Friday 19 June 2009

Correcting the BERL report part 3: Alcohol Production Costs

After yesterday's marathon post summing up our adjustments to BERL's costs of lost output, this one will be pretty quick and easy. We now take on the costs of resources "diverted" to harmful alcohol consumption.

BERL says that half of the alcohol consumed in New Zealand is consumed by harmful drinkers (one Kiwi adult in six). Recall that BERL's threshold for harmful drinking is less than two pints of beer for men (two glasses of wine for women) per day on average. At that point, they say not only that all consumption is irrational but that it also provides zero benefits: not just for additional consumption, but also for all prior harmless consumption. So they count as costs half of all spending on alcohol in New Zealand, less GST.

Ganesh Nana has argued that differences between our analysis and his come down to differences in world view and that we're too willing to assume rationality when it comes to harmful drinking. But BERL does more than just step outside of the rational addiction model: they drive gross benefits down to zero for all consumption, including all below-the-threshold consumption, the instant your consumption exceeds their epidemiological threshold.

Reasonable people can argue about the extent to which the rational addiction model holds. But a reasonable application of a non-rational addiction model wouldn't assume zero benefits as soon as the two pint per day threshold were crossed: instead, it would say that once some threshold were crossed, benefits would be exceeded slightly by costs and that the difference between the two would increase the farther from the threshold you went until asymptotically reaching zero at some point far out on the consumption axis.

Instead, BERL threw in a step function that I cannot believe is consistent with any plausible utility function: prior to the threshold, benefits at least equal costs; after the threshold, benefits don't just equal zero, they're sufficiently negative to precisely offset all of the gross benefits from any prior consumption. Now, I've conducted an unscientific poll of members of the Department of Economics here at Canterbury. Half of those providing a response say you can't build a utility function that has these characteristics. The other half say that believing any model consistent with those characteristics would itself be evidence of the irrationality of the model's author. The best utility function (in my view) of the ones we've come up with has a discontinuity at the harmful threshold that jumps down towards negative infinity for the epsilonth unit after the threshold but then jumps back up to zero for all subsequent units. Or, in discrete terms, benefits are positive and match costs up to the 40th gram of alcohol for men; the 41st gram has very large negative benefits that just offset all of the benefits from the prior 40 grams, and then consumption from the 42nd gram onwards provides zero benefits. Fortunately, I don't believe this model.

And Ganesh thinks we're the ones with the strange world view? I don't think so.

So, half of all alcohol consumed is consumed by harmful drinkers and so BERL counts half of all household expenditure on alcohol, net of GST, as pure waste.

There are two big problems with this, even leaving aside where they set the threshold.

First, BERL's headline cost figures includes excise taxes paid to the government. Yes, you read that correctly. While these taxes are certainly a private cost to the drinkers, they're also an external benefit to the government. But these tax revenues are never netted out from BERL's headline costs of harmful drinking, though they're discussed in a separate tabulation of costs to government (more on that later). The headline costs of harmful drinking, according to BERL, include half of all excise taxes paid to the government. And then Geoffrey Palmer finds fault with New Zealand's excise tax regime because excise taxes are so much less than BERL's measure of the social costs of harmful drinking which include half of all excise tax revenues.

It's a rigged game folks. Increase the excise tax, and the social costs of drinking increase by half of the amount of the increase in collected taxes. BERL had to have known this when Palmer was commenting on the social costs of alcohol and they, to the best of my knowledge, did nothing to correct things. I took an early swing at the report back in April, then chided BERL in discussions over at The Visible Hand blog for not protesting Palmer's use of its report. I hadn't at that point caught that tax revenues were in there as a cost, but BERL would have known. Adrian Slack, principal author of the report, commenting in a personal capacity, replied
First in response to “BERL should have made the LC very aware of…”. We didn’t prepare the report for their consumption. As with anything that enters the public domain, it is the consumer’s right to interpret it as they see fit and for them to take responsibility for their reaction to it, not for the author to manage their response to it.
It was about at this point that I decided to head in hammer and tongs on the BERL report. In contrast to BERL, I've been doing my best to prevent my numbers from going wild. There's such a thing as professional ethics.

So, the first adjustment we make is to cull excise tax revenues from this figure. We bring excise taxes back as their own separate line item later on, where it shows up as a private cost to drinkers but an external benefit to government.

Next, we think a little harder about the relevant counterfactual than BERL did, or maybe we're just bigger fans of consistency (see below). BERL is trying to add up the costs of being in a world where there's harmful drinking compared to a world where there's no harmful drinking, but they here employ a counterfactual that assumes zero drinking by harmful drinkers rather than moderate drinking by harmful drinkers. In short: they say that we should count all of the alcohol consumed by harmful drinkers, and we say they should count only the portion above the appropriate gender threshold. I tediously backed out the proportion of alcohol consumed beyond BERL's threshold as compared to the proportion below the threshold and counted only the above-threshold consumption as a cost. Netting out excise taxes reduced BERL's figure from $698.7 million to $440.7 million; netting out consumption below the threshold reduced the figure further to $215 million. And not an ounce of that reduction - about half a billion dollars - depended on my having a world view consisting of anything other than sound economics.

Here's another fun fact. When BERL separately tabulates the cost to government of getting rid of harmful drinking, they correctly try to net out only that portion of excise tax revenues paid on alcohol consumed above the harmful threshold, assuming that drinkers will scale back drinking just to the threshold. This minimizes the costs to government of getting rid of harmful drinking. When they tabulate their headline costs of drinking, they include all alcohol consumed by harmful drinkers, not just the portion above the threshold. This maximizes the social costs of harmful drinking. I suppose that's consistent with a particular world view. Just not mine.

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