Cigarette Taxation and Demand: An Empirical Model

This paper evaluates the impact of taxation on cigarette consumption, using a recursive model that includes a retail price equation and a dynamic demand equation. The analysis is based on panel data for 11 western states over the period 1967–1990. Results indicate that cigarette consumption is price‐sensitive, with a demand elasticity of –0.40 in the short run and –0.48 in the long run. A tax increase, such as that imposed in California in January 1989, can have a strong effect of reducing cigarette consumption by between 11.2 percent in the short run and 13.4 percent in the long run. These results support the theory of rational addiction and the hypothesis that, as a part of their oligopoly behavior, the tobacco companies often do raise end‐market prices by more than the amount of the increase in tax rates .