Excise tax increases, cigarette consumption and government revenue: A win-win-win situation in South Africa

Corne van WalbeekSchool of Economics

University of Cape Town

This research was made possible with funding from the American Cancer Society

Win-win-win in South Africa

• Win 1: Public health

• Win 2: Government revenue

• Win 3: Tobacco industry benefits through their pricing strategy and this pricing strategy has had a positive impact on public health and government revenue

Why are excise tax increases so effective in reducing tobacco consumption?

• Despite its addictiveness, people respond to changes in the price of cigarettes

• Price elasticity of demand for cigarettes in SA (and many low- and middle-income countries is around -0.6)

• Thus a 10% increase in cigarette prices reduces consumption by 6%• Not all people respond to changes in cigarette prices, but the poor

and youth are typically more responsive than the better-off and the old

• Some indicative numbers:– 1000 smokers initially– If price increases by 10%, we would expect 3% (= 30) smokers to quit– Remaining smokers will cut down their consumption by an average of

3% (some more and some less)

Lesson 1 from South Africa

Specific taxes are good, but they have to be updated regularly, especially in inflationary times

Excise tax increases do not keep up with inflation

Since 1994 rapid excise tax increases followed the small nominal increases in the 1970s and 1980s

Government commits to a TC policy based on keeping the tax burden at 50% of the retail price

Lesson 2 from South AfricaDon’t make the tobacco industry your tax advisor on excise tax matters

Minister of Finance, 1983: “The Tobacco Board has presented justified arguments for the maintenance of the status quo regarding the excise taxes on tobacco, and I do not intend to wake sleeping dogs”

Minister of Finance, 1986: “any increases in excise duties at present could be counter-productive, since it could in fact – on account of the potentially adverse effect on consumption – lead to a reduction of revenue from this source”

Article 5.3 of the FCTC: In setting and implementing their public health

policies with respect to tobacco control, Parties shall act to protect these policies from commercial and other vested interests of the tobacco industry in accordance with national law

Lesson 3 from South AfricaKeep the tax system simpleSpecific tax is administratively best, and does not actively encourage the creation of

low-price market

Complicated tax systems are likely to be used by the tobacco industry to their benefit, and against the public health and/or fiscal interests of the government

Example of a complicated excise tax regime: Jamaica – Special consumption tax (SCT):

• A specific amount per 100 cigarettes PLUS• An ad valorem tax of X % on cigarettes in excess of specified benchmark value

– “Excise levy” payable to the National Health Fund: 23 % of the sum of the ex factory price and the SCT

– General Consumption Tax (GCT): Like VAT, an ad valorem tax

Lesson 4 from South Africa

The math is quite simpleIgnoring the impact of changes in income, the impact of a 20% increase in the (specific) excise tax is as follows:

Excise tax as percentage

of retail pricePrice

elasticity

Excise tax increase

(percentage)

Net-of-tax price

increase (percentage)

% change quantity

% change govt revenue

40 -0.6 20 0 -4.5 14.6

40 -0.3 20 0 -2.3 17.3

40 -1.1 20 0 -8.1 10.3

40 -0.6 20 10 -7.6 10.9

40 -1.1 20 10 -13.4 3.9

70 -0.6 20 0 -7.6 10.9

70 -0.6 20 10 -9.0 9.2

Lesson 5 from South Africa

Big increases in the excise tax have resulted in big increases in tax revenue

Between 1993 and 2011 real excise tax increases by 487% and real excise tax revenue increases by 249%

Lesson 6 from South AfricaThe industry has a very strong interest in exaggerating the threat of illicit

trade– “The increase in the excise tax will encourage illicit trade” (TISA and BAT, numerous years)– “The illicit market has grown from nothing ten years ago to 20% of the total SA market”

(TISA, 2006)– “Illicit trade has doubled over the past two years” (BAT CEO, 2010)– “The government loses R2.6 billion each year to illegal sales” (TISA, 2011)

The evidence for a large increase in illicit sales is not convincing

• In an environment of rapidly increasing average prices and strong tobacco control legislation it seems unlikely that total cigarette consumption would increase by 11% between 2003 and 2009

Bottom line: While illicit trade may be a real issue in many countries, and one should always be vigilant, the industry is not a credible source about the magnitude of the problem

11% increase in total (legal and illicit) sales

4.3% increase in legal sales

Aggregate cigarette consumption in SA

Lesson 7 from South AfricaThe tobacco industry’s pricing model may have beneficial long-run fiscal and public health consequences

• The third WIN in the equation: Tobacco industry in SA is more profitable now than before, despite the decrease in cigarette consumption

• Sharp increase in the net-of-tax price (and thus profit) per cigarette• Can do this because tobacco industry in SA, as in most countries, is highly concentrated• Low price elasticity works in the industry’s favour

• Excise tax in SA is specific but set such that tax burden is 52% of the retail price

• Substantially increasing the excise tax initiated a cycle of 1. Increasing retail price (excise tax being passed through)2. Decreasing consumption (as consumers respond to higher prices)3. Increasing net-of-tax price (as industry wants to maintain/expand its profitability)4. Increasing retail price (as the net-of-tax price increases)5. Decreasing consumption (as consumers respond to higher prices)6. Increasing excise tax (as government wants to maintain the 52% tax burden)7. Increasing retail price (back to point 1)

A gradual upward ratchet of the real price of cigarettes, with a corresponding decrease in consumption