The effects of high taxes on tobacco

Excise can be imposed on goods, where the government usually has certain targets or policy outcomes in mind. One of the biggest motives behind excise has to be raising revenue for the government. Excise tax is a great source of income as the price sensitivity of excisable goods is usually low. [1] However, there are other policy issues, such as, restricting the consumption of goods, meeting external costs etc. Tobacco, alcohol and fuel are probably the prime targets for excise as they are fairly insensitive to price hikes and at the same time has a negative effect to the society and environment. In most cases, the government may heavily tax the more harmful alternative of one commodity in order to promote consumption of the more environmental friendly options, for example, leaded vs. unleaded fuel.

This essay is going to analyse the effects of high taxes on tobacco. Given the addictive nature of tobacco, to what extent is it really going to effect the consumption? Do high taxes really mean higher revenue for the government? Are there other factors (such as reduced consumption, smuggling, cross border and duty free shopping) that may cause the tax revenue to decrease over time? What are the economic effects of rising taxes on tobacco on the different demographic groups?

Effect of high tobacco tax on consumption

In order to examine the effects of high tobacco tax on consumption, first we need to look into the nature of tobacco. Tobacco is addictive in nature, the demand for addictive goods usually tend to be fairly elasticity [2] , meaning the effect of any price change does not affect the demand to a great extent in the short run. Therefore, it will be fair to say that when there is an increase in price people will generally tend to switch cheaper or inferior brands instead of giving up smoking. Sometime smokers will switch from legitimate brands to contraband or counterfeit products in order to avoid paying tax. Other times, smokers may engage in cross border shopping where they buy the products from a neighbouring jurisdiction with lower excise on tobacco products.

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This is not so much an issue in Australia; however, it is a big problem in countries belonging to the EU, ASEAN and the US. Higher taxes will cause smokers to engage in ‘price avoidance’ activities. A telephone survey was conducted in the US as a part of the Community intervention trial for smoking cessation (COMMIT) study which analysed the pattern of cigarette purchasing amongst smokers when faced with a price hike. The survey showed that even though the smokers did react to price changes, instead of giving up smoking they found cheaper alternatives. [3] 

However, there exists another school of thoughts, where they claim that tax increase is the most effective solution for governments when trying to reduce consumption. The Word Bank is of the same opinion regarding tax increases on tobacco. According to a study undertaken on changes in smoking prevalence in Australia since 1990,’…..shows that price increases were by far the most important factor driving reductions in smoking across the whole population over that period.’ [4] 

High taxes on tobacco may have a two tiered effect where demand for cigarettes reduce as a result of increased tax and hence increased price. Also, the increased tax revenue is then used to pay for the externalities that are caused by the consumption of tobacco, i.e. pay for health rehabilitation centres for smoking related diseases. ‘Excises are often rationalised as charges for the external cost that consumers or producers of excisable products impose on others.’ [5] 

High excise rates and revenue

Irrespective of the low elasticity of demand, when excise rates on tobacco are increased, demand and consumption will fall in the long run. There is no doubt that in the short run the tax revenue will increase, but eventually after a certain point revenue will fall. This incidence is best illustrated by the ‘Laffer Curve’. The curve talks about taxes and revenues being directly proportional to each other up to a certain point (the optimal point of taxation) after which they become inversely related where revenue starts falling as taxes increase.

There are a number of reasons behind this phenomenon. The biggest reason being, as discussed above, demand for tobacco is inelastic, smokers often engage in tax avoidance behaviour, often switching to smuggled or counterfeit products, engage in cross border shopping or switching to cheaper/inferior brands. All of this will lead to reduced revenue for the government.

Some may argue that increasing taxes on tobacco will result in an increase in the tax revenue, price elasticity being one of the biggest arguments. Also, not many countries have reached the tax incidence on cigarettes of 66-80% target recommended by the World Bank. Therefore, there is scope to increase tax without worrying about fall tax revenue.

It is also argued that if the government can design and implement a simple and transparent tax system, it will reduce administrative and compliance cost. For example, specific taxation as opposed to ad valorem tax will be less costly to implement. Simple tax system coupled with efficient management of the tax administration personnel to police tax avoidance and tax evasion activities will lead to high and stable tax revenue. [6] 

Effect of high tobacco tax on different classes of people

High taxes affect smokers in different ways. In determining the effects of taxes on smokers, it is important that we look at the different subgroups of smokers, as they are not homogenous. The smokers can be divided by age, social standing, purchasing power etc. According to the Australian Bureau of Statistics people in the lowest 20% of the income group spend 1.8% of total spending on cigarettes or tobacco products compared to 0.8% in the highest 20% of the income group. [7] In this section we will discuss mainly about the subgroups of smokers.

It is argued that high tobacco taxes deters young adults or under aged smokers more than the adults. As price increases, the younger population finds it harder to afford to continue the same level of consumption and hence affordability falls amongst the younger population. ‘Underage smokers have less buying power on average than their adult counterparts so the cigarette taxes affect them more. In addition, adult smokers are more likely to be experienced smokers with many more years of smoking than underage smokers. Thus, smoking is probably a more integral part of the lives of adult smokers than it is for younger smokers. This would imply that cigarette consumption has relatively large tax elasticity for youth smokers but not for adult smokers.’ [8] 

Higher burden on lower income family

High taxes affect the lower income families the most. Some economists see taxes on tobacco as a regressive tax as the higher tax incidence does not take into consideration the standard of living of the tobacco consumers. The lower income group in the society would bear the higher tax burden compared to the higher income group. As the disparity of disposable income between the two groups vary widely, affordability within the lower income group will fall with a price hike, such that cigarettes will be less affordable to these family. However, as mentioned earlier, as cigarettes are quite addictive in nature, depending on the addiction of the smokers they might not be able to cut down on consumption, in which case they may prioritise the purchase of cigarettes over other necessary things. In such scenarios it will be the lower income families that will be affected the most when taxes increase. Therefore, this is why some argue that taxes on tobacco are regressive in nature.

However, it can also be argued that tax on tobacco may be regressive, but the overall effect, in the long run is indeed progressive. According to a Michelle Scollo, an Australian tobacco researcher, ‘the key issue in determining whether tobacco taxes are regressive is the extent to which people in various socio-economic groups actually do reduce tobacco consumption in response to price increases’. Scollo’s rationale is that so long as tobacco excise increases do indeed deter people from lower socio-economic groups from taking up smoking or influence them to quit, then they may be viewed as progressive.’ [9] 

Effects of earmarking revenue generated from increasing taxes

Sometimes revenues for excise taxes are earmarked to fund certain government projects or programmes. It can be used to cover the external costs that may rise as a result of consumption of those commodities. For example, some of the revenue from fuel taxes may be earmarked for road maintenance, or some of the tobacco taxes may be earmarked for health. Sometimes this may pose a number of problems.’Thailand has additional special taxes on cigarettes, earmarked to fund particular categories of government spending (eg ThaiHealth). While such hypothecated taxes have popular appeal, they can easily create significant distortions – for example, if they become the focus of intense lobbying, particularly by those who benefit from the earmarked funding. [10] ‘

Earmarking of funds also pose the risk of ‘structural deficit’ where the government earmarks the revenue from cigarette taxes for the funding of certain programmes.

Sometimes governments have the tendency to allocate the whole amount of the increased tax revenue to certain programmes, where the incremental increase in revenue from tobacco tax is the number one source of revenue to fund that program. The issue that is not considered is, as the price rises and demand falls for ‘legitimate’ or ‘taxed’ tobacco products, actual tax revenue falls, and there is a gap between the expected and actual revenue. [11] 

After examining both the pros and cons of setting high excise taxes on tobacco and tobacco products, I am of the opinion that it is unsuitable to set high excise tax rates on tobacco. As we have repeatedly seen, the elasticity of demand for tobacco is low; any increase in the tax rate will cause the smokers to switch to smuggled, counterfeit brands. From revenue perspective, this will do the government more harm than good, as consumers will switch from legitimate brands to smuggled brands or switching to cheaper brands or other tobacco products. This will mean less overall revenue for the industry and in turn less tax revenue.

If the government is wanting to restrict consumption, increasing taxes is not the answer. Along with a suitable, sensible excise policy, the government should take active steps be to educate the general population about the negativities of cigarettes smoking. Expose and educate the youngsters about the consequences of smoking and the health risk that smoking imposes. At the same time, enough resources need to be deployed to police any smuggling and price avoidance activity.