Fixed-rate excise taxes are frequently implemented to lower consumption or steer the public away from harmful habits. However, economic principles suggest that when a flat fee is added to products of varying quality, it can actually encourage people to choose the more “potent” or high-end versions of those goods.
The Alchian and Allen Effect
This phenomenon is known in economics as the Third Law of Demand (or the Alchian and Allen theorem). It describes how adding a fixed cost—like a tax or shipping fee—to two competing products narrows the relative price difference between them.
A classic example involves Washington apples:
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At the Orchard: A premium apple might cost 10 cents and a standard apple 5 cents. The premium apple is twice as expensive.
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With Shipping: If it costs 5 cents to ship any apple to the East Coast, the prices become 15 cents and 10 cents.
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The Result: Now, the premium apple is only 1.5 times as expensive. Because the “upgrade” feels cheaper relative to the total cost, consumers are more likely to buy the high-quality fruit. This is why the “best apples” are often shipped away, leaving the lower-quality ones for the locals.
From Apples to Public Health
While “shipping the good apples out” is harmless, the same logic applies to regulated goods like fuel, alcohol, and tobacco. When a flat tax is applied per unit, consumers often gravitate toward “upgraded” versions:
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Fuel: Higher per-gallon taxes often lead to an increase in premium gasoline sales.
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Alcohol: During the Prohibition era, the “quality” people sought was potency. Because it was risky and expensive to transport illicit goods, smugglers focused on highly concentrated spirits (like moonshine) rather than beer or wine, leading to more dangerous consumption patterns.
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Tobacco & Vaping: Flat taxes on cigarettes often push smokers toward brands with higher nicotine or tar content to “get more” for the same tax price.
The Danger of Unintended Consequences
This “quality substitution” poses a significant challenge for public health policy. If a tax is meant to reduce harm, but it accidentally pushes consumers toward more concentrated or potent substances, it may worsen the very problems it was intended to solve.
As taxes rise or prohibitions are enacted, the “fixed cost” of obtaining the product—whether that cost is a literal tax or the risk of getting caught—encourages the market to provide the most potent version possible.
Rethinking Tax Design
To be effective, excise taxes must be designed with an understanding of human behavior. Policymakers should consider:
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Ad Valorem vs. Fixed Taxes: Percentage-based taxes (ad valorem) don’t shrink the price gap between low and high quality in the same way fixed taxes do.
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Substitution Risks: Acknowledging that consumers won’t just quit; they will often “move up the ladder” to higher-potency products.
Without careful planning, well-intentioned taxes can transform a goal of moderation into a driver of excess.