Cigarette Tax: Distribution of Tax Burden or the Incidence of Taxation - Term Paper Example

Cigarette Tax: Distribution of Tax Burden or the Incidence of Taxation Mainly microeconomics is concerned with the theory of small individual units; a single consumer, single firm or single market. Taxation is of course a macroeconomic policy introduced by the state or the government but the impact of taxation on the producer and consumer should be judged on the microeconomic concept. Tax incidence is the study to explore who actually bears the economic burden of the tax. The basic concept of the incidence of tax is generated for the concept that the person who is taxed by the government may not be the person who faces a welfare loss due to this tax. Thats why the term ‘indirect tax’ has emerged. In this topic we would concentrate on a special case: the tax imposed by the Federal Government on the cigarettes and its impact on the consumers and producers. The incidence of taxation can be explained through the help of demand-supply apparatus. Thats why, to explain the transfer process of the burden of taxation , we need to be clear about the determinants of demand and supply and how they affects the demand and supply of any commodity. Let us consider the factors that determine the demand for cigarettes. Before we go through the economic analysis of taxation on the cigarette we should first be clear about the objectives of the government. What are the main objectives of the government for such a taxation policy? The answer has two components. 1. To raise the revenue from taxation and 2. To offset the external diseconomies created by smokers. While a tax is imposed on the product the government earns revenue from that. Now we consider the externality. Externality means while the action of any agent either benefits or harms another agent but none is rewarded or penalized for that. Here smokers create negative externality. Thats why, to penalize the smokers for the negative externality they creates the government has introduced the tax. In this context we have to consider the private and social cost of smoking. While a person smokes he has to pay the price of the cigarette. This is his private cost. The matter of fact is that beyond the private cost there are some social costs of smoking. It brings about air pollution by releasing carbon dioxide and nicotine oxides which are harmful for the environment. Moreover, there remains the problem of passive smoking by others which cause health hazards for the passive smokers. The costs of these factors are not measured while the private cost is calculated. In determining their optimum level of smoking the smokers equate their marginal benefit with marginal private cost. Thats causes a market imperfection. By taxation the government has tried to solve the problem of externality. Let us show the externality with the help of the following diagram. In the following diagram the horizontal axis measures quantity of consumption. The vertical axis measures cost and benefit of cigarette smoking. The MPB is the marginal private benefit curve that shows the negative relationship between the amounts of consumption and the marginal benefit curve and MSC is the marginal social cost curve. MSC is above the MPC that implies the private cost of smoking is lower than the social cost. The equilibrium of the consumer is achieved when the marginal private cost curve intersects the marginal private benefit curve from below. Hence OQ is the optimal point on the private ground; but if we consider the social ground the equilibrium point should be E, not F. At the point of private equilibrium the excess social cost is AB= FD. Thats the external diseconomy created by the smokers. To solve the problem of the external diseconomy the consumers of tobacco should be taxed in such a way that the marginal private cost curve synchronizes with the marginal social cost curve for the consumers of cigarette. So the basic objective of the policy of increased tax by the Federal Government is to solve the problem of negative externality created by the smokers. The government is aware of the fact that the indirect taxation would enable the producers to transfer apart of the burden of tax on the consumers of cigarette. That would definitely cause a rise in the price and according to the law of demand price rise would cause a decline in smoking rate over the country. That would also cause a decline in the producers’ surplus and consumers’ surplus. Consumption decline would bring about betterment in environmental standard and solve the problem of passive smoking to much extent. Cost, Benefit MSC MPC B D E A F MPB 0 Q* Q Q (Maddala and Miller 1989) Among the various factors influencing the demand for cigarettes first we have to consider the price of the cigarettes. For a normal commodity there is a negative relationship between the price of the commodity and its demand when other factors remain unchanged but that convention may not be applicable for cigarettes as cigarette is a toxic commodity and the consumers who smoke have a preference bias to it. Normally people who are addicted to it consume it regularly. It is empirically found that the rise in price has a small effect on the consumption of cigarettes, what is actually found is a shift from costlier brand to cheaper brand. We can say that demand for cigarette has low price elasticity (below 1 for United States of America). Thats why the demand for cigarette does no response much to the change in its price. (Lyon and Simon, 1968) The income level of the consumer also plays a vital role in determining the demand. According to the law of economics demand for a commodity is determined by the level of income in the hand of the consumer. In normal case the demand for any commodity is directly related to income of the consumer. Like price elasticity, the income elasticity of demand is also low for cigarettes. (Barnett, Keeler and Hu 1995) Next thing we have to consider is the presence of substitute of cigarette in the US market. In the US market the available substitutes of cigarettes are the nicotine gums and de-nicotinized cigarettes. But those are not much popular substitutes. (Johnson, Bickel and Krisenbaum ,2004) On the other hand if we consider the supply side factors for cigarette we find that the following factors determine the supply of cigarettes in United States. The price of cigarette influences the volume of supply of cigarettes by a company. Normally the law of supply of economics states that the supply of a commodity is positively related to its price. Other factors remaining unchanged a rise in the price of the commodity ensures higher profit margin. Thats why a direct relationship is found between the price and supply from the producer’s behaviour. The cigarette is not an exceptional case in this context. The next thing that matters for a supplier of any commodity is the price of the inputs of production. If the technology of production, price of the final product etc are unchanged a rise in the input price would cause a rise in the cost and hence a decline in the profit margin of the producer. Hence that would cause a downward pressure on the supply of the commodity. Similarly a decline in the price of the inputs causes a rise in the profit margin under the same situation and hence there would be an increase in the supply of the commodity. This can be expressed with the help of a following diagram: Pc P0 S1 S0 Q1 Q0 Qc (Varian, 1999, p. 293) In the above diagram the horizontal and the vertical axes measure the quantity and price respectively. The initial supply curve showing the one to one correspondence between the price of the commodity and quantity supplied is S0. Let us start our analysis from the situation while the price is P0, the equilibrium quantity at the price level is Q0. Now we consider that there is a rise in the input price (say the price of raw tobacco). At price level P0 the equilibrium quantity now becomes Q1. By using different prices we can find that the quantity declines. Hence we can find that joining the new price quantity combinations we obtain the new supply curve S1 which is at the left of the initial supply curve. The same thing can happen on supply while the government introduces any tax or subsidy policy. If there is a tax imposition by the government that would cause a decline in the profit margin of the producer and hence the supply of the commodity declines because initially the producer has to pay the tax and later on the burden can be transferred to the consumers. Thats why a rise in the tax rate on the product (it may be a value added tax or excise tax or revenue tax or sales tax) is reflected through a leftward shift of the supply curve of the product. Similarly a subsidy programme by the government would cause a rightward shift of the supply curve (increase in supply). (Fullerton, 1980) On 31st March, 2009, the Obama government announced the new tax increase on the tobacco products. The statistics can be given as: U.S. Federal Tax increase on a pack of cigarettes from $0.39 to $1.01 per pack Federal tax on pipe rises tobacco from $1.0969 per pound to $2.83 per pound Federal tax on RYO tobacco hikes from $1.0969 per pound to $24.78 per pound Federal tax on cigarette papers rise (50 or less) from $0.0122 to $0.0315 Federal tax on cigarette tubes rise (50 or less) = $0.0244 - New rate is $0.0630 (Cigarette Smokers News, 2009) This taxation policy on cigarette by the Obama government has met a good consequence. Especially it has been proved to be a good policy for the kids of the country and the younger generation. Different studies have proved that this tax increase programme has caused a decline in smoking among the younger generation. The decline in youth smoking accounted for seven percent. On the other hand the rate of overall decline in smoking including all age group accounted for four percent. (ClearWay Minnesota, n.d) Now we can make an economic analysis of the above taxation measures on the ground of demand and supply to judge how much part of the burden is transferred to the consumers by the producers. This will be done with the help of a partial equilibrium analysis by using demand and supply apparatus. From the above diagram we can say that while a tax is imposed on the cigarettes there will be a decrease in the supply of the commodity which is represented by the leftward shift of the supply curve i.e. the corresponding supply price of every level of quantity would rise or in other words at each price level the corresponding supply would decline. If the demand curve is not perfectly elastic that would definitely cause an upward pressure on the price level of the commodity. It has already been empirically proved that the demand for cigarette is highly inelastic as it is a toxic material. The ultimate effect would be derived after the demand supply mechanism. That can be expressed with the help of the following diagram. Pc A S* S B C D J E K H F D O V R T Qc (Rosen, 2002) In the above figure the horizontal and vertical axes measure quantity of cigarette and price of cigarette respectively. D is the initial demand curve showing the one to one correspondence between price and quantity demanded while other factors remain unchanged. On the other hand S is the original supply curve that represents the one to one correspondence between price per unit and quantity supplied. The initial equilibrium point is E, determined by the interaction of demand and supply. The equilibrium price is OD and the equilibrium quantity is OT. Now we consider the tax imposed by the government on cigarette. Consequently there would be a decrease in supply and the supply curve shifts from S to S*. The vertical difference between S and S* represents the tax per unit by the government. At the initial price OD now the quantity demanded is OT but the quantity supplied is OV. Hence there is an excess demand situation in the market to the extent VT. That would definitely put upward pressure on the price of cigarettes. The price of cigarettes would start to rise gradually. With this rise in cigarette price we can see two movements. There will be a decline in quantity demanded by the smokers which is represented by a leftward movement along the demand curve and simultaneously there would be a rise in quantity supplied by the producers which is represented by the upward movement along the new supply curve S*. This mechanism is continued unless the market is again stabilized at the point of intersection of demand curve D and the new supply curve S*. The new price is OB and the final market clearing quantity is OR. Hence there is a small fall in demand and high rise in price. The main factor attributable for this kind of adjustment is the inelasticity of the demand function for cigarettes. The price rises by the extent BD that equals CJ. Now let us consider the redistribution effects of this taxation. Before the imposition of tax the consumers were consuming OT amount of cigarette at OD price per unit. The total expenditure was represented by the area of the rectangle OTED. But the willingness to pay for OT units was represented by the area of the quadrangle OAET. The consumer surplus (the difference between willingness to pay and actual expenditure) was represented by the area of the triangle AED (= OAET- OTED). After the imposition of tax the consumers consumption level is OR and price per unit is OB. Hence the actual payment becomes OBCR. The total willingness to pay for this level of consumption is OACR. Hence the consumers’ surplus becomes ACB. Hence the loss in the consumers’ surplus can be given as the difference between consumers’ surplus before and after taxation. The loss of the consumers’ surplus is represented by the area of the quadrangle BCED (= ADE- ABC). The government revenue earned from this type of taxation is calculated by the product of multiplication of the post tax market clearing quantity and tax per unit charged. The post tax quantity is OR (= KH) and the tax per unit is HC. Hence the total revenue of the tax captured by the government is given by the area of the rectangle HKBC (HK X HC). Out of that the consumers payment to the government is represented by the area of the rectangle BDJC (rise in price multiplied by the amount of post tax consumption). The tax burden per unit that is transferred to the consumers is represented by JC. So JH/HC is the proportion of the total burden transferred to the consumers. CJ/JC is the proportion of tax burden that the producer has to bear. Now we consider the part of the producers’ surplus. Initially the producers were selling OT amount of commodity at price OD per unit and hence total revenue was ODET. The willingness to accept to sell that amount of commodity was OFET. Hence the producer surplus (difference between total revenue and willingness to accept) was given by the area of the triangle FED. But after tax the supply curve changes its position as the minimum supply price rises due to tax. Then the equilibrium quantity is OR and price is OB. Hence total revenue is OBCR and the total willingness to accept is OGCR. Hence the producers’ surplus is represented by the area of the triangle GCB. We can’t be sure whether the producer has been better off or worse off. Moreover, we can not say anything about the area CEH. The part CJE is a loss from the consumer’s surplus but it accrues to none of the agents; neither the government nor the producers. Similarly the part HJE is also a loss from the part of produces surplus that accrues neither to the consumers nor the producers. Those can be mentioned as the deadweight loss of taxation. The part is called deadweight loss because the taxation policy is always known as a policy that creates market distortion forcefully. This is because, the theory of market states that the markets should be allowed to work uninterruptedly to secure the welfare of the country. According to the theory of Pareto regarding welfare economics the free market operation maximizes the social welfare as the marginal cost pricing rule is followed. On the other hand the consumers have to pay according to their marginal utility. Hence the maximization of social welfare is possible. But the fallacy of the market oriented theory is that the market does not consider about the social cost function. For example if we consider the production of a company the market oriented theory would only account for the costs on the tangible goods and accounted services. It will consider the cost of raw materials, the cost of machineries but it would never account for the loss of welfare of the society through air pollution created by the exhaust of it, it would never consider the adverse effect of water pollution created by its drainage. These are the concepts of social cost which are hardly accounted. Though the market system does not consider the social and environmental cost the government has to take care of this things as the main objective of the government is to maximize the level of social welfare of the country by securing environmental and health standard and maintenance of an healthy environment through imposition of taxes and penalties of environmentally and socially harmful activities. Thats why the tax is imposed by considering the externality effects of cigarette production. The part of the share of the tax burden mainly depends upon the elasticity of demand and supply. If the elasticity of supply is high it will be convenient for the producer to transfer the burden of taxation easily to the consumer. Higher price elasticity of supply implies that the producer has the ability to change the supply easily according to the price change of the commodity. It happens especially when the producers can hold the excess capacity. The special feature of the perfectly competitive system is that the producers are not able to hold excess capacity in their hand. On the other hand if we consider the imperfectly competitive markets like monopoly or oligopoly or monopolistic competition we find that the producers have the higher capability to hold excess capacity. They mainly adopt the policy of quantity adjustment. The above situation depicted by the figure is a situation of imperfect competition in the market. Thats why the supply curve is highly elastic. On the other hand as the cigarette has least number of substitutes in the market it is difficult for the consumers to avoid the price hike due to taxation. We may consider another case which is closer to perfect competition and the supply of the cigarette is highly inelastic. Then we can show the distribution of the excess burden of taxation within the producer and the consumer. P S* S A B D E F H D O M N Q In the above diagram the horizontal and vertical axes measure quantity and price respectively. D is the demand curve and S is the initial supply curve. The initial supply curve of the product is S. The equilibrium price and quantity are given as ON and OD respectively. Equilibrium point is given by E. Now we consider that the government imposes a tax. Consequently the supply curve shifts leftward and the new supply curve is S*. The vertical difference between the two supply curves represents the tax rate. Now the new price level is determined by the intersection of new supply curve S* and the demand curve D. The price is OA ( Read More