Tax Incidence, Tax Burden, and Tax Shifting in Tobacco Industry - Assignment Example

1. Excise tax is a government tax and is indirectly levied on a product. Raising the excise tax or putting an excise tax on a product will raise the price of the product as it directly gets reflected in the price of the product. For example, if the government imposes excise duty on cigarettes then the price of cigarettes will increase thereby reducing the equilibrium quantity and increasing the equilibrium price. This is seen below In the above diagram we see that when the government levies an excise duty of $2 per cigarette box it gets reflected in the price as the price of cigarette increases by same proportion making the price to be $8. The increase in price makes the consumer spend more on the consumption of cigarette which thereby pushes certain section of the population to reduce their spending on cigarettes. This causes a decrease in demand of the product thereby decreasing the equilibrium quantity to Q2 from Q1. This theory clearly follows the law of demand which states that as the price of goods rises the demand for the product falls and vice versa. This is a phenomenon which is visible in low and middle income countries where the population is more prices sensitive. (World Bank, 2010) It is also evident that the younger generation who are more prone to cigarette are price sensitive so an excise duty helps to reduce smoking and ensure that the demand for cigarette falls. 2. Raising the excise duty on cigarettes puts extra burden on both the consumer and the producer as they both have to pay the additional taxes. The load of the extra burden borne either by the producer or consumer depends upon the price elasticity of demand. If the demand for cigarette sis more elastic than the burden has to be borne mostly by the producer as shown below It is seen in the above diagram that when the demand is more elastic the burden of tax is borne by the producer. This is seen from the fact that the fall in quantity demanded from Q1 to Q2 is much higher compared to the rise in price from P1 to P2. As a result the producer has to bear the major chunk of the taxes. In case the demand is more inelastic then the chunk of the taxes has to be borne by the consumer as the change is price is much higher compared to the change in quantity demanded. This is evident from the chart below In the above diagram we see that when the demand is more inelastic the consumer has to bar the major chunk of the taxes as the fall in quantity demanded from Q1 to Q2 is smaller compared to the rise in prices from P1 to P2. Thus the taxes burden is shared between the producer and the consumer in the long run but the proportion of taxes borne by the producer and the consumer depends upon the price elasticity of demand. 3. Price floor is an opposite mechanism as compared to price ceiling. Price floor determines “the minimum price that needs to be paid for a particular product and is devised to protect the producer”. (Price floor, 2010) The graphical representation looks as follows Price floor will help to reduce the consumption of cigarettes as it will ensure that the prices are set above the equilibrium price. It creates a gap between demand and supply. Since the price is more so suppliers supply more. Consumers are not willing to purchase at this point as they have to pay more. To ensure that the price floor mechanism works government will have to interfere and “purchase the excess supply, subsidies consumption, use strict measures to ensure that the price is same and decide how much needs to be produced”. (Price Floor, 2010) This will ensure that certain sections of the consumer who use to smoke are not able to purchase the same given the constraints of income. This will thereby drive the demand for cigarettes down and will help to reduce smoking. A study conducted in the direction of price floor shows that “price floor sometimes lead towards a creation of multiple equilibrium points which makes the market inefficient”. (Bhaskar, 2007) This thus presents some important fact to ensure that important steps are taken which will ensure that multiple equilibriums is not created so the inefficiency doesn’t creeps into the system. If it does then the consumption of cigarettes won’t be affected and having a price floor will not provide the benefits that it should have provided making it useless. 4. The anti smoking campaign will reduce the demand for cigarettes thereby affecting the cigarettes manufacturers as they will have to bear the decrease in supply which will convert into losses for the company. In the short run the manufacturers will incur losses as the excess production will be pushed by the company in the market. To ensure that the cigarettes are sold the company will reduce prices. This will not bring an effect by raising demand in the short run as it will take time to be converted into actual demand. This will thereby make the manufacturer suffer losses in the short run. An interesting fact to note is that a cigarette manufacturer operating in a perfectly competitive market should continue its operation in the short run as long as it is able to recover the variable cost. Since, in the short run certain factors of production are fixed and if the firm doesn’t continue operations then it will lose the fixed investment as they have to be incurred irrespective of the production. This makes it important for the firm to continue its operation as long as the variable cost is covered. In the long run a cigarette manufacturer incurring losses cannot continue its operations as all factors of the production are variable. There is no fixed factor of production. So, if a cigarette manufacturer continues operations while it is not able to cover its variable cost would mean loss for the business and will require to be shut down. This will thereby force certain players get out of the market. This will help the producer as when certain manufacturer shut down operation then the other cigarette manufacturer can raise the price as the demand is more thereby enabling them to earn zero economic profits and earn normal profit. The graph for the same looks as follows Thus the firm will incur losses in the short run forcing certain players to shut their operation finally resulting in zero economic profits and only normal profits in the long run. 5. The tax imposed on cigarettes will help to reduce the consumption of cigarette if used effectively and wisely by the government. Imposing a tax will have an effect both from the perspective of the producer and consumer and will thereby help to bring a check on cigarette consumption. Excise tax will reduce the disposable income available with the consumers as the prices of cigarette will rise thereby effecting their purchasing power. This will force the consumer to look for substitutes of cigarette which has nicotine products. (World Bank, 2010) The government on this front needs to look at ways to ensure that the nicotine products are not available in the market. This will thereby help to reduce consumption in low and middle income countries and will help to check cigarette smoking. It is seen from the diagram below The above chart shows that increase in taxes will shift the consumption demand but needs to be ensured that there is uniformity in policy across the country. This could otherwise lead towards shifting the consumption pattern to elsewhere. A study in the same direction shows that to gain the maximum incentive from cigarette taxes it is important to ensure uniformity in taxes, production and distribution to ensure maximum benefit from the imposition of taxes. (Licari & Meier, 1997) Since, the decrease in disposable income will force the producer to look towards sharing the burden of taxes so that certain section of population continue smoking will make them look towards sharing the burden to rise demand. This will have a negative effect from what the government intends to look to garner from imposing taxes as certain section of the population who could have given up smoking will continue as the price rise is not substantial. This is shown below This will have an effect on the government proposal to reduce consumption as the changes in price is not substantial thereby not getting the same effect it could have garnered if the entire cost had been passed to the consumer. This is an area the government has to watch out for as it could have an effect on the consumption of smoking. (Entin, 2004) The other important aspect along with the taxes is to ensure that the government is able to increase the financial cost of the products by having smoking free policies, tax burden and advertising bans. (Cummings, 2002) This is an important aspect to watch out for along with raising the taxes as it will help to ensure that the different approaches which the producer and consumer can take are looked after. The imposition of taxes thus can have a have an effect which is not huge but will help to curb smoking to a certain extent. To ensure maximum leverage and gain from the imposition of taxes it is essential that steps are taken to reduce the consumption of other nicotine products by raising the taxes on such products so that the consumers are unable to spend on those as well. This will help to create a ripple effect and will ensure that the financial cost bring down the demand of cigarette and other products thereby helping the government to reduce cigarette smoking. References Bhaskar V, 2007, “The competitive effect of price floor”, The Journal of Industrial Economics, Volume 25, Issue 3, page 329-341 Cummings K, 2002, “Policies and programs to discourage the use of tobacco products”, Oncongene, Volume 21, Number 48, pg 7349-7364 Entin S, 2004, “Tax Incidence, Tax Burden, and Tax Shifting: Who really pays the tax”, retrieved on January 8, 2011 from http://www.heritage.org/research/reports/2004/11/tax-incidence-tax-burden-and-tax-shifting-who-really-pays-the-tax Licari M & Meier K, 1997, “Regulatory policy when behaviour is addictive: Smoking, Cigarette Taxes and Bootlegging”, Political Research Quarterly, Volume 50, No 1, 5-24 Price floor, 2010, “Price Floor retrieved on January 8, 2011 from www.economics.fundamentalfinance.com World Bank, 2010, “Measures to reduce the demand for tobacco”, The World Bank Group, retrieved on January 8, 2011 from http://www1.worldbank.org/tobacco/book/html/chapter4.htm Read More