Reducing health costs and increasing Government revenue beyond COVID-19: Raising cigarette taxes
Harini Weerasekera and Chamini Thilanka
The susceptibility of smokers to
contract COVID-19 has been recognised
by the World Health Organisation (WHO) and other medical authorities. In
Sri Lanka, concerned
parties have called for a temporary ban of cigarette sales as a measure to
contain the spread of the virus – a commendable move. However, beyond the
pandemic, it is important to have appropriate cigarettes taxation measures in
place whenever cigarettes are in the market, to reduce consumption, raise
government revenue, and reduce the health costs of smoking. Easing the
government’s health cost burden from smoking (6% of government revenue in 2015)
has become even more crucial amidst the COVID-19 outbreak, where health
resources are already stretched thin.
In a previous
IPS blog, the case for increasing specific excise tax rates on cigarettes
and simplifying Sri Lanka’s existing 5-tier cigarette tax structure was
highlighted. Increasing and simplifying excise taxes are prescribed by the WHO Framework
Convention for Tobacco Control (WHO FCTC) and are the most cost-effective tools
that governments can employ to reduce smoking rates. However,
the tobacco industry strongly opposes raising taxes on cigarettes. Further, Sri Lanka has some
misinformed cigarette taxation practices in place, such as taxes differentiated
by the length of cigarette and ad hoc cigarette tax changes that are linked to
the country’s overall VAT policy. This blog shows the fallacies in these
arguments and practices, and highlights the importance of streamlining taxation
policies in the country, with the objective of reducing smoking prevalence and
reducing smoking related health costs.
Switching to Beedi Consumption
Currently, cigarettes in Sri
Lanka are taxed at five different excise duty rates, based on the length of the
cigarette (Table 1). As per WHO FCTC recommendations, if Sri Lanka is to
simplify its tax structure by taxing all cigarettes at one rate, regardless of
length, the tax on shorter cigarettes would have to be increased. Over time,
there has been pushback from the tobacco industry to keep
taxes low on the cheapest type of cigarette, arguing that raising this tax
will incentivise users to switch to beedi consumption. However, the Alcohol and
Drug Information Centre’s (ADIC) survey
data indicate that beedi consumption has, in fact, declined over time,
despite the narrative peddled in media that consumption has increased in
response to cigarette tax increases. As a percentage of current smokers, the
share of beedi users declined from 11% in 2013 to 5% in 2018. Further, in 2017,
only 2.5% of current smokers were found to be substituting cigarettes with beedi,
following cigarette price increases; in contrast, 87% reduced cigarette usage
and 3% switched to cheaper cigarettes. This evidence contradicts the argument
that smokers replace formal cigarettes with illicit cigarettes and beedi.
Table
1: Excise Duty on Cigarettes in Sri Lanka – December 2019
| Length of cigarette | Tax (LKR per 1000) |
| Length below 60mm | 13,360 |
| Length 60-67mm | 22,300 |
| Length 67-72mm | 37,650 |
| Length 72-84mm | 43,100 |
| Length Exceeding 84mm | 48,350 |
Source: Ministry of Finance, Gazette Notifications
Taxation versus Pricing of Cigarettes
Prices of
cigarettes have continuously increased at a global level, as per the WHO’s calculations.
However, such price increases usually consist of a higher net-of-tax price component.
Net-of-tax is simply the portion of the price left once the tax is deducted. In
Sri Lanka, the price of the most sold cigarette brand (JPGL) increased more
than threefold between 2008 and 2018, this increase was due to both the increase
of tax per stick (LKR) as well as net-of-tax (Figure 1). This pattern can be
observed in other cigarette brands as well. The price of a cigarette borne by the
consumer consists of production cost, profit, and tax. A marked feature here is
that a high share of the net-of-tax price is absorbed as a profit margin by the
producer, which eventually results in pushing prices up by more than the tax
increase, while stagnating the government tax revenue.
As such,
although tax increases – to which the industry is resistant – usually push
prices up, the beneficiary tends to be the cigarette industry, rather than the
government, gaining a higher markup than tax revenue, respectively.
Value Added Taxes (VAT) on Cigarettes
A problematic feature of Sri
Lanka’s cigarette taxation policy is that, over time, tax policy has fluctuated
according to changes in the country’s overall VAT rate. The VAT is applied on
several goods in Sri Lanka, and is a fixed rate that is common to all goods that
fall into the VAT net. Cigarettes have both excise duties and VAT applied on
them. However, when the overall VAT rate in the country fluctuates based on
external factors unrelated to cigarettes, excise taxes are adjusted to reflect
this change. This is not in line with best practices; excise rates should be
raised to adjust for changes in inflation and income, and not according to
changes in VAT. This is because cigarettes might still be affordable for
consumers, if the price is not raised to reflect a rise in inflation or income.
For instance, in 2014, cigarettes
were exempted from VAT and so excise rates on cigarettes were raised to adjust
for the shortfall in revenue. More recently, in 2019, the VAT rate was reduced
from 15% to 8%, so excise rates on cigarettes were raised for the same reason.
As such, there is a tendency for movements in the excise tax to be determined
by changes in the VAT rate, rather than be adjusted in line with inflation and
income. It is important that cigarette tax policy focuses on raising excise
taxes, independent to VAT rate movements.
Conclusion
The blog flags and debunks three
arguments against the WHO recommendations to raise excise taxes on cigarettes
and establishes that (1) although there is a negligible trend in switching to
lower-priced cigarettes, the common response to price rising is the reduction
of cigarette consumption, not replacing the tobacco consumption with illicit
cigarettes and beedi, (2) the producer has benefited more from cigarette
tax/price increases than the government in terms of revenue per stick, and (3) the
effectiveness of cigarette taxation vastly depends on the type of tax imposed.
As such, separating ad-valorem taxes from excise tax on cigarettes and
following-up the WHO recommendation (specific excise taxation with inflation
and income adjustment) is the most effective way of curbing cigarette
consumption as well as increasing government tax revenue.
A forthcoming
IPS study estimates through a tax modelling exercise, that if (1) excise
taxes on cigarettes were raised to adjust for inflation such that they become
less affordable, and if (2) the existing tier structure was incrementally
collapsed into a uniform tax rate over a four year period, government
revenue from tobacco will increase by LKR
37 billion, cigarette consumption will decline by one billion sticks, smoking
prevalence (of +15 years) will decline to 12.5%, with the number of premature
deaths from tobacco use that can be avoided in the future amounting to 141,391.
These are significant outcomes for Sri Lanka’s health and fiscal space, and can
be implemented at no cost to the government. As such, it is suggested to
increase tobacco taxes in this manner, to increase tax revenue and reduce
health costs incurred by the government, regardless of industry pressure
against the implementation of such policies.
(Harini Weerasekera is a
Research Officer and Chamini Thilanka is a Research Assistant at the Institute
of Policy Studies of Sri Lanka (IPS). To talk to the authors, email harini@ips.lk / chamini@ips.lk. To view this article online and to share your
comments, visit the IPS Blog ‘Talking Economics’ – http://www.ips.lk/talkingeconomics/)