Incentives matter: tax file

From Carpe Diem comes this example of how taxes affect incentives.

TAMPA - Last spring, the cigar industry fretted that the government might tax so-called "little cigars" into oblivion. Several months later, though, it appears the makers of cigarette-shaped little cigars have found a way to escape the high taxes. The cigar makers have added more weight to their cigars, reclassified them as large cigars and now are subject to a lower tax rate, said Norman Sharp, president of the Cigar Association of America.Under the new tax rates, little cigars and large cigars are taxed differently, which apparently has given rise to some major changes in cigar production. For example, factories in the United States and Puerto Rico produced about 743 million large cigars in August, according to data from the U.S. Department of the Treasury. That's up 85 percent from August 2008, when they made 402 million large cigars (see chart above).

Meanwhile, production of little cigars plummeted. In August, factories in the United States and Puerto Rico produced about 145 million little cigars, down from about 480 million little cigars in August 2008. Cigars made outside of the United States and Puerto Rico saw a similar rise in large cigar production and decline in production of little cigars (see chart).

What's going on? Sharp, the cigar association president, said it appears cigar makers changed their production techniques to factor in the SCHIP tax. Cigar makers began adding enough extra weight to their little cigars so they exceeded the 3-pounds-per-1,000 threshold. So they could be classified now as large cigars.

The economic lessons from this are: If you tax something you get less of it and taxes are always distortionary, because taxpayers will change their behaviour in a effect to avoid or minimise the taxes. In other words taxes affect incentives. A possible exception incentive effect is a lump-sum tax.