Can tax alone raise price and curve tobacco consumption?

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Can tax alone raise price and curve tobacco consumption?

December, 2009

¦The Tobacco Industry, Bangladesh¦

Bangladesh is one of the most profitable tobacco markets in the world, with annual sales of around $1bn dollars. According to industry figure, prevalence of tobacco use has been increasing in women. 36% of total adult population (15+ years) smokes, while 19.7% use tobacco. Although prevalence of smoking is higher in adult male (46.8%) than adult female (25.4%), yet the prevalence in adult women is much larger than Asia count (9%). Surprisingly, prevalence of smokeless tobacco (24.4%) in adult women is far larger than adult men (14.8%). 6.9% of youth (13-15 years) use tobacco products and 2% of them smoke1. Recent increase in prevalence among women is attributed to rampant growth of marketing tactics of the tobacco industry. The 1 billion dollar industry sees women as the key potential underserved market.

The industry is characterized by an oligopoly and vertically integrated market. The fragmented structure of this market endows the producers with a commanding power. Producers here enjoy most of the potential industrial earning. BATB, the market leader, made a net profit of TK 1637 million with EPS of 27.28 TK in first three quarter of 2009 as compared to Tk. 1,125.91 million and Tk. 18.77 respectively for the same period of previous year. This may be compared to pretax profits in 1998 of US$15.4 million - a 140% increase in just 10 years2! AKij Group is the volume leader in the tobacco industry. It became serious challenger to the BAT early this decade. Dhaka Tobacco, one of the sister of Akiz Group made an annual sales that is more than Tk 18.00 billion in 200812.

Cigarette constitutes only 30% of the total tobacco industry. The majority of the industry is driven by non-filter smoke tobacco like Biri and smokeless tobacco like Gul, and Jorda etc. This 70% market covers poor users and is mainly driven by Dhaka tobacco industry and AKTC with their Biri products. These producers run many distribution points in local hubs. Bidi -- cheaper handmade cigarettes, are popular among the poor and account for 75% by volume of the smoke tobacco sold.
The cigarette industry has been enjoying an inconsistent growth of 3% yearly at present. The industry comprises of products that vary with different tastes and price. A little amount of tobacco is exported by Akij Group tobacco to the Gulf and South East Asia where huge number of expatriate Bangladeshis live and work12.

Although a significant number of farmers are employed in growing and curing tobacco, yet their voice is very low. Tobacco companies offer lucrative amount of money as loans to trap farmers. Sometimes the companies provide them with bank loans for agriculture along with tobacco seeds, fertilizer, polythene bags and high-powered pesticides3. Tobacco is a cash crop. Farmers are often attracted by ready markets and ready cash, only a few of them calculates actual production costs and the margin. Further, tobacco companies encourage them to grow the leaf until their soil degrades, then they move on to remaining fertile areas where crop yields will be higher and wood will be available for curing the leaves. The crop is grown on roughly 61,000 hectares of land and takes up 0.7% of the country's arable land. More than 200,000 farmers and 10 million laborers are engaged in producing the crop11. In addition, farm families, including women and children, are exposed to fertilizers and pesticides during planting and growing, toxic tar from green leaves during harvest, and fumes from kilns during curing. 57000 people die every year out of health hazards due to tobacco use and handling. An indirect cost of tobacco is estimated at $652.86 million USD (loss of income from death or disability due to tobacco-related illnesses). Tobacco's further toll includes health care costs, lost productivity, and suffering among smokers, passive smokers, and their families.

By a close examination of both supply and demand side of the industry, one can realize that tax measure alone cannot be taken as mutually exclusive anti-tobacco measure to curve down tobacco consumption. It took approximately 25 years to curve consumption of tobacco 35% down for a developed country like the U.S (From 1965 to 1998). They did so with doubling federal tobacco tax through a span of 20 years together with other moves like broadcast ban, activist move, and master settlement agreement (see figure -2, USDA 1986 Surgeon General's Report)).

¦Do tobacco consumers always respond to price increase? ¦

Statistics worldwide shows that tobacco usage is more prevalent in poor, uneducated and relatively high - income segments of population. Among the poor segment, younger population responds more to price measures. The impact of price on consumption often, is measured by the price elasticity of demand, where the elasticity is defined as the percentage change in the quantity consumed resulting from a one-percent increase in price. As age increases, tobacco users however, become more price-inelastic whether they are poor and/or uneducated or not (Becker, Grossman and Murphy, 1994). A research confirmed an inverse relationship between price elasticity and age, with estimates for youth price elasticity of demand up to three times those obtained for adults (Gruber, 2000, Ross and Chaloupka, 2001, Harris and Chan, 1999)4. And if young adult of today becomes price-inelastic with aging, it becomes very difficult to make them give up tobacco only through raising price by tax measures.
"Young people and the poor are the most price-responsive"- a report shows so. The report also indicated that as real price decreases, consumption increases. This was evident in a study on from South Africa (1970-1988). Also, as price rises, consumption falls, but by less than the percentage rise in price (as overall demand is price-inelastic and it falls in a continuum of -.2 to -.8). Further, as incomes rises, so does consumption - and total revenue (as the income elasticity of demand is greater than one)4. For example, studies show that a higher income smoker would not be willing to reduce consumption by $1 today in exchange for becoming the richest person in the world in ten years! Therefore, it appears that lower-income individuals are much more price elastic than higher income individuals. This apparently tends to decrease the regressivity of tobacco taxation relative to standard measures.5 Moreover, while the overall price elasticity of demand of tobacco product is much less than one, the elasticity of demand for the lowest-income consumers is much higher than for high-income consumers5,6.

Therefore, price elasticity of demand falls with rising age and income7,8. The reasons that price elasticity falls with age and it becomes more inelastic in late adult can be attributed to the action of nicotine. Nicotine is a neuro-adaptor or addictive substance that while taken with tobacco, releases dopamine, serotonin and nor epinephrine - three chemical or hormone from the brain. Theses chemicals make adults more tolerant to tobacco. As a result, adults become more or less physically dependent on tobacco. Physically dependent tobacco users become more price-inelastic, which means s/he is more unlikely to respond to price increase. On the other hand, teens who smoke may not account for the long-run implications of addiction (Gruber and Koszegi 2001)5. A young adult while starts tobacco use does it because s/he is influenced by heavy promotion tactics by a mighty force -- the tobacco industry which makes them psychologically dependent on tobacco. But as they do not earn much, they easily respond to higher post-tax price.

¦What to do? ¦

Finding a suitable mix of or trade-off between both supply and demand side interventions can effectively curve tobacco consumption. "Comprehensive tobacco control helps countries to reduce the rising number of heart attacks, strokes, cancers and other non-communicable diseases"; "Slowly but inexorably, WHO and its Member States are making progress in controlling the epidemic of tobacco," - says Dr Douglas Bettcher, Director of the WHO Tobacco Free Initiative. With efforts to implement the WHO introduced a package of evidence-based demand reduction interventions to control tobacco called MPOWER in 2008, to help countries implement some of the demand reduction measures in the WHO Framework Convention and its guidelines1. These are:

1. Monitor tobacco use and the policies to prevent it
2. Protect people from tobacco smoke
3. Offer people help to quite tobacco use
4. Warn about the dangers of tobacco
5. Enforce bans on tobacco advertising, promotion and sponsorship
6. Raise taxes on tobacco. Less than 10% of the world's population is covered by any one measure.

¦The crux of demand side intervention¦

On the demand side, focusing more on preventing young adults from starting and using tobacco appears important. This prevention can be done in a holistic approach by a combination of total ban on promotion, help young adults ceasing consumption through bringing the real price out of their reach through effective taxation measures and cessation support. The effective taxation measure however, depends on a broad based tobacco tax that should optimally increase switching cost from higher to cheaper brand of tobacco products rather than reducing consumption5. In addition, an effective tax should create an environment where the producers find no way other than passing the tax burden/incidence forward on to consumers. But ensuring such environment appears difficult because of the nature of Value Added Tax which however, leaves incentive for producers to absorb or pass a portion of tax backwards. This is why most of the countries prescribe an excise or like specific tax on tobacco products. But implementing specific tax on points of sales on the other hand, is resource intensive. That means it needs intense monitoring that relies on ICT, technology, labor and other infrastructural support. Therefore, specific tax is very difficult to implement in a situation where infrastructure is weak.

¦The knit between demand side and supply side intervention¦

Producers pass tax burden forwards only when they have fewer surpluses than ever. Producers will have fewer surpluses when they cannot absorb any part of the tax burden in a situation where they have narrow profit cushion. But unfortunately, tobacco producers in a developing country like Bangladesh have more of a surplus and wider profit cushion than developed countries for many reasons.

First, labor and material cost is the lowest in this region. Growing tobacco is not prohibited because; a significant percentage of poor population is employed in this cash crop industry. At present, 61,000 hectares of land is under tobacco cultivation. 33,775 million tons of tobacco is produced every year9. Moreover, producers pull women and children from homework and school respectively to grow and cure tobacco and manufacture smoke and smokeless tobacco with ease. So, producers get handsome variable margin or gross profit by gaining resource through lower wage and material cost than other parts of the world.

Second, when tax rises, it remains easier to pass the tax burden backwards on factors of production for many reasons. "When the imperialists were here, we were forced to grow indigo. Now we are tricked into growing tobacco"- said a tobacco farmer10. For example, poor tobacco growers are entrapped in loan guaranteed by manufactures, because they cannot repay loan in time. Therefore, growers cannot negotiate with much power. Moreover, the labor forces in tobacco manufacturing industry is perfectly immobile and have high switching cost because, agro-based industry where they can fit in, appears not adequate and/or flourished. High switching cost makes labor' voice very low. Therefore, when tax rate rises, producers keep their surplus intact by passing the tax burden backward to suppliers, i.e., growers and labor force. Producers naturally and for obvious reasons try not to pass tax burden on to consumers because, most of them are poor and/or young adult and quickly respond to slight price increase.

Third, the tobacco producers can absorb a substantial portion of the tax burden when they face difficulty in passing it backwards to keep volume of sales intact in a situation where price increases gradually.

Last, the producers find incentives to start evading tax in a situation where tax is raised abruptly and when they do not have wider surplus or profit cushion. In this situation, they neither can pass extra tax burden both backwards and forwards, nor can they absorb it. Therefore, they take more risk of being heavily punished under lax law by evading tax to keep sales volume intact.

¦The need for simultaneous supply side intervention¦

It appears that tax should be increased gradually with other anti-tobacco measures in a holistic multi-disciplinary approach. Among others, the approach to pulling tobacco growers and labor force out of tobacco industry and putting them in agro-based industry appears very appealing in economic and social sense. The approach needs interdepartmental attention that involves ministry of finance, agriculture, labor, health, food and women and social affairs, etc. Attracting more investment in agro-based industry is one of the attractive ways of reducing the tobacco producers' surplus in two interrelated ways. First, agro-based industry can create more employment opportunity that in turn however, will lower switching cost of labor force and tobacco growers. Second, lower switching cost surely can enhance negotiating power of the supply side, stop backward shifting of tax burden and reduce producers' surplus and gross profit.

Therefore, supply side interventions look very important for effective taxation and reducing real price of tobacco. In other words, taxation appears most effective measure to take real price of tobacco out of reach of consumers among the demand side interventions only when it is taken as collectively exhaustive with supply side interventions and other demand side measures. These interventions together decreases producers' surplus and leaves a number of narrow options for tobacco producers. First, lower surplus compels producers either to pass tax burden on consumers or to absorb it. If they absorb the burden, it further lowers the surplus/profit. Second, it leaves incentives to evade tax which however, should bear stiff penalty. And final, it compels them to exit from tobacco business or shift to other location of the world where holistic measure like these are absent or at lease appears inadequate.

¦Tackling smuggling - a bi-product of Holistic approach to tobacco control¦

Smuggling may ensue, when both supply and demand side interventions work effectively. Differences between taxes and prices and corruption within across countries suggest a motive for smuggling (Merriman, Yurekli and Chaloupka, 2000). Smuggling of tobacco currently estimates an equivalent of 6 - 8% of global consumption (Merriman, Yurekli and Chaloupka, 2000). Therefore, one of the key interventions on the supply side should be the control of cigarette smuggling in addition to effective tax measures. Aggressive enforcement of anti-smuggling laws, and stronger penalties for those caught violating these laws (Joossens et al, 2000) should be in place, for example, provision of band roll or stamp, warning labels in local languages, better methods for tracking cigarettes through the distribution chain etc.8.

In this situation, it needs cross-functional, multi-disciplinary taskforce and collaborative culture where knowledge, experience and evidence based best practices can effectively be shared within and across national boundaries. Collaborative culture acts as multidimensional hub that is required to combat transnational organized economic crime like, money laundering which however, is needed for smuggling. However, multi-lateral agreements ratified by all the parties concerned across the borders are also important among others though.

¦The type and amount of tax that can make tobacco less affordable¦

Taxation is the most effective measure - higher taxes induce quitting and prevent starting. A 10% price increase reduces demand by 4% in high-income countries and 8% in low or middle-income countries. Excise tax if implemented successfully, can effectively pass tax burden on to consumers and make tobacco product less affordable. But this is too good to be true. Price by itself is a misleading indicator of affordability, since it does not take income into account. When income rises more than the increase in tobacco price through taxation, tax become ineffective to contain or reduce affordability of tobacco products. To the extent that tobacco control is a priority area for government and policy makers, tobacco prices and taxes should be adjusted against some standard of affordability, not against a standard of a real price or a real tax only. "Tax (or price) should be increased such that cigarettes become increasingly less affordable." This recommendation implies that the nominal price of cigarettes should increase by at least the sum of the inflation rate, the real per capita income growth rate and a small interaction effect6.

¦Other Comprehensive Programs to Reduce Tobacco Use¦

A portion of the tobacco tax may be earmarked to support programs on the electronic and printed media to comprehensively inform people about the active and/or passive cost of using tobacco products. Comprehensive programs to reduce tobacco use are based on an assumption that there is a synergy among various anti-smoking policies improving their individual effectiveness. In general, these programs have one or more of four key components:

• National and community interventions,
• Counter marketing campaigns,
• Antismoking policy and regulation, and
• Surveillance and evaluation (USDHHS, 2000).

In recent years, several governments, mostly in high-income countries, have adopted comprehensive programs to reduce tobacco use, often funded by earmarked tobacco tax revenues7.

The government may:

• Impose a comprehensive ban on all forms of promotion including advertising and sponsorship of tobacco products,
• Ban use of the products in public places and public transports to protect the health and rights of the non-users,
• Integrate activities of NGOs and civil society to the issue, and;
• Crack down the "safe haven" of ‘foreign cigarettes' -prevent smuggling7

- in order to lower 50 consumption of tobacco products and hence increase the amount of money to be spent on food and other basic necessities of life.

¦Tobacco taxation in Bangladesh - does it work? ¦

In Bangladesh, over 10.5 million people who are currently malnourished could have an adequate diet if money spent on tobacco were spent on food instead, saving the lives of 350 million children under age five each day. The average household in which at least one member smokes spends 2.8% of total expenditures on tobacco products. This figure ranges from 1.5% for the poorest households to 4.5% for those with the highest incomes.

At present, 31% of local revenue raised comes from tobacco tax (2008-09). 63% of the retail price of a pack of tobacco is collected as tax. Enduring tax evasion in Bidi is partly attributed to socio-economic structure. Women and street boys are taken into Bidi industry as a source of low cost labour. Moreover, the industry is located in the remotest places in villages where physical infrastructure is hardly present. As a result, law enforcing becomes very difficult on revenue defaulters. In addition, the remote firms do not brand their products. As a result, it becomes difficult to trace non-compliant firms out who evade taxes.

For health and revenue reasons, National Board of Revenue has a policy to switch users from cheaper to higher or premium brands of tobacco products. For this reason, government tries to close price gap that exists between hand made bidi and different price bands of cigarettes. There are strong lobbyist / advocacy groups in favour of bidi users. They often argue that poor population cannot afford to by low brand cigarettes if the price point difference between bidi and low brand are kept considerably wider. But the gap could not be closed rapidly through price measure because, rapid growth of price in lower brands and bidi ensues tax evasion which for obvious reasons, appears difficult to prevent. Possibility of smuggling moreover, cannot be overlooked as it was prevalent before 1998.

The historical tax line on bidi and cigarette shows that there is a negative correlation between cigarettes and Bidi tax revenue, which eventually proves that taxing lower brand or bidi more should have extensive switching effect (Figure-3).

In last ten years, National Board of Revenue tried to aggressively contain and reduce tobacco affordability. After introduction of 555 and Benson & hedges, smuggling stopped in late 1990s. From 2000, NBR gradually increased excise duty on bidi from 25 taka per thousand to 30 taka. In 2004, it introduced 15% VAT on Bidi in place of excise tax and implemented 17.5% supplementary duty. In 2008, rate of Bidi supplementary duty was increased from 17.5% to 20%. As a result, total tax on per thousand Bidi reached 48 taka—a almost 100% increase in just eight years! Simultaneously, NBR has been withdrawing supplementary tax gradually from lower brand cigarettes to keep switching cost low from Bidi to lower brand. Moreover, NBR has successfully implemented 15% VAT and 10% supplementary duty on widely used chewing tobacco from 1998.

With passage of time, NBR inherited many challenges however, to take tobacco users out of tobacco affordability. It needs simultaneous and adequate structural, administrative and legal reforms to combat tax evasion and smuggling when comprehensive measures will continue to decrease the customer base of tobacco industry. So, the comparative impact of excise tax on all forms of tobacco and other socially and economically undesirable products can be re-examined and implemented. As effective tobacco tax measures appear regressive, the poor tobacco users could be compensated in two ways. Firstly, a portion of tobacco tax may be earmarked to support poor tobacco users to quit, for example, treating illness due to tobacco curing, handling and other directly related diseases. Secondly, the earmarked fund can be used to support users who want to quit.

The possibility of impact of a comparative larger increase in the marginal rate of corporate/income tax on tobacco industry on reducing producers surplus should be studied and implemented if appears feasible.

¦The Bottom-line¦

In a demand-driven market like tobacco we have to focus more on containing distribution, promotion and sales in short and medium term, then on production in long term.

1.3 billion people smoke cigarettes or other tobacco products. The figure could raise 1.6 billion by 2025. Among 1.3 billion smokers, 80% are in low- and middle income countries (1 in 3 adults). Tobacco use continues to be the leading preventable cause of death, killing more than 5 million people per year. If the current consumption patterns continue, and unless urgent action is taken to control the tobacco epidemic, the annual death toll could rise to 8 million by 20301 and one billion people in the 21st century. Smoking is increasing in the developing world. 2.5 million die in developing countries annually; but by 2030, mortality in developing countries will be more than doubled than that of developed countries. Harm of second-hand smoke causes about 600,000 premature deaths per year, countless crippling and disfiguring illnesses and economic losses in the tens of billions of dollars per year1.

There is strong evidence that tobacco tax increases, the dissemination of information about the health risks from smoking, restrictions on smoking in public places and workplaces, comprehensive bans on advertising and promotion, and increased access to cessation therapies are effective in reducing tobacco use. Only 5.4% of the world's population was covered by comprehensive smoke-free laws in 2008, up from 3.1% in 2007. This means that 154 million more people are no longer exposed to the harms of tobacco smoke in work places, restaurants, bars and other indoor public places1. 94% of people however, remain unprotected by comprehensive smoke-free laws shows that much more work needs to be done.

Tobacco consumption can be powerfully intervened if a holistic approach in administering a mix of demand and supply side measure in short, medium and long run is chosen and implemented in a cross-functional and multi-disciplinary environment. Price measure in demand side through taxation can play very powerful role being resident in this mix.


1. WHO Report on the Global Tobacco Epidemic, 2009: Implementing smoke-free environments
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16. Tobacco burden FacTs: Ratified the Framework Convention on Tobacco Control on June 14, 2004.
17. Debra Efroymson and Saifuddin Ahmed , Building Momentum for Tobacco Control: The Case of Bangladesh
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