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Tobacco is the single biggest avoidable cause of cancer in the world. Smoking causes over a quarter of cancer deaths in the UK. So we want the Government to bring in a tobacco industry levy where tobacco companies, who have made vast profits on the back of a public health epidemic, pay an annual fee to fund tobacco control services.

This is particularly important, given the recent cuts announced to the budgets of local authorities, who are now responsible for stop smoking services.

Kat Smith headshot

Dr Katherine Smith

Mark Hellowell headshot

Dr Mark Hellowell

We asked Dr Mark Hellowell, an expert in health financing, and Dr Katherine Smith, who has examined tobacco industry responses to different forms of taxation, both from the University of Edinburgh, to explain the economics of how a tobacco levy would work, and the concept of ’hypothecation’; what it is, how it works, the arguments for and against, and how it can be used to improve the public health services.

Mark is a senior lecturer on public policy who has advised the World Bank on healthcare financing. Katherine is a reader in global public health who has written extensively on the impact of policy on health inequalities.

What is hypothecation?

Hypothecation, also known as ‘earmarking’, is the word used by economists to describe the process of assigning tax revenues for a specified purpose.

In its ‘pure’ form, it involves linking the spending on a particular programme directly to the money raised by a particular tax. It’s not new: the BBC licence fee is a familiar example.

But it contrasts with the overwhelmingly dominant approach to public finance in the UK, in which public services are funded from a single pot of money, with decisions over how to fund different services taken by the Chancellor of the Exchequer.

Why might earmarking be a good idea?

It offers two potential benefits:

First, it connects people to the taxes they pay, by allowing voters to see what they’re spent on. As the centre-left think tank, Demos, argued, this is “good for democracy, encouraging sovereignty to be shared between elected representatives and citizens”.

Indeed, it has been proposed that this is the real reason that senior politicians are often so hostile to hypothecation: it weakens central control by building a bridge between service providers and users.

Second, it can help bolster public support for taxation. Pragmatically, earmarking is likely to make people more accepting of higher taxes and therefore can help government decisions to increase certain forms of taxes which boost public funding for specified services. So if, for example, a proposal is made to introduce a new tax on the basis that the funding will be used to support a popular service, like education or healthcare, it is more likely to enjoy public backing.

So why isn’t it more popular with governments?

Despite its potential to increase public support for tax increases, governments in general, and finance ministries in particular, tend to be sceptical about earmarking, for several valid reasons.

Firstly, with ‘pure’ earmarking, it is unlikely that the ‘right’ amount to spend on a particular service will be the same as the amount of money raised from a particular tax.

Secondly, the amount it raises can – like the economy as a whole – be quite unpredictable. And for some taxes, such as ‘sin taxes’ on tobacco or alcohol – which also attempt to help people change behaviour – the revenues may even reduce over time, by design.

So if the services paid for are valued by society (and if they are not, then questions should be raised about why we are funding them at all), this unpredictability is inefficient and is unlikely to be politically acceptable.

This matters, because governments should be seeking to raise money in the most effective way possible, and to spend it in the most efficient way possible. As pointed out by the Institute of Fiscal Studies for the two reasons above, it can be very difficult for policymakers to justify hypothecation.

But rather than creating a new earmarked fund, a government could decide instead to raise an existing tax, such as an extra penny on the basic rate of income tax. The problem with this is less about efficiency and more about accountability: it is normally difficult to verify that a government’s promises have led to any changes in the allocation of public spending.

Suppose, for instance, the government says it is going to spend the money raised by that extra penny on income tax on the NHS. This might sound good, but without detailed plans as to what the government would have spent on the NHS in the absence of this increase (which a government would not normally produce – and might even be unable to produce), it would be impossible to verify that this is actually how the extra cash had been allocated.

Commercial opposition to earmarking

Because earmarking can make people more amenable to taxation, it’s something that businesses are often opposed to, especially where hypothecated taxes are linked to their products. Tobacco industry lobbyists have been adept at using economists’ concerns about earmarking to argue against it.

Common arguments include the idea that earmarked funds will be used in ways which the public does not support, and/or which differ from those described in government proposals. Such views may be helped by the fact that governments often do divert the funds in practice (e.g. to make up for budgetary shortfalls). More generally, evidence shows that, over time, hypothecated taxes become less strict – and the extent of earmarking less clear cut.

Without proper methods for letting the public know that earmarking has taken place, this may reduce the acceptance of earmarked taxes – and strengthen the hand of those opposed to them.

How might hypothecated taxes be made to work?

There are powerful economic arguments for earmarking, especially if (as seems likely in the current fiscal context) there is a case for increasing spending on public goods and public sector services.

In the case of a tobacco tax, these arguments are strengthened by evidence showing how such taxes can influence behaviour, making society (and individuals, including smokers) better off. A tobacco levy can provide the funding to create a more ‘direct’ positive behaviour change – by funding interventions such as Stop Smoking Services, mass media campaigns, and efforts to tackle illicit tobacco.

In the context of the forthcoming Spending Review, in which many areas of public service, including the NHS, are likely to see unprecedented funding constraints over a long period, there is a clear need for innovative forms of taxation that the public agree with.

To head off the potential for government manipulation, the Office of Budget Responsibility could be asked to monitor the earmarked funds and ensure that they are used only used for their specified purposes. That would also help to safeguard the political acceptability of the move.

Yet, even if carefully and sensitively applied in this way, commercial interests are likely to lobby strongly against the introduction of a tobacco levy.

Strong and sustained political will, alongside clear and unambiguous evidence of changes in behaviour, are likely to be necessary conditions of long-term success.

Mark and Katherine