An old and important idea in economics is that certain socially harmful behaviours can be dealt with not through bans or regulation but through the price mechanism. By taxing so-called “negative externalities”, we can rely on prices and consumer choice to balance the harms and benefits of things like pollution, traffic congestion and carbon emissions.
And so it is with smoking. It’s bad for people’s health and imposes costs on our healthcare system. But we also want to respect people’s choices. And prohibition doesn’t work. So a “Pigouvian” tax on tobacco is the right public policy response.
The tricky part is getting the level right. Set it too low, and one doesn’t balance the harms and benefits. Set it too high, and one encourages a black market in illicit cigarettes.
That’s exactly what has happened in Australia over the last decade. Motivated by a toxic combination of overzealous public health advocates who were convinced that a higher tax rate would reduce smoking and successive governments who were (sorry) addicted to excise revenue, the rate was pushed up relentlessly.
It led to more smoking, not less, a collapse in government revenues, and the entrenchment of some truly unsavoury criminal elements in our country.
We’re now in a situation where organised crime holds a seemingly impregnable position in the tobacco market. Enforcement isn’t feasible. The simple but counterintuitive answer to this problem is this. Cut the excise to zero. At least for a while.
But first, here’s how the policy debacle unfolded.
Excise was about 26¢ per stick until a one-off 25 per cent increase took effect on April 30, 2010.
Then there were eight consecutive annual increases of 12.5 per cent, in addition to inflation indexation, beginning in December 2013 and running through September 2020. After a two-year pause, there were three more 5 per cent increases from September 2023 to September 2025. So here we are, with the current excise standing at $1.53 per stick. The excise alone on a pack of 20 is more than $30.
Now, if there were no illicit cigarettes, then smoking (at least ignoring vapes) would surely have declined. But the massive increase in excise invited bad actors to bring illegal, untaxed, unregulated cigarettes into the country. They’re sold in so many outlets – in plain sight mind you – that police can’t stop the sale of illicit ciggies. Cops will tell you, quite rightly, that they have more important things to do than play whack-a-mole – shutting down one of thousands of hole-in-the-wall shops selling illicit smokes only to see others pop up down the road.
In a remarkable piece of statistical detective work, the Australian Bureau of Statistics has documented exactly what the market response to the excise increases has been.
By looking at the amount of nicotine metabolite in wastewater from 60 treatment plants across the country and matching this to data from sources such as supermarket scanner data and ATO tax data the ABS was able to tease apart the size of the legal and illicit tobacco markets.
What the ABS found is truly shocking. It reported that:
- “The quantity of nicotine consumed in Australia increased by almost 40 per cent from 2017 to 2025, with most of the increase occurring since 2021.” That compares to population growth of just 14 per cent.
- “Consumption from illicit sources as a share of total tobacco consumed rose from 12 per cent in 2017 to 80 per cent in 2025.”
- “Prices for legal tobacco products have almost tripled since December 2016 driven by annual tobacco excise increases, while estimated prices of illicit tobacco products have remained relatively constant.”
This is both horrifying and entirely predictable. It’s a public policy error of staggering proportions, and it raises the hard question of what to do. The answer may surprise you.
The short-term answer is to cut the tobacco excise to zero. Here’s why.
The right way to think about tobacco is as a “market with network externalities”. The canonical examples of such markets are two-sided platforms such as Uber and Amazon. But tobacco has important similarities.
In an academic paper published in Management Science Robert Akerlof, Luis Rayo and I provided a formal framework for thinking about how these markets work. A market with a network externality is one in which more total purchases in the market make buying more attractive. That’s easy to see with Uber. More riders make becoming a driver more attractive, leading to shorter waiting times and thus more riders. In illicit tobacco, increased total sales breaks a taboo, which means that enforcement becomes harder, making buying illegal smokes – which are way cheaper than legal ones – more attractive.
The key insight about how markets with network externalities work is that firms compete differently from firms in regular markets. In regular markets– like supermarkets or banking – firms compete for the marginal consumer. In markets with network externalities firms (or types of firms) compete for the dominant market share – a large block of consumers all at once.
This almost perfectly explains illicit tobacco in Australia. Illicit smokes went from 12 per cent of the market in 2017 to 80 per cent in 2025 by virtue of being able to undercut legal cigarettes on price. This was thanks to the fact that legal smokes have a $ 30-a-pack price disadvantage due to excise.
But a small cut in excise won’t reverse this trend now that the illicit market is entrenched. Marginal changes to relative prices won’t do the trick. We have to shift the entire equilibrium by rewinding the clock to 2016.
The way to do this is to cut the excise to zero. That way, it’s actually legal tobacco that has a price advantage. Illicit tobacco requires evading detection at the border, plus nasty and expensive enforcement tactics like threatening to firebomb outlets that won’t sell their product. Faced with zero excise, the illegal guys can’t compete and will be forced out of the market.
That’s how we undo the colossal policy error of the last decade. After that, we can at least start over and consider how to have a sustainable excise that addresses public health concerns and raises a little money.
Extracted in full from: https://www.afr.com/politics/federal/the-counterintuitive-fix-for-our-30-a-pack-policy-disaster-20260621-p608s9
