Vice Squad
Sunday, October 26, 2003
 
Tax Revenues as a Benefit of Vice Legalization


Yesterday I gave a "sample class" on the Regulation of Vice to parents of
students at the University of Chicago. Things seemed to be going smoothly
enough until I hit a snag in discussing tax revenues from legalized vice. I'll
try to recap and clarify here.

Vice policy debates, I claim, differ from other sorts of policy discussions in the
prominence of the three and one-third vice concerns of kids, addicts,
externalities, and (the one-third component) harms to adult, non-addicted
consumers (or producers). While prominent, however, the three and one-
third concerns are by no means the only influences on vice policy. Workplace
productivity effects are also commonly brought up in vice policy argumentation --
I think in general incorrectly (though they are partially accounted for in the
one-third concern of harms to non-addicted adult consumers, as I hope my
previous post (linked above) makes clear.)

What about the argument that the legalization of drugs or prostitution (see today's
earlier post), say, would bring with it a large benefit in the form of tax revenues
for the government? I think that this contention is not entirely correct, or at least,
it requires some explication. It is true that a legalized vice can generate significant
tax revenues, as the cases of alcohol, tobacco, and gambling abundantly illustrate.
(For instance, the Bureau of Alcohol, Tobacco, and Firearms collected $13.5 billion in
fiscal year 2000 from alcohol and tobacco excise taxes.) The problem is that on a
first-cut analysis, these revenues do not represent a net social benefit, as they are
paid for by consumers. In other words, the tax revenues are simply a transfer from
vice consumers to the government (or to the beneficiaries of the programs that the
government pays for with the revenues). If the government shows up at my door
and demands an additional $100 in tax revenue from me, there is no direct social
gain -- I am out $100, and the government is up $100. It is a wash in terms of the
size of the pie (absent any other info, at least), though the size of individual slices
has changed.

I think that there are two further considerations that can be quite important,
however. First is that the black market for illicit vice can operate rather like
a taxation system, but a clumsy one. All of the precautions that I have to take
to consume my illicit vice, all of the sneaking around, etc., essentially raises the
price of the good to me, but without being received as revenue by anyone
else. Legalization could keep the effective price of the vice to consumers the
same, but by replacing the clumsy tax (which just wastes resources) with a
standard one (that gains revenue), there can be a social gain -- measured
essentially by the size of the tax revenues. (By keeping the effective price the
same, consumers are indifferent between the clumsy tax and the legal one; but
the government (or its beneficiaries) gains by the extent of the revenues.) For this
reason, the argument that a vice ban is widely evaded really is a good argument for
legalization: the more the clumsy tax is being paid by evading the ban, the greater
the potential gain in replacing the clumsy tax with an equivalent legal one. (And if
the taxes really are equivalent, consumption of the vice will stay the same, too.) An
article that develops this argument with respect to the minimum drinking age is
Donald S. Kenkel, "Prohibition Versus Taxation: Reconsidering the Legal Drinking Age."
Contemporary Policy Issues 11:48-57, 1993.

Incidentally, the more efficient the underground market, the smaller the clumsy
evasion tax. So, organized crime and corruption can undermine the incentive
to legalize a vice! At the same time, though, the fact that organized crime is
collecting what looks a lot like a tax will motivate some to suggest that the
government could collect it just as easily, with better social consequences. On
this point and the more general argument, see pages 45-47 of my book,
The Political Economy of Rule Evasion and Policy Reform.

The second complication about tax revenues is that they are only a wash in
terms of social benefits if the tax itself is not correcting for some market distortion.
But to the extent that decisions to consume potentially addictive products are marked
by some degree of short-sightedness, however, the tax could help correct for this
distortion. It could even be the case that consumers of a potentially addictive good
are made better off by a higher tax on the good, as the tax helps them to bolster their
self-control. For a development of this argument and some empirical evidence, see
this paper by Jonathan Gruber and Sendhil Mullainathan.

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