Cigarette Taxes and the Third Law of Demand

Abstract

Alchian and Allen's "Third Law of Demand" (1967) states that as a fixed cost increases by the same amount for low - and high-quality goods, the ratio of the prices of high - to low-quality goods will fall and the quantity demanded of high quality goods relative to low quality goods will increase. Barzel (1976) notes that the incidence of state cigarette taxes seem to be passed forward to smokers by more than 100%, suggesting that the quality composition of cigarettes in the market becomes more heavily weighted by high quality cigarettes as state taxes rise, as predicted by the Third Law. We examine Barzel's hypothesis using data from the contiguous 48 states and the District of Columbia from 1970-2010, examining the effects of state tax changes, federal tax changes and the Master Settlement Agreement on the degree to which state taxes are passed forward to smokers.

Keywords: Tax Incidence, Cigarettes, Fiscal Federalism, Master Settlement Agreement, Third Law of Demand

JEL Classification: H22, H71, H73