Effects of Cigarette Taxes on the Demand for Cigarettes - Research Paper Example

Cigarette Taxes Introduction The quantitative demand analysis depicts the changes in the demand for a particular commodity due to parametric change. The task is to analyze the effect on the demand for cigarettes due to the imposition of taxes. In this respect a study might be carried out on how people’s conduct alters with the increase in price of the cigarettes. This will be illustrated by the price elasticity of the cigarettes, which shows the proportional change in the quantity demanded due a percentage change in its price. Another factor that assists in the demand analysis is the cross-price elasticity, which shows the percentage change in quantity due to the change in price of any other good. If the price of cigarettes increases, not only will the quantity of the cigarettes fall but simultaneously it may also affect other commodities. The aspect of income elasticity will also be incorporated here, which will show us whether income and demand for cigarettes move together or not. Effects of cigarette taxes on the demand for cigarettes: Lately the world economy has been more concerned about the harmful effects of smoking. Though, from time immemorial, people are trying to resort to drugs or other narcotics, this gives them a tranquilizing effect in their minds. One of the most common intoxicants is a cigarette, which serves as the escape route from their harsh realities of life. In the recent times, smoking has taken the shape of an epidemic, which is affecting not only people’s minds but also their lives. Many steps have been taken, such as campaigns showing how smoking is injurious to heath or health programs to restrict the usage of cigarettes per day. In spite of this, people are reckless to quit smoking, as they find no perfect substitutes of it. In regard to this the governments of all the countries are starting a new tax regime especially US government. This consists of an increase in the price level of cigarettes by the imposition of proportional tax or a lump sum tax. By proportional tax structure, a particular rate of tax is imposed on price of cigarettes. In respect to the US governments the tax structure usually takes the form of excise or sales tax. Here, a fixed rate of cents is imposed on the price of cigarettes. Let the tax rate‘t’ be imposed on the price of cigarettes, ‘p’, the new price is now ‘p (1+t)’. According to the law of demand, the price and demand of a normal good are negatively related. Here, cigarette is a normal good since with the fall in price, smoking becomes more attractive and popular among the individuals. The following diagram shows the effect of price hike on the demand for cigarettes. Price P(1+t) p (q2) (q1) Quantity Fig-1 Source (Varian, 295) In the above figure it is observed that if cigarettes posses the quality of a normal good, then as price increases to p (1+t), the quantity demanded will decrease from q1 to q2. The price elasticity also shows a certain degree of elasticity due to sensitivity of the quantity to the price change. It might be greater than one or equal to one. In contrast to the above analysis, if cigarettes become a necessity for any human being due to ones habit, then the price elasticity will be always less than one. It will be inelastic by nature. This implies that with any price change per cigarette, the quantity demanded will not affected much. So, with tax imposition the smokers will not quit smoking or move to any other substitutes. This is illustrated as follows: Price (p+t) p Quantity Fig-2 source: (Varian, 295) Q In the above figure, the scenario is completely changed. The demand curve is vertical for chain smokers. No matter what prices of the cigarettes, individuals will not change their demand. The demand function remains unchanged with respect to the expenditure on cigarettes. It can also be said that, due to few close substitutes for cigarettes, the price elasticity will be less than one or rather inelastic. Here the quantity demanded remains fixed at Q. The imposition of taxes thus produces an ambiguous effect on the demand of the cigarettes. With respect to various income groups also, the demand for cigarettes varies. Imposition of tax does not affect people from the high-income group. This can be shown with the help of income elasticity of demand. If cigarettes are a normal good for some group of people, then with the rise in income, the demand for it also increases. People coming from a rich income group will not curb down their consumption of cigarettes due to the price rise. The poor people will try to decrease the demand for cigarettes for the price hike. They can switch their expenditure to any other substitutes of cigarettes or they can consume a cheaper brand of cigarettes. For the rich people the income elasticity is perfectly elastic, as the demand for cigarettes will increase. It is inelastic for the poorer sections of the society. So, it is understood that with a tax hike on cigarettes, the reduction of the demand will be not be to full extent. (Rabin and Sugarman, 128). The table below shows the changing consumption levels of cigarettes in US over the years 1990-2004. Empirical estimation Now, an empirical estimation of the demand for cigarettes might be done using data of Indonesia. This country has been chosen instead of USA owing to the availability of a continuous dataset for cigarette prices, consumption and tax. We may generalize the findings of this case based upon the assumption that cigarette users would have the same or similar behavioral pattern across the world. The following is the demand equation in general: Q = a + b.P; P: Price of cigarettes, Q: Quantity consumed The data for consumption of cigarettes and prices of cigarettes have been presented in the appendix (table 1) over the years 1980-2001. Running a regression with Price (P) as regressor and Q as dependent variable the following results have been found: SUMMARY OUTPUT Regression Statistics Multiple R 0.017236154 R Square 0.000297085 Adjusted R Square -0.049688061 Standard Error 17.31053399 Observations 22 ANOVA   df SS MS F Significance F Regression 1 1.780986791 1.780987 0.005943 0.939315 Residual 20 5993.09174 299.6546 Total 21 5994.872727         Coefficients Standard Error t Stat P-value Intercept 70.37578683 28.22901629 2.49303 0.021552 X Variable 1 -0.001766705 0.022916287 -0.07709 0.939315 Table 1 (appendix) We cannot estimate the demand for cigarettes in the form of a standard demand curve because the coefficient of price is not significant at 5 percent level of significance (p-value = 0.939315 >0.05). Now let us look at the elasticity of demand for cigarettes ((q/q)/(p/p)). For this, logarithmic values of price and consumption of cigarettes are taken and regression is conducted with log P as regressor and log Q as dependent variable. The following part of the result shows insignificant coefficient of Log P. However if we take the coefficient (of log P) as the elasticity, then we find the value to be negative and equal to -0.52 (approximately). This is much less than one. However the negative linear relation itself does not hold in case of cigarette consumption. Part of ANOVA results for regression of log Q against log P   Coefficients Standard Error t Stat P-value Intercept 3.395657925 2.45095256 1.385444 0.181175 X Variable 1 -0.515221608 0.794773391 -0.64826 0.524189 Table 1 (appendix) Next in order to estimate the cross price elasticity we assume coffee to be a complementary good to cigarette and try to estimate the elasticity. However once again we get insignificant result while regressing log Q against log P1 (price of coffee). It is therefore difficult to get a normal or standard result for cigarette consumption both while measuring elasticity of demand and cross elasticity of demand. The following part of the result shows the insignificant value of the coefficient (p-value = .72 > .05) and hence the cross price elasticity cannot be determined (just like the elasticity):   Coefficients Standard Error t Stat P-value Intercept 1.64180615 0.471118 3.484916 0.002835 X Variable 1 0.090913457 0.249839 0.363889 0.720427 (table 2) Again the regression of tax (% Nominal Excise Tax to Nominal Price) imposed on cigarettes against its consumption also shows insignificant results (p-value 0.095 > 0.05). This might be shown as below:   Coefficients Standard Error t Stat P-value Intercept 19.16129 28.18169 0.67992 0.50435 X Variable 1 2.004181 1.14275 1.753823 0.094773 Table 1 (appendix) Thus from the above results, we find that cigarettes cannot be always treated as a normal good, rather it is a necessary good most of the times and therefore no linear demand relation is determined. The actual value of elasticity of demand for cigarettes ranges between zero and unity for different classes or categories of people. The demand curve is an arc instead of a straight line and there are two points of price and quantity to be determined (Lipsey and Harbury, 64-65). Tax imposition Imposition of taxes does not have only one consequence of decreased demand. The tax hike also accompanies many supplementary effects on cigarettes. An increase in the price level may hurt the consumers by increasing the expenditure of their commodity basket. This leads to a disruption of the consumption function. So, a political strategy of increasing revenues through taxes on cigarettes is not feasible at all. In US economy, the empirical observations shows that in South California, there has been a drastic fall in the range of smokers. Although, this might not be for the tax imposed but for the awareness of diseases caused by chain smoking. One more effect on the collection of revenues is that of destabilization policy. If, due to tax imposed, the demand actually falls, with no one left to buy cigarettes; the tax regime is not accepted. Tax are imposed in such a way that people who are chain smokers will not leave smoking and this will add to the revenues of the government. Due to an increase in price, smuggling can also be promoted with the trade of cigarettes. Since it is a form of narcotics, people who do not have enough money to pay for the expensive cigarettes buy them from an illegal market. It leads to the rise in commitment of crime in the economy. The objective to reduce smoking will be smashed into pieces by the government authorities. It has completely changed the source and the channel through which one can get cigarette. Cigarettes form a very popular commodity for smuggling due to its lightweight; high-demand and different tax structure across regions. The most deadly effect of taxation can be the act of terrorism. Due to an increase in the price level of any commodity due to tax, an individual’s behavior and consumption completely changes. This can reach the extreme point of violence against the political authorities of the economy. Terror attacks and death can paralyze the economy due to this modified human behavior. Thus, any government policy can affect economy to step into the path of terrorism. Smoking reduction due to a tax can create a healthy environment among all the individuals and lead to the betterment of the economy. It can save one’s life from the harmful diseases like lung cancer, bronchitis etc. In the initial periods, only campaigning against the fatal consumption of cigarettes has been a failure. Seeking an escape route from the loneliness, and depression through smoking can be brought to an end. This is taken in the form of restrictive tax regime. An imposition of tax over cigarettes increases its price and decreased the aggregate demand for the good. This will lower the level of tobacco production and thus has a negative effect on the employment level of the economy. (Evans) Distributional effects of cigarette taxes: A tax imposed on a commodity passes from the producers and the retailers to the consumers. The question that arises is that who bears the burden of cigarette taxes. For the consumption of cigarettes, if different tax rates are imposed on the people, then gains from consumption of substitutes can be obtained. Like, if the poor people are more inclined towards using more cigars then, reduction of tax will have a lesser impact on them. Correspondingly, if a high rate of tax is imposed on the high-income group of people, they are less sensitive to this hike. The distribution of tax varies across the income groups. People who are relatively poor do not afford to pay for the higher price. This drives down the group of people from the tax burden. On the other hand, individuals hailing from a wealthy family are insensitive to the increase in the price of cigarettes. Since, cigarettes taxes are usually of excise tax types, the excess burden of tax lowers the purchasing power of people. In order to escape from this trap, they modify their consumption to other available substitutes. So, the entire burden fall over the rich people whose consumption functions do not response to the cigarettes tax. The bulk of the taxes fall upon the high-income group people. This picture does not remain the same if all individuals consume the same amount of the product. In this case, individual who have the ability to pay more, are not taxed heavily. It violates the theory of vertical equity, which states different level of taxes over different level of income levels. The tax structure takes a different shape, as all the groups have to pay same amount of taxes. It squeezes out a larger proportion of tax from the poor households. . In other words, the cigarette taxes are regressive by nature. This is because a high percentage of income is taken away from the poor in the hands of the rich. Here, the tax burden is solely on the shoulders of the low-income group people. Increase in taxes can be progressive if due to the increased price level of the cigarettes, the poor people reduce their consumption. In that case, the poor people who are more sensitive to the price change are free from the tax burden. This variability of tax- burden gives long-run benefits to the poor in the form of economic welfare and healthy living. (Yurekli, 65-66) Government’s contribution: The revenues collected from the cigarette taxes have been proved to be successful in terms of financing the budget deficit. The form of cigarette taxes take accounts the states taxes. As soon as the revenues are collected, a portion of the revenues goes to all the states, which depend on Government subsidies to produce any public good. With the remaining revenue amount, the Government invests in several health programs, charity associations and other social campaigning programs. Among these programs, tops the list are the cancer research grants, harmful diseases caused by the tobacco consumption and healthy defense sector. States usually, utilize these funds towards providing medical facilities to the poor people. Investment of the revenues in the health department is made to ensure health awareness among the people of the economy. Apart from these, the tax revenues are deposited in the bank to earn an interest. This will yield a larger amount after a specific time period, which is invested in the building up national parks or any other high-budgetary goods. Revenue collection by the federal state does a lot to initiate awareness programs to force individual to quit smoking. One main objective to impose tax in the consumption of cigarettes is to discourage people to buy cigars. It is one of the vulnerable ways to hit back the consumption of the good, especially among the poorer sections of the society. The strategy of such a fiscal policy eradicates the crowding out over the purchase of cigarettes. The tax collected also goes to fund the Children’s Health Insurance Program (CHIP), which is to help the uninsured, poverty-stricken families to grow their children in a healthy environment. The excess of government expenditure over the earnings forces the authority to raise the level of taxes on such habituated commodities. (Paddock) Since, for most of the people living in the urban society, it is not possible to quit smoking, the tax imposition hardly matters for them. This will distribute the taxes from the producers to the consumers. In this way, the massive revenue collected is utilized in financing the state expenditure especially in the long-term development projects. Even, some states municipalities also impose taxes on the sale of cigarettes. These are used for road maintenance or improvement in the educational environment of schools. The victims of chain smoking from a low-income family background have to accept death due to the increased costs of hospital charges and medical tests. The tax revenues received by the government are utilized to provide medical treatment to the infected patients. This is done in a cost-effective manner such that the smokers can escape the path of death and lead a healthy life. The process of receiving taxes shows those cigarettes taxes has both positive as well as negative impacts. In one direction it is an initiative to stop smoking and prevent the lives of several individuals from the death. On the other hand, it seeks the objective to maximize government revenues due to high demand of the good. A noteworthy policy implication depicts the development of health care programs and implementation of advanced medical facilities for the poor families. Charity programs for the betterment and education of the children are also promoted through these funds. Long-term projects in the construction of national parks, roads, educational institutions and Medical center forms an integral part of the tax-investment program. Conclusion: The above discussion portrays that in order to conquer the habit of smoking and mop out the phenomenon of death; a tax is imposing on cigarettes. The form of tax can be proportional or lump sum in nature. In the US economy, the cigarette taxes are usually in the form of excise tax. This can be specific or ad-valorem in behavior. The ad valorem tax is a way to impose a particular tax rate on the price of the cigarettes. Due to this tax imposition, there is fall in the purchasing power of the individuals. The tax burden is usually on the rich consumers as they are less sensitive to the price of the cigarettes. If both the poor and the rich individuals consume same amounts, then the tax becomes regressive by nature. This will imply that the low-income group of people will be faced with the increasing burden of the taxes. This shows that different rates of tax should be imposed for different groups of people. Apart from reduction of consumption, there are other effects of tax imposition. Like the fostering of illegal activities like smuggling, destabilizing revenue policy, hampering the consumption function and it also modifies the human behavior. This modification changes the individual to a terrorist. The revenues collected are used up in providing health care and medical facilities to the poverty-stricken families. It promotes anti-tobacco habits through several public programs and finance budget deficits. The policy, thus, preaches to free the economy from the bondage of fatal and intoxicating effects of smoking. Appendix. Table 1   Cigarette price Cigarette % Nominal Excise Tax to Nominal Price year (Rp/pack 16 pieces) Consumption (pack/capita/year)   log P log Q 1980 1383.8 59.2 18.7 3.141073 1.772322 1981 1379.6 61.8 20.1 3.139753 1.790988 1982 1297.5 57.3 21.8 3.113107 1.758155 1983 1248.8 60 20 3.096493 1.778151 1984 1167.2 62.5 25.3 3.067145 1.79588 1985 1148.5 64.8 26.2 3.060131 1.811575 1986 1135.3 68.4 26.3 3.055111 1.835056 1987 1050.2 64.9 24.1 3.021272 1.812245 1988 1011.1 74.3 25.3 3.004794 1.870989 1989 1022.9 66.5 26.6 3.009833 1.822822 1990 1132.9 71.1 23.4 3.054192 1.85187 1991 1266.3 66.5 25.4 3.102537 1.822822 1992 1274.9 61.2 22.3 3.105476 1.786751 1993 1192.4 64.5 24.1 3.076422 1.80956 1994 1101.9 74.7 25.4 3.042142 1.873321 1995 1097.7 74.1 25.8 3.040484 1.869818 1996 1138.5 85.3 26.3 3.056333 1.930949 1997 1101.6 87 26.5 3.042024 1.939519 1998 1277.6 85 19.8 3.106395 1.929419 1999 1346 9.4 24.8 3.129045 0.973128 2000 1334.8 92.1 31.5 3.125416 1.96426 2001 1758.2 90.2 28.8 3.245068 1.955207 (Djutaharta, Surya, Pasay, Hendratno and Adioetomo, 48) Table 2: Cigarette Year Prices of coffee to growers (US cents per lb) or P1 Consumption (pack/capita/year) Log P1 Log Q 1983 51.53 60 1.71206 1.778151 1984 46.63 62.5 1.668665 1.79588 1985 48.18 64.8 1.682867 1.811575 1986 77.02 68.4 1.886604 1.835056 1987 60.19 64.9 1.779524 1.812245 1988 54.49 74.3 1.736317 1.870989 1989 31.55 66.5 1.498999 1.822822 1990 45 71.1 1.653213 1.85187 1991 78 66.5 1.892095 1.822822 1992 95 61.2 1.977724 1.786751 1993 115.53 64.5 2.062695 1.80956 1994 173.51 74.7 2.239325 1.873321 1995 160 74.1 2.20412 1.869818 1996 140 85.3 2.146128 1.930949 1997 112.26 87 2.050225 1.939519 1998 99.41 85 1.99743 1.929419 1999 75 9.4 1.875061 0.973128 2000 68.43 92.1 1.835247 1.96426 2001 53.61 90.2 1.729246 1.955207 The values in red are the estd. ones Source: International Coffee Organization References: Evans, Matt. “Cigarette tax measures may have unintended consequences”. Biz Journals, Friday, November 1, 1996. Available at: http://portland.bizjournals.com/portland/stories/1996/11/04/editorial4.html (accessed on June 29, 2010) Djutaharta, Triasih, Surya, Henry Viriya, Pasay, N. Haidy A. Hendratno and Sri Moertiningsih Adioetomo, AGGREGATE ANALYSIS OF THE IMPACT OF CIGARETTE TAX RATE INCREASES ON TOBACCO CONSUMPTION AND GOVERNMENT REVENUE: Case of Indonesia, Jan 2005, available at: http://rctfi.org/reports/Tobacco%20Taxation/DjutahartaAggregateAnalysisFinal.pdf (accessed on July 5, 2010) International Coffee Organization. Price Data, Historical Data, available at: http://www.ico.org/new_historical.asp (accessed on July 5, 2010) Lipsey, Richard E and Colin Harbury, First Principles of Economics. Oxford University Press. 1992. Paddock, Catherine, Senate Panel Approves Huge Tobacco Tax To Fund Child Healthcare, Medical News Today, July 2007, available at: http://www.medicalnewstoday.com/articles/77369.php (accessed on July 5, 2010) Rabin, Robert and Sugarman, Stephen. D. Regulating Tobacco. New York: Oxford University Press Inc. 2001 Varian, Hal. R. Intermediate Microeconomics. New York: W W Norton and Company,1999 Yurekli, Ayda. “Design & Administer Tobacco Taxes”. Available at: http://www1.worldbank.org/tobacco/pdf/Taxes.pdf (accessed on June 29, 2010) Read More