Tobacco taxes and the Laffer Curve

Back in 2011, I mentioned that the Irish Office of Revenue Commissioners had suspected a Laffer Curve at work in the country's tobacco taxation policy. In Laffer's curve, revenue increases as the rate of tax increases but only up to a certain point after which further tax rises lead to lower revenues as a result of people avoiding the tax.

After reading that a third of British smokers buy their tobacco from 'non-shop sources' I decided to see if Laffer was in action over here. The ONS's tobacco bulletin is a rich source of information on taxes and sales. This is how many million cigarettes have been sold each year since 1997. Note the impact of the Great Booze Cruise Epidemic of 1999.

Despite the fall in consumption, the Treasury has generally been keeping its head above water although there has been a decline in the last two years which suggests a Laffer effect.

Again, you will notice the impact of the Smokers On Tour 1999 bootlegging/smuggling/personal supply mission which so annoyed ASH off at the time. It was later brought somewhat under control by giving people recommended personal allowances and clamping down on white van man. It also led to the government ditching the tobacco duty escalator for most of the next decade, only to revive it when the economy went down the plughole in 2008. It's quite clear from the graph when Alistair Darling raised tobacco duty. George Osborne has done likewise, as well as increasing the rate of VAT. Revenues went up but, despite further above-inflation tax rises in 2013 and 2014, they have since fallen.

What this graph doesn't show is the effect of inflation, so I got the figures showing the total tax on a packet of Benson and Hedges from the Tobacco Manufacturers' Association and adjusted them for inflation. I also adjusted the total tobacco duty revenue figures for inflation. If we combine the figures from 2007 onwards, putting them in 2015 prices, what we see is a classic Laffer Curve.

Today, the rate of tax is £6.83, which seems to be about a pound more than is optimal for generating revenue. The difference is not trivial. The government is getting more than a billion pounds less, in real terms, than it was getting in 2010 and 2011.

You could argue that if the whole point of tobacco duty is to get people to stop smoking then the loss of revenue is a sign that the policy is working. But is that the reason revenue is falling? Look again at the top graph and you will see that the decline in cigarette sales has been suspiciously sharp since 2009, from 49 billion to 33 billion cigarettes. That is a drop of 33 per cent. In the same period adult smoking prevalence has dropped by much less, from 21 per cent to 19 per cent (ie. a drop of 10 per cent) and there has been non-trivial population growth to partially offset it.

Some of the decline can be explained by people switching to roll-your-own tobacco and some of it can be explained by the emergence of e-cigarettes. But still, a drop of 33 per cent in five years? It's not difficult to see the invisible hand of the black market at work.