Why the soda tax won't raise the money pre-K requires

One of the biggest issues facing Philadelphia is how to fund Mayor Kenney's goal of providing universal prekindergarten programs. The mayor has proposed taxing sugar-sweetened beverages (SSBs). Unfortunately, while the pre-K initiative is critical, the expected funding goals are not likely to be met.

I support Kenney's universal pre-K initiative. I have been involved with this issue for nearly a decade as a board member of the Economy League of Greater Philadelphia. My "Random Economics" column on Oct. 8, 2014 - 18 months ago - argued that this program should be funded. I strongly believe in pre-K education. But once pre-K is started, it would be an educational disaster if it were not funded fully and correctly.

And in a city that is perpetually fiscally stressed, choosing a revenue source that fails to provide the needed funds is not an option.

Here is why I am worried that the mayor's revenue estimates will not be met.

Start with the extent to which demand will drop as a result of the tax increase. Economists call the sensitivity to price changes the "elasticity of demand," and it is the most crucial aspect of the calculation. The mayor's team assumes an elasticity of -1, which simply means that for every 1 percent increase in price, there is a 1 percent decline in demand.

The assumed elasticity is too low. The University of Connecticut's Rudd Center for Food Policy and Obesity tax calculator was used to estimate revenues. However, the Rudd Center calculator employs an elasticity of -1.21, which means that for every 1 percent the tax rises, demand falls not 1 percent but 1.21 percent, or 21 percent more. A recent paper that reviewed the literature calculated the average elasticity to be even higher, -1.29.

By itself, this assumption of a -1 elasticity means the mayor's revenue estimates may be at least 20 percent too high. Unfortunately, the mayor's team gave no reason why the elasticity chosen was so low.

It is likely that the sensitivity to the price changes will be closer to the Rudd Center number than the city's assumption for many reasons:

The percentage increase

in price was estimated by the city to be at least 55 percent. In most other cases, the tax resulted in a price rise in the 10 percent range. That is important, since the greater the price increase, the greater the reaction.

Think of it this way: If, overnight, the price of gasoline rose from $2 to $2.20, you would get annoyed, but not cut back much. If it rose to $3.10, you would change your driving habits pretty quickly.

With the 3 cents-an-ounce tax, the cost of beverages would increase anywhere from about 25 percent to as much as 200 percent. A 2-liter bottle that retails, on sale, for $1 would have a tax of more than $2. A 12-pack of 12-ounce cans that sells, on sale, for $2.50 would have a tax of $4.32. Roughly half of all sales are for 2-liter bottles and multipacks, and that is where the highest price increases occur.

It is now generally accepted by all sides that the city's poor constitute the major market for SSBs. A large increase in price would create an even larger negative impact on demand in the poorest communities, as they cannot afford the increases. Advertising in those areas would decline because of the limited sales, further eroding demand.

The relatively high percentage of demand by Philadelphia's poor was not factored into the calculations.

The high tax would also affect the selling strategies of restaurants. Free refills would be uneconomical and would likely be terminated. Refills will likely be priced separately. Self-service soda fountains would have to stop dispensing SSBs as the volume and, therefore, costs would be uncontrollable. Those changes would lower demand more in Philadelphia than in other cases since it is the large price rise that would force those changes.

There is a wide variety of available sugar-sweetened, naturally sweetened, and non-sugar-sweetened substitutes. The more the alternatives, the more you stop buying the product.

The problems with the city's estimates don't end there. The mayor's economists assume the delinquency rate, which they currently put at 10 percent, would actually decline over time. That makes no sense when you consider that the sharp rise in price would encourage both legal and extralegal tax avoidance activities.

Households living near the borders - and many do in this long, narrow city - would have another incentive to do more of their shopping outside Philadelphia. The purchase of one 12-pack of soda could more than make up for any added gasoline costs.

Retailers, especially smaller ones, have similar incentives and capacity to purchase SSBs outside the city, avoiding the tax.

Over time, alternative distribution systems will likely be developed that would shift sales outside Philadelphia unless there are significant enforcement activities. Will the city create a SSB Enforcement Bureau? Really? The avoidance rate is likely to rise over time, reducing revenues, potentially significantly.

And for me, there is one more and very disturbing part of the story. The city is assuming it is an island country that can place a tariff on imported products. The only way this tax works is if both wholesale and retail purchases made outside Philadelphia, in foreign lands, such as Bucks County, Delaware, or New Jersey, from foreign companies located in these foreign lands, can be taxed once the goods enter the city. Otherwise, everyone buys from sellers outside Philadelphia.

That attitude toward taxation is troublesome and even bizarre. If this taxing strategy holds for SSBs, can it be imposed on other products? What message about tax policy will the city be sending to firms looking to locate here? Image and tax strategy matter when it comes to economic development, and this is quite a worrisome message.

Universal pre-K education should be implemented. But for all the reasons described, a tax on sugar-sweetened beverages is not likely to come close to generating the necessary revenues required to fully fund the program.

jnaroff@phillynews.com

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A Disclaimer

For the last five years, I have been a periodic economic consultant to the American Beverage Association. I am currently working on estimates of the revenue-raising potential of the sugar-sweetened beverage tax. This piece was not requested by the ABA, it is not part of my contract with the ABA, and was not reviewed or approved by the ABA. I only ask that you read it first and judge the logic afterward.