Contrary to the view that tax increases on tobacco and alcohol increase revenues at the same time as reducing consumption, two reports show that the contrary appears to be the case, in a classic case of "the Law of Diminishing Returns".

In the UK, exxcise duties and VAT levied on alcohol rake in about £15 billion a year for the Treasury, which is approaching 3% of the government’s total annual revenues. But, according to HMRC, fraud illicit produciton and smuggling cost the Treasury about £600 million a year in lost revenue, or more than 6% of what it derives from drink taxes.

Its answer? To keep on increasing taxes. Duty on beer, for example, has been increased by 35% over the past three years. In the last 12 months, beer sales fell by 7.1%. Over the same peroid, sales of spirits were flat but revenues were up by 6%, not fully reflecting the extent of the duty and VAT hikes this year. Wine sales were 2% lower but revenues rose by 3%. So while the Treasury is gaining extra revenue from increased taxes, the growth rate is not matching the level of the tax hikes.

Since no-one is suggesting that consumption itself is falling, the conclusion is that the discrepancy is accounted for by consumption of illicit products.

In Ireland, meanwhile, a similar picture can be seen for cigarettes. A report examining the factors affecting tobacco consumption between 2002 and 2009 by the Revenue Department has concluded that price is the most important factor affecting consumption patterns.  The authors found that a 1% increase in price led to a 3.6% decrease in consumption of taxed cigarettes.

'Such a large decrease in taxed consumption is only partly caused by lower smoking levels' , the report said. ‘The remainder must be caused by smokers switching to substitute cigarettes.’ The report also said that further tax hikes would lead to more consumption of untaxed cigarettes.

In both instances, the Law of Diminishing Returns will eventually mean that the higher taxes go, the less governments will derive from them – that drinkers and smokers will be unable or unwilling to afford to maintain consumption levels and that a tipping point will be reached.

Those who claim that higher taxes are a win-win should think again. Extra duties can have the opposite effect to that intended, as well as encouraging illicit production, faking and fraud.