Excise Taxes on Tobacco: How Much Scope does the Government Have?

C.P. VAN WALBEEK*(1)IN THE PAST DECADE smoking has become a hotly debated issue. On the basis of its (alleged) negative externalities, there havebeen calls to abolish smoking and the tobacco industry (SAMRC 1988, 1992). Pressure from the anti-smoking lobby has resulted inlegislation restricting smoking in public places and on public transport being passed in recent years.Implicit in the reasoning of the Medical Research Council and other pressure groups is the view that the total social and privatecosts of smoking are greater than the benefits derived from this activity.This is challenged by Reekie and Wang (1992) and Reekie (1994), who argue that, notwithstanding the health hazards, smoking mayhave a net benefit to society. They argue that smokers have already discounted the hazards associated with smoking (Reekie andWang 1992:4). Using a state dependent approach*(2) to standard decision theory, they show that, given people's differentpreferences, it is possible that smoking confers benefits on (some) consumers. In a subsequent paper, Reekie (1994:231) estimatesthe consumer surplus from smoking and finds that "on the most pessimistic of assumptions, ... consumers (would) still receivesubstantial benefits from smoking".Abedian and Dorinngton (1994) strongly contest Reekie and Wang's "facade of technical, empirical, and scientific sophistication",arguing that their theoretical approach and empirical research are flawed. They propose that consumers are not as rational andcapable

1996 SAJE v64(1) p21

of processing information as the standard theory leads one to believe. They argue that this, together with the addictive nature ofsmoking, renders Reekie and Wang's "contrived" results unacceptableThe present study does not enter this debate. Smoking is accepted as a fact of life. The fundamental question here is: By how muchcan the government realistically increase its excise revenues by increasing tobacco excise duties? In other words, the study isaimed at quantifying the taxability of the tobacco industry.*(3)Excise duties on cigarettes and other tobacco products are generally regarded as sumptuary taxes, given the negative externalitiesof smoking (Buchanan and Flowers 1987:327). Generally, people have become more health conscious and are more aware of thepotential detrimental consequences of smoking. In recent years the medical community has emphasised the harmful impact ofpassive smoking. This has led to a strong resistance to smoking, particularly from the non-smoking community. Given thesenegative externalities, a tax on the consumption of tobacco is seen as fair and acceptable by large sections of the population. Thisform of government revenue thus implies only a small political opportunity cost.*(4)Currently there are enormous fiscal demands on the South African government. The already heavy direct tax burden makes itvirtually impossible for the government to increase its revenues from this source. Other sources of revenue will have to befound to fund government expenditures. In this context an indirect tax such as excise duty has considerable merit.The first part of the paper is descriptive, and focuses on the historical magnitude and importance of excise duties on tobaccoproducts. The second part of the paper deals with the excise generating potential of tobacco. An econometric model is used toestimate the price elasticity of demand for tobacco. This is then used to estimate the effect of increases in excise duties on totalexcise revenues from tobacco.

1996 SAJE v64(1) p22

1. Historical OverviewExcise duties on tobacco products*(5) are not new in South Africa; in fact, it has been a source of government revenue since atleast the formation of the Union in 1910. The historical picture is presented in Table 1. From column (4) in the Table it is clear thattobacco excise duties contributed significantly to government revenue in the post-war period until the early 1970s. The ratherdramatic increase in the contribution of tobacco excise duties during the Second World War is noteworthy. The fiscal demands ofthe war effort resulted in substantial increases in the excise rate on cigarettes. In addition, pipe tobacco and cigars, previously notexcisable, were included in the excise base in 1942 (Tobacco Board 1960).Table 1. Tobacco Excise Taxes in Historical Perspective

Year Total TobaccoExcise Duties

(Current Prices,R million)

Total Govern-ment Revenue(Current Prices,

R million)

Tobacco ExciseDuties

(Percentage ofGovernment

Revenue)

Total TobaccoExcise Duties

(Constant1990 Prices,

R million)

12

(1) (2) (3) (4) (5)

19911/12 0,29 29,3 0,98 na

1920/21 1,31 53,7 2,43 39,7

1930/31 1,72 45,3 3,81 53,8

1940/41 4,09 120,6 3,39 127,8

1950/51 21,20 306,0 6,94 424,0

1960/61 52,60 696,0 7,55 751,4

1970/71 99,80 2 265,0 4,40 1 084,8

1980 293,80 12 441,0 2,36 1 152,2

1990 710,80 67 334,0 1,06 710,8

Sources: Tobacco Board; SARB,1994; Auditor-General.In the remainder of the study the focus is on South Africa's experience with tobacco excise duties in the period since 1960. Incolumn (2) of Table 2 the contribution of tobacco excise duties to government revenue since 1960 is shown on an annual basis. Thesalient feature of this variable is the significant decrease in the relative

1996 SAJE v64(1) p23

share of this source of income throughout the period. This may obviously be the result either of a decrease in total tobacco exciseduties (the numerator in the ratio) or of an increase in government revenue (the denominator). The approach followed in thissection is to investigate changes in both the denominator and the numerator. Three aspects are discussed, namely (i) changes ingovernment revenue, (ii) changes in the consumption of tobacco; and (iii) changes in the excise rate on tobacco products.Concerning the first factor, it is true that the government sector has expanded throughout the century, and especially in thepost-war period. Since 1960 government current revenue has grown from about 18 per cent of GDP to its current level of about 28per cent (SARK 1991, 1994). Between 1960 and 1992 real government revenue has grown at an average annual rate in excess of 5 percent. However, despite the strong growth in government revenue and the relative decline in the agricultural sector, the decrease intobacco excise revenues, relative to government revenue, is too large to be explained by the increase in government revenuesalone. In column (3) of Table 2 total tobacco excise duties, expressed in constant 1990 rands (i.e. without any reference togovernment revenue), are shown for the period 1960 to 1992. Total real tobacco excise revenues increased steadily between 1960and 1980, but fell dramatically between the early 1980s and 1987. Subsequently, these excise revenues remained relatively stable,but at a low level compared to the 1970s and early 1980s.Another possible reason for the decline in the relative share of tobacco excise duties has to do with the consumption of tobaccoproducts. If there were a decrease in the consumption of tobacco, this could cause a relative decline in excise revenues on twocounts: (i) by decreasing the tax base and (ii) by providing the tobacco industry with a strong case to request a real reduction inthe excise rate on tobacco. This, in turn, would decrease the real retail price of tobacco and stimulate demand.From column (4) in Table 2 it is clear that there has, in fact, been an upward trend in the consumption of tobacco since 1960. Overthe

1996 SAJE v64(1) p24

period 1 960 to 1992, consumption increased at an average annual rate of 1,8 per cent. Given an annual population growth rate: ofabout 2,5 per cent, per capita consumption has also decreased by only a relatively small amount over the same period.*(6) Thus, itseems that anti-smoking campaigns and health warnings have had only a limited impact on per capita tobacco consumption. Whilethe growth in total consumption expenditure outstripped the growth in tobacco consumption by an average annual rate of abut 1,8percentage points during the period 1960 to 1992, the tobacco industry, while admittedly unspectacular, definitely did not decline inabsolute terms.This leaves the real decrease in the excise rate on tobacco products as the main reason for the decline in the relative share oftobacco excise duties. Excise duties on tobacco products, like most other excisable goods, are levied as a specific tax (i.e. a taxbased on physical properties such as mass or volume) as opposed to an ad valorem tax, which is levied on the monetary value ofthe product. Excises on cigarettes are levied as a certain amount x per 10 cigarettes plus another amount y if the mass of 1 000cigarettes exceeds 1,5 kilograms. All other tobacco products are excisable by mass (Tobacco Board 1993:24). The Minister of

13

Finance can increase the excise rate at his discretion. This usually takes place at the reading of the Budget.Prior to the 1970s, inflation was insignificant and it was not necessary to adjust the nominal excise rate regularly; hence the realexcise rate remained relatively constant. This is shown in column (5) of Table 2. However, when inflation accelerated in the middle1970s, the government failed to adjust the excise rate at regular intervals. Also, when the adjustments were made, they were usuallysmaller than the inflation rate. The consequence was that tobacco excise duties dwindled in real terms.*(7) In fact, real excise rateson cigarettes decreased by about 70 per cent between the early 1970s and 1987.*(8)The Margo Commission observed this and recommended that the excise rate on all goods which are subject to specific exciseduties, should be adjusted on a regular basis (RSA 1987:400-401). The government accepted these proposals and, since 1987, thereal excise

1996 SAJE v64(1) p25

duty on tobacco has stabilised. However, in a historical context the tobacco excise duty in South Africa is still at a very low level.Table 2. Important Aspects of Tobacco Excise Duties, 1960-1992

Year Tobacco ExciseDuties

(Percentage ofGovernment

Revenue *(9))

Total TobaccoExcise Duties

(Constant1990 Prices*(10),

R millions)

Total Consumption of Leaf

Tobacco (MillionKilograms)

Excise Rate onCigarettes (Constant1990 Prices, Centsper 10 Cigarettes

(1) (2) (3) (4) (5)

1960 -- 734 22,7 --

1965 5,8 770 24,8 57,6

1970 4,7 1 009 29,1 70,6

1975 3,4 1 096 33,8 62,3

1976 3,6 1 200 36,0 62,3

1977 3,5 1 310 35,4 56,0

1978 3,2 1 245 34,1 50,8

1979 2,9 1 202 36,0 44,9

1980 2,4 1 154 37,3 39,5

1981 2,4 1 145 37,2 41,1

1982 2,4 1 160 39,3 35,8

1983 2,1 1 027 39,0 34,5

1984 1,8 937 39,0 30,9

1985 1,6 875 38,1 26,6

1986 1,3 753 37,9 22,4

1987 1,3 704 41,0 19,3

1988 1,2 724 42,6 19,8

1989 1,1 735 40,5 18,4

1990 1,1 711 43,6 18,1

1991 1,2 710 41,9 21,4

1992 1,4 769 40,7 19,8

Sources: See Table 1.In the 1994/95 Budget Speech the Minister of Finance announced that the government intended to raise tobacco excise duties to

14

fifty percent of the retail price, which is comparable to other

1996 SAJE v64(1) p26

countries (Department of Finance 1994:5.7).*(11) This increase will be phased in over a number of years. As a first step the exciserate was increased by about 25 per cent in nominal terms, which implies a real increase of about 15 per cent (Department of Finance1994:5.7).To summarise, it is clear that the government has neglected tobacco excise duties as a source of government revenue. By notadjusting the excise rate on a regular basis, the real excise rate has dwindled. Total real tobacco excise revenues have substantiallydecreased. Now the government wants to increase its share of the "tobacco cake". Two questions arise, namely: what will thepossible effect on the quantity demanded for tobacco be if the government increases the excise rate?, and by how much can thegovernment realistically increase the excise rate if the only consideration is the maximisation of government revenue? It is to thesequestions that we now turn.

2. The Excise Potential of TobaccoThe method followed in this section consists of two steps. The first involves specifying and estimating a demand function fortobacco from which one can derive the price and income elasticities of demand. In the second step the estimated demand equationis used to estimate the impact of excise rate increases of different sizes on demand. Plotting the excise rate against the totalexpected excise revenue, yields a curve for tobacco excise duties analogous to Laffer's curve for income tax. From this curve onecan read off at which rate maximum revenues are realized.a) Specification of the Demand FunctionThe demand for any product is generally specified as a function of its own price, income of consumers, population size, the price ofrelated goods (substitutes and complements), tastes and product-specific factors. According to the habit persistence hypothesispast consumption is also a major determinant of current demand. With an addictive product like tobacco habit persistence is likelyto occur.*(12)

1996 SAJE v64(1) p27

Formally, the demand for tobacco can be presented as:Qd = f(Qd(-1), P, Ps, Pc, YD, POP, ADV, Z)

where Qd is the quantity of tobacco demanded, Qd(-1) is the quantity of tobacco demanded in the previous period, P is the price

of tobacco, Ps is a vector of prices of substitutes, Pc is a vector of prices of complements, YD is disposable income, POP is the

population size, ADV is the effect of advertising, and Z is a vector of preferences or tastes.In the empirical estimation of a demand function either a linear or a logarithmic mathematical form is generally used. Each hasadvantages and drawbacks. The logarithmic form has the benefit that the resulting coefficients can be interpreted as elasticities.The disadvantage is that these elasticities are assumed constant. For small price or income changes the practical implications arenot serious, but for larger changes it may result in unrealistic changes in the quantity demanded. With the linear form theelasticities are not constant, which is more realistic, but the coefficients cannot be interpreted as elasticities as with the logarithmicspecification, although they can be calculated fairly easily.The implied consumer surplus of the two specifications is another relevant issue. Given that a product-specific tax like excise dutyimpacts on the consumers' surplus, the size of the pre-tax surplus is a key determinant of the tax potential of such a product. Alogarithmic, vis-a-vis a linear specification of the demand function implies an "explosive" consumer surplus (Reekie 1994:229-230),which suggests that the product has greater tax potential than a linear demand function indicates. In fact, a logarithmicspecification implies that the tax revenue from such a product is an ever-increasing function of the tax rate. The implication is thatthe government can raise the tax rate to unrealistically high levels (say 99,9 per cent of the tax inclusive retail price) and then stillincrease its revenues by increasing the rate further. This is clearly unrealistic. Thus for the purposes of this study, the linearform of the demand function is preferred.

1996 SAJE v64(1) p28

Three sources of data on the consumption of tobacco products were used. The first is the IDC's data comprising the variouscomponents of the South African manufacturing sector. Data on the quantity demanded (in constant 1990 prices) and prices of alltobacco products, taken together, are available on an annual basis. The second source of data is the Tobacco Board's annualreports. The consumption of tobacco is expressed on an annual basis in terms of mass; no data on the retail price of tobaccoproducts are provided. The third source is taken from Reekie (1994:228) and includes the consumption and price movements ofcigarettes only. Consumption is measured in number of packs of cigarettes. Unfortunately, the level of correlation between the

15

demand (consumption) variables obtained from the three sources is not as high as one would have hoped.*(13) This casts somedoubts on the accuracy of the data in general.With respect to the empirical estimation of the function, the most important explanatory variables of the demand for tobacco,however defined, are consumers' income, price of tobacco, past consumption and population size.*(14) Personal disposableincome, deflated by the CPI, was taken as the relevant income variable. In order to obtain a real price of tobacco the nominal figureswere deflated by the CPI. The relevant population measure should theoretically be all those of age 14 (or 16) and above but, inorder to simplify the analysis, the total population was used, on the assumption that the total population grows at the same rate asthe smoking-age sub-population).*(15) Past consumption was incorporated by means of a lagged dependent variable. Given thattobacco does not have any outright substitutes or complements, it was not necessary to include the prices of these in theequation. It was particularly difficult to incorporate a qualitative variable such as tastes into the equation. The approach followedwas to assume that tastes change gradually over time; this was embodied by means of a linear time trend. No a priori constraintswere placed on the expected size of this coefficient.The most significant estimation problem experienced was that of mufti-collinearity. The absolute values of the simple correlationcoefficient between the potentially relevant independent variables

1996 SAJE v64(1) p29

were in excess of 0,90 in most cases. The standard errors of the individual coefficients were inflated as a result. Thus, increasing thenumber of independent variables often resulted in statistically insignificant coefficients. As a case in point: including both currentincome and a lagged dependent variable in the equation invariably resulted in either incorrect signs or statistically insignificantcoefficients.Table 3. Implied Elasticities under Different Regression Specifications

Number of Equation andSource of Data *(16)

Short-run PriceElasticity ofDemand

Long-run PriceElasticity of

Demand

Short-run IncomeElasticity of

Demand

(1) (2) (3)

1. Tobacco Board -0,32 -0,53 na

2. IDC -0,53 na 0,48

3. Reekie (1994); Eq. 1 -0,99 na 0,58

4. Reekie (1994): Eq. 2 -0,66 -1,52 na

Given the problematic data and the estimation problems, it was considered preferable to present a number of regression equations,rather than just one. In the Appendix these are provided, together with a short discussion of the estimation problems which wereexperienced. In Table 3 the (implied) price and income elasticities of demand of the different specifications are shown.*(17)Where relevant, the short- and long-run price elasticities*(18) are also provided. A salient feature of Table 3 is the substantialvariation in the price and income elasticities. The estimated short-run price elasticity based on the data of the Tobacco Board(-0,32) and the IDC (-0,53) compares well with most other studies (in other counties) which have been undertaken in this field.*(19)The short-run price elasticity implied by Reekie's data is very high.*(20) Furthermore, the long-run price elasticity of demand(where applicable) varies from -0,53 (Tobacco Board) to -1,52 (Reekie). Despite these discrepancies, it was decided to retain thedemand functions in their present form, given that, on an a priori

1996 SAJE v64(1) p30

level, there is no specific reason for preferring one function to another, despite potentially better statistical characteristics. Also, aswill be pointed out in the following section, drawing from different data sources and equations enables one to compare results in amore meaningful way.b) The Excise Potential of Tobacco ProductsIt is clear that the price of tobacco is an important determinant of the quantity demanded. The price paid by the consumer can bedecomposed into two parts: the amount received by the "producers" (which includes wholesalers and retailers) and the amountreceived by the government in the form of taxes (i.e. excise duties, VAT or GST and import duties). Of the three types of taxes, theemphasis in the present paper is on excise duties. Admittedly, VAT on tobacco products yields substantial government revenuesbut, since it is levied on most other consumer products at the same rate, tobacco products are not penalised relative to otherproducts. The only tax which distinguishes tobacco from most other products, then, is excise duties (disregarding the negligibleimpact of import duties). Thus, in order to keep the analysis simple, only excise duties are considered in what follows.

16

The retail price of tobacco, net of sales tax, consists of the "producer" price plus the (specific) excise tax. An increase in the excisetax causes an increase in the equilibrium price and a decrease in the equilibrium quantity. The issue of who (i.e. consumers orproducers) carries the burden of the tax is determined by the price elasticities of supply and demand. In this study it is assumedthat the supply curve is infinitely elastic. This means that tobacco consumers bear the full burden of the excise tax.*(21)An important question is: will the impact of a change in the excise tax rate on total government excise revenue be different if thesupply curve is less than infinitely elastic? This question is answered by referring to two hypothetical supply functions. InFigure 1 two supply curves (S

elastic and S

inelastic) are shown with a given demand curve. S

elastic refers to an infinitely

elastic supply

1996 SAJE v64(1) p31

curve. Sinelastic

refers to a supply curve that is less than infinitely elastic; it is not implied that the price elasticity of supply is

necessarily less than unity. Initially no excise tax is levied. The equilibrium price is OE and the equilibrium quantity is ON. Theimposition of an excise tax of magnitude T results in an upward shift of the supply curves. With a perfectly elastic supply curve(S

elastic)the price increases to OA and the quantity decreases to OL. The total excise revenue received by the government is area

ABCE. With a less than infinitely elastic supply curve (Sinelastic

), the excise tax causes the price to increase to OF and the

quantity to decrease to OM. The total excise revenue received by the government in this case is FGHI. Since EA is equal to IF, itfollows that the government receives more revenue (area JGHK in this case) when the supply curve is less elastic. In this study, itis assumed that the supply curve is infinitely elastic; in this respect the revenue estimates, from the point of view of thegovernment, are "pessimistic".

Fig. 1. The Impact of an Excise Tax on Total Government RevenueThe first step of the analysis is to choose a base year. The most recent year for which data is available for all relevant variables is

1996 SAJE v64(1) p32

1989. All calculations and estimates are thus based on 1989 data.In the second step the "producer" price is determined. This is done by first adjusting the retail price with the relevant GST rate (13per cent in 1989), after which the excise duty is subtracted.Thirdly, the excise rate is repeatedly increased by some fixed amount. This causes the retail price to increase by the amount of theexcise tax plus the extra sales tax on the excise tax. The effect on the quantity demanded is noted for each consecutive increase. It isimportant to point out, however, that this is a rather artificial method of approaching the issue. Consecutive small increases in theretail price, as suggested by this analysis, may have a different impact on people's consumption patterns than a small number oflarge increases. The latter situation is more likely to occur in practice. However, in this study, no further attention is paid to thisissue.*(22)In the final step the expected excise revenues at each excise rate is calculated as the product of the excise rate and the expectedquantity demanded. The excise rate and the expected excise revenues are plotted against each other, yielding a curve similar to aLaffer curve for income tax. From this Laffer curve one can read off how much scope the government has to increase the excise rateand how much revenues it can extract from this source.In Figure 2, four Laffer curves reflecting the excise potential of tobacco products are shown, with reference to the four demandequations discussed in the Appendix. Other than the Laffer curve based on the data of the Tobacco Board, the results aresurprisingly consistent.*(23) This is also borne out in Table 4, which is a summary and extension of Figure 2.In 1989 excise duties made up about 31 per cent of the "producer" price of tobacco products (Tobacco Board). This is denoted bythe vertical line in Figure 2. At the intersection of the vertical line with the Laffer curve we can read off the expected total exciserevenues on the vertical axis. The difference between the turning point of the Laffer curve and the current level of total exciserevenues (which had an index value of about 20 in 1989) is

1996 SAJE v64(1) p33

the additional revenue potential of tobacco excise duties. In order to maximise total tobacco excise revenues, the governmentshould set the excise rate at the turning point of the Laffer curve. This analysis suggests that the government should raise theexcise rate to at least 88 per cent of the "producer" price (Equation 4). Other specifications and data sets suggest that the exciserate can be raised to more than 100 per cent of the "producer" price (Table 4, column 2). According to the most conservativeestimate the government can expect to increase its tobacco excise revenues by at least 73 per cent (Equation 4); the other threeregression equations suggest an increase of at least 100 per cent (Table 4, column 3).How much will such an increase in the tobacco excise rate cost the industry and the consumer? The analysis suggests that the

17

demand for tobacco could fall by between 41 and 46 per cent (column 1 Table 4). This seems rather high, given the addictive natureof the product. However, the equivalent figure for the USA is estimated at about 40 per cent (The Economist 1993), which compareswell with the results obtained here.

Fig.2 Revenue Potential of TobaccoIn terms of increased retail prices the four equations give rather divergent answers, even though all equations suggest that theretail

1996 SAJE v64(1) p34

price of tobacco can be ,raised quite substantially (column 4, Table 4). According to Equation 1 (Tobacco Board data) this can beas much as 122 per cent. On the other hand, Equation 4 (Reekie's data) suggests that the retail price can only be raised by acomparatively meagre 44 per cent.Table 4. Effects if Excise Revenues were to be Maximised

Different DemandFunctions

PercentageChange inQuantity

Demanded

PercentageChange in

ExciseRevenues

Excise Dutyas

Percentageof Producer

Price

PercentageIncrease inReal RetailPrice (as in

1989)

(1) (2) (3) (4)

Eq.1: Tobacco Board -46 +240 191 +122

Eq.2: IDC -43 +113 113 +70

Eq.3: Reekie (1994) (short-runimpact; Eq. 1) -44 +128 123 +70

Eq.4 Reekie (1994) (long-runimpact; Eq. 2) -41 +73 88 +44

3. ConclusionThe aim of this paper was to investigate the excise potential of the tobacco industry. The justification for increasing the exciseduties on tobacco products was not because smoking is considered harmful or detrimental to society per se, but simply becausethe government needs more money.In the first section it was pointed out that excise duties (in constant 1990 rands) on tobacco products have dwindled from morethan R1 000 million in the early 1970s to less than R750 million twenty years later. As a percentage of government revenue thedecrease is even more pronounced. The decrease in tobacco excise revenues is primarily the result of a decrease in the real exciserate. During the 1970s and early 1980s the government failed to adjust the specific tobacco excise rate at regular intervals, which, inthe presence of inflation, resulted in a rapid erosion of the revenue

1996 SAJE v64(1) p35

base. In 1987 the Margo Commission recommended that the government should adjust the excise rate at regular intervals. Since1987 real tobacco excise revenues have remained fairly constant. In the 1994/95 Budget Speech the Minister of Finance indicatedthat the government intended to, over time, raise the tobacco excise rate to about 50 per cent of the retail price.*(24)Besides investigating the history of tobacco excise duties, the aim of this paper was to investigate by how much the governmentcan realistically increase the excise rate if it wishes to maximise its revenues from this source. A number of demand functions fortobacco were estimated, based on three different sets of data. For each of these demand functions a Laffer curve was estimated.Although there were some significant variations in the data, three of the four Laffer curves showed a fairly close correspondence.The main conclusions are as follows:(i) The government can raise the excise rate to at least 110 per cent of the "producer price" of tobacco if it wishes to maximise itsexcise revenue (according to three o f the four specifications). This is in line with the stated intention of the government.(ii) The government can expect to double (at least) its revenues from tobacco if it increases the excise rate to these levels.(iii) The analysis suggests that raising the tobacco excise rate to the proposed levels could lead to a reduction in consumption ofbetween 41 and 46 per cent.(iv) The real retail price of cigarettes should rise by between 44 and 122 per cent from their 1989 levels, if the government were to

18

maximise excise revenues from tobacco.

1996 SAJE v64(1) p39

AppendixTHE ESTIMATED DEMAND FUNCTIONS USING DIFFERENT DATA SETSDefinitions of variables used, together with source of data:TCONS85 Consumption of leaf tobacco (Tobacco Board);ICONS85 Private consumption expenditure on tobacco products (IDC);RCONS85 Consumption of cigarettes in packs of 20 (Reekie 1994);PDI85 Personal disposable income, deflated by the CPI (1985=100) (SARB);IDCRP85 Price of tobacco products, deflated by the CPI (IDC);RRP85 Price of cigarettes, deflated by the CPI (Reekie 1994).In order to keep the analysis tractable, TCONS85, ICONS85 and RCONS85 were normalised to a comparable index (1985 = 100).Similarly, the two price variables were normalised to an index (1985 = 1). These adjustments do not affect the essence of the resultsin any way.In the following subsections the individual equations, based on the various data sources, are presented.Equation 1: Tobacco Board Data

TCONS85 = 90,858 + 0,394 TCONS85(-1) - 27,509 IDCRP85

(3,01) (1,95) (2,66)

R2(adj.) = 0,848

DW = 2,258 Time period: 1972-1990

Durbin's h = -1,187

Both coefficients are of the correct theoretical sign and significant at the 10 per cent level. Despite numerous attempts, PD185proved to be insignificant and often of the wrong theoretical sign. A time variable (proxy for changes in tastes) and populationvariable did not prove significant either. This is probably due to strong multi- collinearity between the independent variables.

1996 SAJE v64(1) p40

Equation 2. IDC Data

ICONS85 = 107,828 + 0, 000745 PDI85 - 46,407 IDCRP85

(1,77) (1,54) (-1,47)

R2(adj.) = 0,911

DW = 1,500 Time period: 1973-90

The coefficients are significant only at a 15 per cent level of significance. This is caused mainly by a large degree of collinearitybetween PDI85 and IDCRP85. Multi-collinearity prevented the inclusion of other potentially relevant independent variables.Equation 3: Reekie's Data (Eq. 1)

RCONS85 = 120,651 + 0,000785 PDI85 - 73,864 RRP85

(3,34) (2,57) (-4,98)

R2(adj.) = 0,976

DW = 1,438 Time period: 1970-89

Equation 4: Reekie's Data (Eq. 2)

RCONS85 = 95,507 + 0,567 RCONS85(-1) - 49, 098 RRP85

(4,92) (6,04) (-4,76)

R2(adj.) = 0,989

19

DW = 2,486 Time period: 1971-89

Durbin's h = -1,161

The explanatory power of each of these equations is very high and all coefficients are significant at a very low level of significance.It was impossible, however, to include more independent variables into the equations, since this, once again, resulted inmulti-collinearity problems.

1996 SAJE v64(1) p41

ReferencesABEDIAN, I. and DORRINGTON, R.E. (1994) An Evaluation of a Recent Attempt to Assess the Social Benefits of CigaretteSmoking. Journal for studies in Economics and Econometrics, 18(1):59-72.ANON. (1993) Cigarette Taxes: The Wages of Sin. The Economist, 326:26-27BALTAGI, B.H. and LEVIN, D. (1986) Estimating Dynamic Demand for Cigarettes using Panel Data: The Effects of Bootlegging,Taxation and Advertising Reconsidered. The Review for Economics and Statistics, 68:148-155.BALTAGI, B.H. and GOEL, R.K. (1987) Quasi-experimental Price Elasticities of Cigarette Demand and the Bootlegging Effect.American Agricultural Economics Association, November:750-4.BOYD, R. and SELDON, B.J. (1991) Revenue and Land-use Effects of Proposed Changes in Sin Taxes: A General EquilibriumPerspective. Land Economics, 67(3):365-374.BUCHANAN, J.M. and FLOWERS, M.R. (1987) The Public Finances (6th ed.). Homewood, Illinois: Irwin.DEPARTMENT OF FINANCE (1994) Budget Speech 1994/95.FUJI, E.T. (1980) The Demand for Cigarettes: Further Empirical Evidence and its Implications for Public Policy. AppliedEconomics , 12: 479-489.HAMILTON, J.L. (1972) The Demand for Cigarettes: Advertising, the Health Scare, and the Cigarette Advertising Ban. The Reviewof Economics and Statistics, 54:401-11.INDUSTRIAL DEVELOPMENT CORPORATION (IDC) (1992) Sectoral Data Series: Manufacturing. Sandton: Department ofEconomic Research and Development, IDC.SOUTH AFRICAN MEDICAL RESEARCH COUNCIL (SAMRC) (1988) Smoking and Health in South Africa: The Need forAction. Pretoria: SAMRC.SOUTH AFRICAN MEDICAL RESEARCH COUNCIL (SAMRC) (1992) Smoking in South Africa: Health and EconomicImpact. Pretoria: SAMRC.REEKIE, W.D. and WANG, L.F.S. (1992) The Benefits and Costs of Cigarette Smoking - A State Dependent Approach. Journalfor Studies in Economics and Econometrics, 16(1):1-12.REEKIE, W.D. and WANG, L.F.S. (1994) Consumers' Surplus and the Demand for Cigarettes. Managerial and DecisionEconomics, 15:223-234.REPUBLIC OF SOUTH AFRICA (RSA) Various issues. Report of the Auditor-

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General: The Appropriation and Miscellaneous Accounts in respect of General Affairs. Pretoria: Government Printer.REPUBLIC OF SOUTH AFRICA (RSA)(1987) Report of the Commission of Inquiry into the Tax.Structure of theRepublic of South Africa. RP34/1987. Pretoria: Government Printer.SOUTH AFRICAN RESERVE BANK (SARB) (1994) Labour, Price and other Selected Economic Indicators of South Africa1923-1993. Supplement to the SARB Quarterly Bulletin, September.SOUTH AFRICAN RESERVE BANK (SARB) Various issues. Quarterly Bulletin.TOBACCO BOARD. Various issues. Annual Report.WARNER, K.E. (1982) Cigarette Excise Taxation and Interstate Smuggling: An Assessment of Recent Activity. National TaxJournal, 35(4):483-490.

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Endnotes1 Lecturer, University of Stellenbosch. This paper was originally presented at the EBM Research Conference in November 1994. Theauthor would like to thank the CRM Barberton, S.A. du Plessis, A. Smith and Professors B.W. Smit and C.L. McCarthy and twoanonymous referees of this Journal for useful comments and suggestions. The usual disclaimer applies.

2 A state dependent approach is employed where the outcome or consequence of a particular action is uncertain and dependent onthe state of nature. In the context of Reekie and Wang's paper the paper the decision-maker chooses between smoking and notsmoking. The decision to smoke or not is influenced by the expected utility obtained from smoking and the probability ofsmoking-induced illness or death. In the final analysis this decision is a matter of personal judgement.

3 A word of caution is necessary. The aim of this paper is to investigate the excise revenue potential of the tobacco industry. In thisstudy the impact of a change in the tobacco excise rate on other sources of government revenue (e.g. income tax received fromemployees of the tobacco industry) is ignored. This is a distinct drawback of the analysis. However, even if one wanted toincorporate these indirect effects, they would be very difficult to quantify. A given reduction in the demand for tobacco productsdoes not mean that the tobacco industry's contribution to government revenues, other than excise duties, will decrease by thesame proportion. One of the reasons is that South Africa is not self-sufficient in the production of tobacco; in fact, between 10 and20 per cent of tobacco consumed in South Africa is imported (Tobacco Board 1993). Unless the excise rate increase results in a verylarge decrease in the demand for tobacco, a reduction in tobacco imports, rather than domestic production, seems more plausible.

4 Raising excise duties on tobacco products is relatively easy from the consumer's (demand) side, given the low degree of buyerconcentration and lack of consumer pressure groups. However, given the high degree of seller concentration in the tobaccoindustry, such government action may be met by fierce opposition from the supply side.

5 Tobacco products include the following: cigarettes, cigarette tobacco, cigars, pipe tobacco, snuff and roll tobacco. Of thesecategories, cigarettes form the largest component, comprising about 80 per cent of the market (Tobacco Board 1993).

6 This data is obtained from the Tobacco Board's Annual Reports. Data used by Reekie (1994) suggest that, over the 1970 to 1989period, the consumption of cigarettes increased at an annual rate of about 4,5 per cent. This strengthens the argument that thedemand for tobacco has not decreased.

7 Of course, the state of affairs benefited the tobacco industry. Given that a large cost component diminished, it gave the industrythe opportunity to either increase its profits or decrease the real price of its products. Concerning the latter, the real consumer priceof tobacco products fell by about 34 per cent in the period 1972 through 1990 (IDC 1992).

8 Excise duties on pipe tobacco are calculated somewhat differently than excise duties on cigarettes. Prior to 1964 these duties werelevied as a specific tax, based on a rather complicated formula based on both historical value and mass. In 1964 this was replacedby an ad valorem duty which was increased intermittently from 55 to 73 per cent. In 1977 the ad valorem duty was replaced by aspecific duty of R1,80 per kilogram. This duty remained fixed until 1989, after which it was raised annually by modest amounts.

9 For the period 1960 through 1976 the figures refer to the financial year ending 28/29 February the following year. For the periodafter 1977 the figures refer to the calender year.

10 For the period 1960 through 1976 the figures refer to the financial year ending 28/29 February the following year. For the periodafter 1977 the figures refer to the calender year.

11 Prior to the 1994/95 Budget Speech exc ise duties comprised less than 20 per cent of the selling price. The very sharp decrease in thereal tobacco excise rate is once again .highlighted by the fact that in 1981 - only 15 years ago - excise duties comprised more than 40per cent of the retail price of tobacco (Tobacco Board 1983, 1993).

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Becker, Grossman and Murphy (1994) published a paper in which they investigate whether smokers are "rationally addicted".Using data for the USA, they find strong support for their hypothesis of "rational addiction".

13 The simple correlation coefficient varies from 0,927 for the correlation between the data of the IDC and Tobacco Board, to 0,957 forthe correlation between the data of the Tobacco Board and what can be called Reekie's data. The obvious implication of these datadifferences is that the results are largely influenced by the choice of data.

14 In their critique on Reekie's attempt (1994) to measure the size of the consumer surplus of the cigarette industry, Abedian andDorrington (1994:65-7) point out several deficiencies in Reekie's empirical specification and use of data. In particular, Reekie'sspecification of the demand function was regarded too simplistic. Many of the comments made by Abedian and Dorrington alsoapply to the present study. It was felt however, that, given the imperfections of the data, highlighted by the relatively weakcorrelation between the dependant variables, it would be misplaced to manipulate the data or to incorporate qualitative variablesinto the equation in an attempt .to enhance the equation's credibility. The aim of the paper is not to provide precise answers, butapproximate guidelines to policy makers. Thus, all in all, a relatively crude approach is not inappropriate in these circumstances.

15 Cane may argue that all variables in the demand function should be in per capita terms (cf. Reekie 1994). It is felt, however, that forthe purposes of this study it its probably better to use aggregate figures. The aim of this study is to determine the total excisepotential of the tobacco industry, not of individual smokers. To calculate the excise potential in per capita figures is misleading.Furthermore, scaling the quantity demanded or income data by the population or a subset of the population results in acomparatively smaller spread (i.e. standard deviation) of both the dependent and (some) independent variables. In such a case itbecomes increasingly hazardous to estimate the size of the consumer surplus and the tax potential of the product (see Abedian andDorrington 1994:65).

16 See Appendix

17 With a linear demand function the price elasticity of demand is computed as the estimated slope coefficient (on the price variable)multiplied by the average price and divided by the average quantity demanded.

18 Given a model , the long-run price elasticity, calculated at the average quantity and price is on the assumption that Qt approximates

Qt-1

19 Studies which have found relatively low price elasticities of demand for cigarettes and other tobacco products are, inter alia,(range of absolute value of price elasticity in parethesis): Hamilton 1972 (0,51); Fuji 1980 (0,48-0,63); Bishop and Yoo 1985(0,41-0,64); Baltagi and Levin 1986 (0,22); Baltagi and Goel 1987 (0,17-0,56); and Becker, Grossman and Murphy 1994 (0,36-0,44).

20 See Boyd and Seldon (1991) and Baltagi and Levin (1986) for references to studies which obtained price elasticities of demand inthe order of -1.

21 This is not an entirely unrealistic assumption to make, given that tobacco can be stored and must, in fact, be cured. According toan empirical study performed by Boyd and Seldon (1991:368) the supply elasticity of tobacco is in excess of 70, which approximatesinfinity.

22 Another important issue which, unfortunately, cannot be incorporated into the model, concerns the possibility of smuggling. GivenSouth Africa's proximity to Zimbabwe, where tobacco is cheaper, a substantial increase in domestic tobacco prices may be a strongimpetus to smuggle tobacco from Zimbabwe. The experience in other countries, notably Canada and the USA, indicates that thosestates which impose higher tobacco excise duties lose some of their excise revenues to other states which levy a smaller exciseduty (see for example Warner 1982; Baltagi and Levin 1986; Baltagi and Goel 1987). In the context of this study, the possibility ofsmuggling casts some doubt on the government's ability to raise the price of tobacco to the level suggested in this paper.However, there is no a priori way of determining at which price smuggling becomes significant.

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22

The comparatively low price elasticity of demand implied by the data of the Tobacco Board is the main reason for the very largeLaffer curve obtained.

24 An excise duty equal to 50 per cent of retail price is, in the terminology used in this paper, equal to a duty of 100 per cent in the"producer" price.

23