**Box 3**

# **Taxing Alcohol and Tobacco in the United Kingdom: The Uses and Limits of the Economic Approach**

The recent ‘Mirrlees Report’ (Institute for Fiscal Studies 2011) in the UK provides an excellent example of the uses and limits of the economic approach to designing excise taxes on alcohol and tobacco. In the UK, such taxes are not unimportant, accounting for about 3.5 percent of tax revenue and a bit over 1 percent of GDP. The rationale for these taxes and their appropriate level and design are considered in detail in one of the staff reports (Crawford, Keen and Smith 2010, hereafter CKS), underlying the Mirrlees Report. While, as CKS (2010, p. 354) stress, it is unlikely that estimates from one country can be carried over without modification to another country or that externalities – which are affected both by institutional arrangements and cultural contexts – are uniform across countries, the main conclusions reached by CKS after a thorough review of the recent theoretical and empirical literature on the structure and effects of taxing tobacco and alcohol are as follows:

- The key factor relevant to the revenue‐raising efficiency of product taxes (the OTR approach) is not their own‐price elasticity – the focus of the revenue‐maximization approach (RMTR) mentioned in the present paper – but rather how complementary or substitutable they are with leisure. Since the best empirical studies of the relation between tobacco and alcohol consumption and the labor/leisure choice so far carried out in developed countries suggest that this relation is complex and unclear, there is no compelling case for above‐average taxation of these products in terms of efficiency.

- In contrast, a good case can be made for externality‐correcting taxation of tobacco and ‘abusive’ alcohol consumption.  Identifying, measuring and determining the correct level of such taxation with respect to tobacco is a complex issue that requires resolving such difficult and often controversial issues as the location and significance of the boundary between internalized and external costs, the treatment of costs borne by family members, the treatment of healthcare costs when partly financed by publicly funded care, and the correct way to deal with effects on wages and productivity.  Much the same issues arise with respect to designing excises on alcohol with the additional complication that most abuses in this case arise from excessive consumption and the marginal external cost may well be very different from the average.   Nonetheless, particularly when such behavioral issues as time inconsistency and lack of self‐control are considered, CKS conclude that some ‘extra’ taxation of these products is likely justified on externality grounds but that existing research does not provide any clear guidance as to the appropriate level of such taxation.

- Finally, with respect to specific vs. _ad valorem_ taxation of ‘sin’ taxes, CKS note that once again the choice is difficult because it depends importantly on the structure of consumer preferences and on market structure – both matters about which we seldom have adequate information to permit fine‐tuned conclusions.  However, on the whole they conclude that the advantages of specific taxes in terms of administrative simplicity, more stable revenues, and being more closely targeted to the externality to be corrected likely outweigh the advantages of _ad valorem_ taxes in terms of distributional impact and dealing with monopolistic suppliers.

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