Fixed-Rate Excise Taxes Produce Harm

Can fixed-rate taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. policies, minimum price laws, and prohibitions encourage more dangerous behavior? Yes, they can, and these ramifications have important implications for tax policy and design.

In economics, the third law of demand—sometimes referred to as the Alchian and Allen theorem—claims that adding a fixed per‑unit cost (such as a transportation cost, tax, or handling fee) to two substitute goods increases the relative consumption of the higher‑quality (higher‑priced) good.

This phenomenon was dubbed “shipping the good apples out” by a famous economics article, and the authors’ example illustrates this point well. In October 1975, a frustrated Washington resident wrote to the “Troubleshooter” column of the Seattle Times complaining that, despite Washington producing fresh, crisp apples, the ones available at the store were, “small and old-looking.”

The response by one of the authors was published in the Seattle Times a week later (and republished in their 1978 Journal of Political Economy paper). It explained how “shipping the good apples out” is a real-world example of one of the principle laws of demand:

Suppose, for example, a “good” apple costs 10 cents and a “poor” apple 5 cents locally. Then, since the decision to eat one good apple costs the same as eating two poor apples, we can say that a good apple in essence “costs” two poor apples. Two good apples cost four poor apples.

Suppose now that it costs 5 cents per apple (any apple) to ship apples East. Then, in the East, good apples will cost 15 cents each and poor ones 10 cents each. But now eating two good apples will cost three not four poor apples.

Though both prices are higher, good apples have become relatively cheaper, and a higher percentage of good apples will be consumed in the East than here.

In other words, when a fixed cost is added equally to both high‑ and low‑quality versions of a product, the relative price gap narrows, making the higher‑quality option relatively more attractive. This causes consumers in distant markets (or after the cost is applied) to choose the better-quality option more often.

Fixed-rate taxes, minimum price laws, and (exorbitantly high-tax) prohibitionist policies act in the same manner as the transportation costs that are added to shipping apples. By increasing the base price of a product, these policies disincentivize lower-quality purchases and shift consumers toward higher-quality products.

The academic research provides examples across many products. Per-mL gasoline taxes tend to lead to more consumption of premium-grade gasoline and proportionately less consumption of regular-grade gasoline. The market share of high-quality wine increases in response to unit taxes on wine, while ad valorem taxes have no significant effects. Consumers shift toward premium cigarettes when per-cigarette taxes increase. Beer drinkers move toward more premium beverages when fixed taxes and beer transportation costs increase. Illicit vaping products tend to be larger and contain more nicotine.

Considering consumer substitution in the face of tax and regulatory changes is important, particularly when excise taxes are intended to improve health.

In the apples example, quality was defined. There were “good” apples and “poor” apples. In the broad marketplace, beauty is in the eye of the beholder. Quality is defined by the individual. Tastes differ. We can group some common quality preferences into broad categories, however. Intentional aging adds quality to wines, spirits, meats, and cheeses. Select vintages produced during excellent growing periods yield higher quality products.

For the purposes of public health and excise taxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. policy, one important measure of quality is potency. Researchers found that quality substitution in cigarette markets led consumers to pick products with greater concentrations of tar and nicotine.

Perhaps the greatest product changes occur in illicit markets, where the fixed costs of operation are greatest. During alcohol Prohibition, alcohol potency increased substantially. Illicit producers switched toward producing very high concentration spirits, prominently “moonshine,” that they sold to consumers. Illicit markets today are no different: highly concentrated products are ubiquitous.

Because higher taxes drive consumers to illicit markets, this isn’t only an issue for the extreme examples of tax policy. Even marginal increases to tariffs and tax rates can fuel illicit market activity, as can market subset prohibitions like flavor bans.

As products become more potent and consumption slides away from moderation to excess, the hazards of consumption increase. Consumption becomes more dangerous for consumers, bystanders, and sometimes producers.

Quality‑substitution response is a well-documented empirical phenomenon. Fixed per‑unit costs narrow relative price gaps and encourage movement up the quality (and often potency) ladder, as evidenced in the cases of premium gasoline, high‑quality wine, concentrated spirits during Prohibition, and the escalation of potency in today’s illicit drug markets. For public health, this is especially concerning. When potency becomes the dimension along which consumers “upgrade,” the risks of harm increase.

These outcomes underscore a critical point for tax policy and regulatory design. Excise taxes and minimum price rules are frequently adopted with the intent of reducing harm, curbing excessive consumption, or discouraging dangerous behaviors. Yet, without attention to how consumers substitute between products, these well‑meaning policies may exacerbate the very harm they aim to prevent. In markets where potency is synonymous with danger, the unintended consequence of shifting consumption toward more concentrated products can be severe.

Designing effective excise tax policies requires understanding how individuals respond when costs rise uniformly across product categories, and how those responses vary when “quality” aligns with increased health and safety risks. Policymakers who overlook these substitution effects risk repeating the mistakes of past prohibitions—encouraging more hazardous consumption patterns despite stricter controls.

Fixed‑rate taxes and prohibitionist approaches should be crafted with care. Without nuance, they can push consumers away from moderation and toward excess, transforming policies intended for public benefit into drivers of unintended harm.