The Case for Economics When Considering Alcohol Tax Levels

“It’s time to raise the alcohol tax,” declared Vox author German Lopez back in December.

Now let me state upfront that I am not confident I know what the correct tax rate on alcohol should be. Lopez may well be right about their being a rational case on economic grounds for an increase based on high-quality, robust analysis. But his article does not make a reasoned case satisfactorily, nor does it link to such analysis.

In fact, it came to my attention as I was finalizing my new paper “How Market Failure Arguments Lead to Misguided Policy” (released today). And I’m convinced his piece is a classic of the genre. This article aims to highlight some of the key objections I have to his approach, which is increasingly common in public debate.

The traditional economic case for alcohol taxation

Libertarian theory aside, the classic case for taxing alcohol will be familiar to those with basic economic knowledge. Alcohol consumption is believed to impose, on net, external costs on people other than drinkers themselves.

When deciding whether to drink, individuals are thought to only consider the balance of private costs (the money it costs to drink, the hangover, the risk of disease or accidents for them etc) and the private benefits of consumption (the confidence, the enjoyment of the taste, the benefits to them of socializing etc).

But clearly, alcohol consumption can have external effects. The costs of alcohol-related crime and driving under the influence are borne by others. There may be net external costs relating to health care, too, given alcohol-related diseases and incidents could necessitate higher taxpayer subsidies or insurance premiums (though, applying such logic consistently, one would have to net off any “savings” that alcohol consumption might deliver in terms of lower Social Security and Medicare payments from reduced longevity).

The economic case for a tax then is this: if we observe net external costs associated with alcohol consumption, then allowing a free market would lead to higher levels of consumption than optimal. If a tax can be imposed that equates roughly to the marginal external costs of consumption, then drinkers are faced with a price reflective of the true costs of their actions.

Due to the “Law of Demand,” the amount of alcohol consumption will fall to the level at which marginal social costs equate to marginal benefits as this tax is imposed. Some of the negative external costs will occur less often, as will some of the private costs. Society as a whole will be better off because the tax means prices now reflect the true cost to society of the product’s consumption.

In order to make the case for a hike in alcohol taxes then, Lopez simply needed to present clear evidence that current tax rates on alcohol are too low to account fully for the external costs of consumption we see. His line of reasoning does not make this case.

1.   Ignoring the benefits and costs framework

Lopez presents good evidence that higher alcohol prices reduce demand for alcohol (as one would expect). It stands to reason then that reduced alcohol consumption will mean fewer alcohol-related deaths and the other negative consequences outlined above.

But he does not seem to acknowledge that alcohol consumption has benefits too. He highlights how excessive drinking causes anywhere between 88,000 and 100,000 deaths per year as a reason to increase taxation, for example. Yet he never acknowledges that alcohol consumption (at least for most drinkers) brings satisfaction, hence why we drink.

Looking purely at the number of alcohol related deaths tells us little about the desirability of taxation on alcohol per se, because it is not clear how many deaths are rational decisions by well-informed individuals to “live for today,” as opposed to deaths resulting from “external costs” of alcohol consumption.

A newer literature embedded in behavioral economics squares this circle by arguing that heavy drinkers are not truly fulfilling their true lifetime preferences when they consume (because of hyperbolic discounting or other irrationalities). But that is not the argument Lopez makes, and nor would we expect this to be the case for all heavy alcohol consumers.

The traditional market failure framework recognizes that allowing people to decide what to consume enhances their welfare, provided that any third-party costs are accounted for. Lopez, on the other hand, sets out reducing deaths from alcohol as an aim in itself – unlinked to any acknowledgement of benefits. He assures us that significantly reducing alcohol-related deaths “doesn’t require prohibition.” But the logic of focusing on just deaths and ignoring pleasure is that we should indeed aim for zero consumption.

By implicitly presuming we all really want to be life-expectancy maximizing, he goes far beyond the market failure framework of dealing with externalities.

2.   Conflating private costs with external costs

Indeed, the traditional case for taxing alcohol is about pricing in external costs – costs imposed on others. Lopez cites a Centers for Disease Control and Prevention study that estimates the economic costs of excessive drinking in the U.S. as totaling $249 billion in 2010, or $2.05 a drink. Implicitly reaching for “externality” arguments, Lopez notes how this figure includes the costs of “crime, drunk driving, health problems, and more,” pitching this tax as a way of accounting for the externalities imposed on casual drinkers and teetotalers by heavy drinkers.

But an examination of the CDC reports shows the major cost to the economy comes not from these external costs, but from “a reduction in workplace productivity,” which accounts for a massive $179 billion of the total.

This, overwhelmingly, is a private cost and not an external cost. If individuals’ alcohol consumption affects their work performance, or their human capital accumulation, or the length of their working life, the vast proportion of that cost would ultimately be borne by the individual themselves through worse employment prospects and lower wages.

Some people may simply prefer a work-life balance where they stay out later to socialize and drink regularly, rather than maximizing at-work productivity. Using the CDC estimates as a proxy for the external costs of alcohol consumption would therefore lead to a tax rate far too high to deal with genuine external effects.

It is certainly true that some part of “worse productivity” would hurt the individual’s employer or the ultimate consumers of goods and services produced by heavy-drinking workers. Lost productivity could also be considered at least partially an external cost in that lower wages or worse employment prospects may reduce an individual’s net tax contribution. If this necessitates higher tax contributions from other taxpayers to maintain government revenues, there is a clear fiscal third-party effect.

But applying such reasoning consistently would profoundly change the scope of economic policymaking. Many decisions throughout our lives affect our measured productivity, pecuniary rewards, and net tax contributions. Implicitly assuming a baseline in which all individuals maximize measured productivity and net fiscal contributions, and considering deviations from this to be a market failure, would be an absurd principle.

Taking time off to have children or to care for a sick relative, staying up late to watch TV regularly and being tired at work, or choosing not to invest in one’s own human capital, might all have similar effects. This is to say nothing of career choices. Opting to become a French teacher or a public-interest lawyer, even when the opportunity exists for one to be a Wall Street trader, means people clearly do not always make decisions to maximize their net tax contributions.

Singling out the productivity effects of alcohol consumption as a unique externality in need of correction, when every day individuals make decisions that affect their productive potential and, indirectly, their net tax contributions, would be unworkable, arbitrary, and wrong.

3.   Arbitrarily comparing alcohol taxes today with the past

One piece of evidence Lopez cites in support of raising the alcohol tax is that taxes on alcohol “were one-sixth to one-third of their inflation-adjusted value in the early 2010s compared to the 1950s.”

This may offer insight into affordability, but it is irrelevant for what alcohol tax rates should be as justified by economics. The economic rationale here is not to reduce consumption to some level or hit any other arbitrary target for outcomes. It is to price in the external costs associated with marginal alcohol consumption, and then allow consumers to decide how much to drink according to their own preferences when faced with the full social costs of their actions.

It’s perfectly plausible that these external costs change over time. And even if they do not, Lopez presents no evidence that the 1950s tax rates were levels which accurately reflected external costs.

4.   Ignoring the implications of heterogeneity between consumers

Lopez rightly acknowledges that key opposition to increasing alcohol taxes arises because individuals who regard themselves as “responsible drinkers” will resent paying more because of the costs primarily imposed by heavy drinkers. He responds by reassuring us that most of the tax (in terms of revenue collected) would be borne by the higher-risk drinkers, simply because they drink more.

But this is in part because, as the academic literature suggests, heavy drinkers are far less responsive to price changes than non-heavy drinkers. A review of the literature by Jon P. Nelson of Pennsylvania State University found that only two 2 of 19 studies on the consumption behavior of heavy drinkers found “a significant and substantial negative price response.”

If we are to make the assumption that heavy drinkers are responsible for most of the external costs of alcohol consumption, then raising the tax on alcohol will deter consumption for exactly the wrong group. Pricing according to some aggregate calculation to find the “marginal” external costs across the whole population could actually worsen economic efficiency. The tax would be too low for heavy drinkers, but way too high for casual drinkers.

Conclusion

Standard economics, which considers the external costs of alcohol consumption, makes a strong a priori case for government action to “price in” these costs. But German Lopez’s article does not get us any closer to understanding what the correct way of accounting for these effects is. And if taxation, his analysis does not help us ascertain what the tax rate should be.