Consumer surplus, producer surplus + fixed cost, and variable cost are shown as different areas.

No supply curve is drawn for the tobacco producers because the big producers have market power through their brands. They are price seekers, not price takers, so a supply curve does not make sense. They each set the price of their own brand to maximize their individual producer surplus (economic profits). For simplicity assume that all the producers set the same price so that there is a single industry price.

Diagram 2 illustrates supply and demand after the tax has been imposed. The payments from tobacco companies to the States, required by the settlement, amount to the difference between the price paid by consumers and the price received by tobacco companies, times the number of cigarettes sold. That area is shown as 'payment to States' in diagram 2. Essentially, the effect of the payments is to increase fixed costs for the tobacco producers (the settlement payments). As a result, prices are raised and consumption falls -- but not by that much.

Diagram 3 illustrates the change in surplus resulting from the settlement. Most of the tax comes out of consumer surplus. The producers lose much less surplus. The deadweight loss is the sum of the consumer surplus and the producer surplus that is not transferred to the States, it is simply destroyed by the tax.

Given that a fixed amount of tax must be collected, the deadweight loss is not as great as it otherwise would be if the demand curve was less steep. This is a general principal. Taxes on goods for which demand is inelastic (gas, tobacco, alcohol, or a poll tax - a flat tax on all living persons) destroy less consumer surplus. We should note that the total loss of surplus to society will be less than the deadweight loss if the States invest the tax proceeds in projects that have positive net present value.

The aggregate market capitalization of the largest tobacco companies has fallen a great deal since the settlement was signed. Those falls can be largely attributed to further setbacks regarding litigation from private individuals and the Federal Government. Much of the agreement was anticipated by the stock market and therefore already incorporated in tobacco company stock prices. In any case, the burden of the agreement with the States will fall largely on smokers.