This blog summarises research undertaken by Dr Martin O’Connell, currently a British Academy Postdoctoral Fellow, with co-authors Professor Rachel Griffith and Kate Smith.
Governments have long used taxation to correct for the socially costly overconsumption of alcohol. These social costs include those associated with alcohol related crime and road accidents, as well as the public health care costs of treating alcohol related disease. Economists often refer to these social costs as externalities – as they are costs associated with an action that are borne by others. Pigou (1920) noted that by setting a tax equal to the incremental social costs of an additional unit of consumption, it is possible to fully correct for the externality – the rise in price the tax causes is just enough to make people account for the full costs of their actions. The Pigouvian idea is deceptively simple, but potentially difficult to implement in reality.
Pigou studied a stylised setting where people are identical, so a single tax rate can perfectly correct for the externality. Diamond (1973) studied optimal corrective taxes when there is variation in consumption patterns and externalities. Ideally, we want each consumer to face a price increase equal to the incremental social costs associated with his consumption. However, when the externality created by an additional unit of consumption varies across people, a single tax rate can no longer fully correct for externalities. The price increase caused by the tax will be too high for some consumers (those that create little social harm) and too low for others (those that create large externalities).
There is much evidence to suggest that the externalities from alcohol consumption do vary considerably across drinkers. A heavy drinker on his umpteenth beer of the evening is more likely to have a larger negative effect on other people than a light drinker on his first. In the US, only 7% of the population are frequent binge drinkers, but they account for around 75% of the costs of excessive alcohol use (Centers for Disease Control and Prevention (2016)). This means that we are in Diamond’s world, in which tax policy is not able to fully correct for the social harms of drinking.
In this setting, Diamond’s suggestion is to set an alcohol tax rate equal to the average incremental social harm across drinkers. However, in a recent paper, we show that it is possible to improve on this optimal single rate by varying tax rates across alcohol products (Griffith, O’Connell and Smith (2017)). Although the externality is generated by consumption of ethanol (pure alcohol), ethanol comes in a variety of products and people may value these products differently. If consumers’ tastes for products are related to the externalities their ethanol consumption creates, this provides scope for product specific tax rates to improve welfare, relative to a single rate applied to all ethanol.
To see why, consider a simple example in which there are two types of consumer: heavy drinkers and light drinkers, and two products: beer and wine. For heavy drinkers the social costs created by the final drink in an evening is high and they only drink wine. The light drinkers create no externality and they drink only beer. Ideally both types would face a tax equal to the incremental cost of their drinking. The best single tax rate that is applied to both beer and wine is equal to the average of these costs across the two types of drinker. However, we can do better than this by setting a high tax rate on wine, and a zero tax rate on beer: this targets the excess alcohol consumption of the heavy drinkers, while leaving unaffected the alcohol consumption of the lightest drinkers. We show that this intuition generalises to a more realistic setting in which there are many alcohol products bought by consumers with different tastes.
Our analysis shows both drinking patterns and how willing people are to switch across products varies across people depending on how heavily they drink. In particular, heavier drinkers respond differently to price changes, compared with lighter drinkers. Following an increase in the price of an alcohol product, the heaviest drinkers are more than three times as likely to switch to another alcohol product, rather than to not buying alcohol at all, than the lightest drinking households.
This willingness to switch between alcohol products means that the heaviest drinking households’ demand for ethanol is less price responsive than lighter drinking households. Households that consistently buy fewer than 7 portions of ethanol per adult per week reduce their ethanol demand by more than 2% in response to a 1% increase in the price of all alcohol products, but households that consistently buy more than 35 portions per adult per week reduce their ethanol demand by only 0.7%.
This variation in tastes for different products and price responsiveness across heavy and light drinkers provide scope to improve welfare by varying tax rates across products. To compute optimal tax rates we use our estimates of consumer choice in the alcohol market along with evidence from the medical literature on how social costs of drinking vary with how much one drinks.
Our analysis show that, by moving to a system of optimal taxes that vary across 18 different types of alcohol (and that involves higher taxes on high-strength spirits, and bringing the taxes on cider in line with those on beer), the government can improve welfare by more than a billion pounds per year, relative to the current UK system.
Dr Martin O’Connell is a British Academy Postdoctoral Fellow.
Centers for Disease Control and Prevention (2016). CDC - Data and Maps - Alcohol. http: //www.cdc.gov/alcohol/data-stats.htm.
Diamond, P. A. (1973). Consumption externalities and corrective imperfect pricing. The Bell Journal of Economics 4(2), 526-538.
Griffith R., O’Connell M. and Smith K. (2017). Design of optimal corrective taxes in the alcohol market. CEPR Discussion Paper 11820.
Pigou, A. C. (1920). The Economics of Welfare. McMillan&Co., London.
The views expressed by our authors on the British Academy blog are not necessarily endorsed by Academy, but are commended as contributing to public debate.