eThesis - Kauppakorkeakoulun sähköiset gradut

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The primary objective of this thesis is to explore whether time-inconsistency in preferences affects the optimal level of cigarette taxation. The traditional view is that only the externalities of smoking should be considered when setting the cigarette tax level, as smokers are assumed to fully internalize the costs to themselves when making the decision to smoke.

The underlying questions concern the existence of self-control problems among smokers resulting in overconsumption of cigarettes, and the ability of taxation to correct these distortions. Related topics considered include the price-elasticity of cigarettes, the distinctive properties of cigarette taxation, private market solutions to self-control problems, and the distributional effects of cigarette tax increases.

The study is conducted as a literature review. Studies from the fields of behavioral economics, health economics, public economics and psychology are reviewed, examined and compared. Existing cigarette tax levels are evaluated in relation with the results from the literature.

Although estimating exact costs of smoking and optimal cigarette tax levels is extremely difficult, it can be stated with certainty that self-control problems (and consequently the internal costs of smoking) should be considered when setting cigarette taxes. Taxes act as a self-control device, reducing the overconsumption caused by self-control problems.

Empirical evidence supports time-inconsistency in preferences. Although it is unclear exactly how severe the tendency to pursue immediate gratification is in relation to smoking decisions, calibrations show that even small levels of self-control problems imply very large optimal tax levels because of the enormous costs of smoking to the smoker herself.

The self-control function most benefits low-income individuals, young individuals, and individuals in developing countries, as they have a relatively high price-elasticity of smoking. This fact also reduces the regressiveness of cigarette taxes. It may even, under realistic conditions, make them progressive. Market solutions to self-control problems are unlikely to be as effective as taxation, as firms are unable to force smokers into reducing the consumption of cigarettes.

If the existence of self-control problems is accepted - as it should be in the light of existing empirical evidence - cigarette tax levels are currently too low despite having been raised considerably in the past decade. The well-being of smokers and the society as a whole can be increased by raising cigarette taxes further.