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The views expressed in this paper are the author’s. They do not necessarily represent Treasury positions.
June 1996
Tom Hall, NZ Treasury
The objective of economic analysis of policy options affecting the consumption of alcohol, as in the analysis of other markets, is to understand how to maximise aggregate utility by efficiently allocating resources.
Externalities lead to an inefficient allocation of resources. Drinking alcohol is associated with negative externalities (e.g., public health costs) and positive externalities, notably reduced public health costs associated with lower incidence of coronary heart disease (CHD).
I define "net externalities" as the sum of negative and positive externalities. Marginal net externalities are increasingly negative the more alcohol is consumed. An exception to this is that the marginal net externality in the consumption range of up to about one drink daily (on average) is positive for individuals who would otherwise suffer CHD and who do not binge-drink. These individuals can also reduce their risk of CHD by other means (for example, by exercise).
Both negative and, probably, positive externalities relate to consumption of absolute alcohol, irrespective of the beverage (beer, wine, spirits).
In the presence of externalities, the uniform excise tax which maximises aggregate welfare is equal to the weighted-average across drinkers of their marginal net externalities of drinking alcohol consumption at their socially-optimal levels of consumption, the weights being the price derivatives of demand of drinkers. That is, the more a price change affects an individual’s consumption and the more a given change in his consumption affects the net externalities he generates, then the more important is that individual in the calculation of the optimal excise.
We do not have the information needed to determine what the optimal excise should be. However, we do have information which allows us to determine whether it is likely that the optimal excise is more or less than the current excise.
A conservative estimate of the annual aggregate net externality associated with alcohol consumption in New Zealand is a range of $432 million to $713 million (in March quarter 1996 absolute dollars). The alcohol excise currently raises about $570 million annually. Thus the current excise on a unit of alcohol is similar to the estimated average net externality of a unit of alcohol. To determine whether the optimal excise is likely to be higher (lower) than the current excise, we only need to determine whether the weighted-average marginal net externality at drinkers’ socially-optimal levels of consumption is likely to be higher (lower) than the average net externality at current consumption-levels. To determine this we need to know:
the distribution across drinkers of their marginal net externalities of alcohol consumption; and
the weighting to be applied to each drinkers’ marginal net externality of alcohol consumption, determined by the price elasticity of demand of drinkers.
With regard to weighting, in light of theory and most of the empirical evidence it is reasonable and indeed possibly conservative to assume that changes in consumption in response to a price change are roughly proportional to the level of alcohol consumption. Therefore the weighting to be given to the marginal net externality of heavy drinkers is far greater than to that of light drinkers.
The distribution across drinkers of their marginal net externalities of alcohol consumption is a combination of the distribution of the two elements of net externalities: marginal positive externalities and marginal negative externalities.
Those who generate a marginal positive externality by drinking are those who drink less than about one drink per day on average (the level at which additional drinking potentially reduces CHD), who would otherwise suffer from CHD and who do not binge-drink. Since these are at most 20 percent of drinkers, and since they change their absolute level of consumption very little following price changes compared with heavy drinkers, they have a very small weighting (at most about 6 percent) in the calculation of the weighted-average marginal net externality of alcohol consumption (i.e., the optimal excise). Therefore the only significant influence on the distribution of marginal net externalities is the distribution of marginal negative externalities.
Marginal negative externalities (in absolute dollars) are a convex increasing function of alcohol consumption. Further, as noted in the preceding paragraph, the large marginal negative externalities of heavy drinkers have a considerably greater weight than the small negative externalities of most light to moderate drinkers. Thus, at a given consumption level, the weighted-average marginal negative externality exceeds, probably considerably, the average negative externality.
The current rate of excise is at a level similar to the average net externality and is thus less, probably considerably, than the weighted-average marginal negative externality at current consumption levels. This means that the current excise is too low. An increase in the excise towards the weighted-average marginal net externality at the optimal consumption level, which is also more than the current excise (the comparison of tlow and t* on diagram 5 on page 27 illustrates this) will increase aggregate welfare. In short, this analysis suggests that the current excise is too low and current consumption is too high to maximise society’s welfare.
However, there are caveats to this conclusion:
  • We have almost no knowledge of what goods or services would be substituted for alcohol, if a higher excise on it were imposed: if the basket of substitutes collectively generate negative externalities, the net external benefit of reducing alcohol consumption would be diminished. However, my subjective judgement is that it is unlikely that, if other harmful goods were consumed as substitutes for alcohol, they would generate negative externalities on the scale that alcohol does;
  • More empirical research is needed to confirm (or deny) that the price derivative of demand among drinkers is roughly proportional to drinking levels. However, there is much evidence relating the price of alcohol to overall consumption and damage levels: the proportionality of the price derivative of demand to consumption levels is unlikely to be significantly incorrect; and if the excise increased, avoidance may well also increase: this, rather than the level of weighted marginal net externalities, is likely to be the binding constraint on optimal excise-increases. This is a possible argument against raising the excise, rather than in support of lowering it.
These caveats, particularly the problem of avoidance, cast doubt on the conclusion that the excise should be increased. On the other hand, the assumptions used in this paper to estimate the externalities associated with alcohol consumption are conservative: less conservative assumptions would reinforce the conclusion that, in the absence of avoidance, the excise should be increased. 
On balance, even though there is doubt that the excise should be increased, the weight of evidence clearly indicates that it should not be reduced.

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