Laffer curve sighted in Ireland

Earlier this year, Ireland’s Office of Revenue Commissioners made a shock discovery, albeit one which sounds slightly dull when put in the language of economics. They found that the price elasticity of cigarettes in Ireland is -3.6, which is to say that a 10% increase in price reduces sales by 36%. This came as a surprise because cigarettes—being notoriously addictive—are usually thought to have a consumption elasticity of less than -1.0, whereas a price elasticity of -3.6 implies that smokers are more price sensitive than people who buy jewellery, DVDs and toothpicks. This struck them as rather counterintuitive, to say the least.

Something was clearly up, and what had been going up was smuggling. Since 2002, the price of cigarettes has risen by 40% in real terms to 8.55 euros a pack and the black market has swollen accordingly. The -3.6 price elasticity figure only took into account legal sales, which have indeed declined significantly. The number of people smoking, however, has not. Smuggled snouts and privately imported baccy have made up the difference.

This is all as you might expect. The thin blue line of customs and excise officers is easily breached once prices in one part of Europe leap far ahead of prices elsewhere. Britain has had a similar experience, with more than half of all rolling tobacco being sold on the black market. None of this comes as a surprise to anyone, except possibly Deborah Arnott of the anti-smoking pressure group Action on Smoking and Health, who wrote in The Guardian in February that disparities in tobacco duty do not lead to smuggling and called for Britain to hike its ciggie taxes still higher.

My reason for mentioning this is not to point out the unintended consequences of sin taxes, but to report a rare sighting of a Laffer curve in a government document. While those on the left continue to debate its existence, Ireland’s Revenue Commissioners are taking the Laffer curve more seriously. They are candid enough to note that “cigarettes remain a sizeable source of exchequer funding. While it may be desirable from a public health perspective to abolish smoking, the €1bn in excise revenue from tobacco would be a significant loss from the fiscal perspective.” As such, they would like to maximise tax revenue and Arthur Laffer might have the answer:

Laffer suggests there may be an optimum tax rate that maximises tax revenue (the peak of the Laffer curve), moving either direction (higher or lower taxes) from that peak will lower revenue.

It seems likely that a Laffer type effect exists in the cigarette market in Ireland and the current level of taxation may be beyond the optimum. Therefore higher tax rates (higher prices) will lead to lower tax revenue.

They even provided a graph which shows a classic Laffer curve:

There are plenty of arguments for and against high cigarette taxes. Some say that the government has a moral obligation to deter unhealthy pursuits while others think it is morally objectionable to exploit inelastic behaviour, ie. addiction. Leaving the ethical debate to one side, it cannot be denied that governments do receive significant sums of money from tobacco taxes and have done for many years. As Ireland’s customs wonks have now realised, this golden goose has reached the limit of how many eggs it can lay. Smokers, like drinkers, traditionally take a hit when economies tank, but governments in the highest taxing nations—including the UK—may have to start taking Arthur Laffer more seriously if they want to protect their income.