Read this chapter to learn how the government provides goods and services in the economy to alleviate problems of the market system.
Smokers impose tremendous costs on themselves. Based solely on the degree to which smoking shortens their life expectancy, the cost per pack of cigarettes is estimated to be $35.64. That cost, of course, is a private cost. In addition to that private cost, smokers impose costs on others. Those external costs come in three ways. First, they increase health care costs and thus increase health insurance premiums. Second, smoking causes fires that destroy property. Third, other people die each year as a result of secondhand smoke. Various estimates of these external costs put them at about $.40 per pack. If a tax were to be based solely on external effects, one would also need to recognize that smokers also generate external benefits. They contribute to retirement programs and to Social Security and then die sooner than nonsmokers. They thus subsidize the retirement programs of the rest of the population. So from the perspective of externalities, the optimal tax would be less than $.40 per pack.
Cigarette taxes, though, are much higher than that. Should they be? Is that fair? One rationale is simply that "sin" taxes are a source of government revenue. Economists Jonathan Gruber and Botond Koszegi suggest something else - that an excise tax on cigarettes of as much as $4.76 per pack may actually improve the welfare of smokers. Smokers, they argue, are "time-inconsistent". Lacking self-control or willpower, they seek the immediate gratification of a cigarette and then regret their decisions later. Higher taxes would serve to reduce the quantity of cigarettes demanded and thus reduce behavior smokers would otherwise regret. Their argument is that smokers impose "internalities" on themselves and that higher taxes would reduce this.
Where does this lead us? If smokers are "rationally addicted" to smoking (i.e., they have weighed the benefits and costs of smoking and have chosen to smoke), then the only program for public policy is to design a tax that takes into account the net external costs of smoking. Current excise taxes on cigarettes seem to more than accomplish that. But if the decision to smoke is an irrational one, welfare may be improved by higher excise taxes on smoking.
In a study titled, "Do Cigarette Taxes Make Smokers Happier," Gruber and Sendhil Mullainathan used self-reported happiness measures and variations in cigarette excise taxes across states to see the effect of excise taxes on happiness of people who have a propensity to smoke. They found that people with a propensity to smoke were significantly happier with higher cigarette excise taxes. This finding, they argue, is more consistent with a model based on bounded willpower and time inconsistency than one based on rational addiction.