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March 25th, 2014:

The seven salvos of sin (taxes)

Tobacco kills one-third to one-half of all people who use it, on average 15 years prematurely. The World Health Organization (WHO) has a target of a 30% reduction in smokers by 2025; but this is one target that would be great to exceed. Alcohol-attributable cancer, liver cirrhosis, and injury caused 1.5 million deaths globally in 2010.

Recently, the representatives of ministries of finance and ministries of health, as well as a host of civil society organizations and international organizations, met in Manila to consider lessons to be drawn from the international experience surrounding so-called sin taxes.

What is a sin-tax? It is a tax that is levied on products or services that are socially costly, thus adding to their price and contributing to state revenue. These type of taxes are levied by governments to discourage individuals from partaking in such activities without making the use of the products illegal. To have so many countries from the East Asian region come together at the World Bank-organized event in Manila, sitting together, was itself a symbol of the emerging interest and consensus around issues concerning sin taxes.

Taking a cue from the catchy campaign around seven wins to advance the recent successful passage of a major Sin Tax Reform in the Philippines, and based on the discussion in Manila, I suggest we consider the seven salvos of sin taxes, as follows:

It’s mainly a health issue; it’s only secondarily a taxation issue. The health consequences of continuing to smoke are dire — tobacco is projected to cause 1 billion deaths in the 21st century, ten times what it did in the 20th century, or currently 5.4 million per year. Therefore, any delay is a costly delay; there should be a ‘bias for action,’ striving to make smoking less attractive to those susceptible to engaging in it. East Asia in particular has cigarettes that are affordable. They are packaged (including by single stick) to minimize access costs. This region accounts for a lion’s share of the world’s smokers. Indonesia, alone, accounts for 5% of the world’s smokers, with two-thirds of men and about 7% of women smoking, and quite heavily, as well as a distressing 18% of children age 10 to 14 years.

Market segments matter. The behaviors across the market segments are quite distinct, with noteworthy differences in elasticities across product categories and prices, for example. Smokers may be inclined to shift between (down) product categories, especially when a price increase is induced through the levying of an additional tax or increase in tax rate. Cigarette companies manage their product categories and packages to offer new attractions to smokers across the different market segments.

Arguments against increasing tobacco tax rates are spurious. The industry – represented by growers, manufacturers, distributors and advertising outlets – are collectively a special interest. They mount arguments to try to galvanize public opinion, or create some forms of fear. One of the most often used is the suggestion that increased rates lead to smuggling. In such circumstances, it is important to reframe the argument. The issue is improving tax and customs administration so as to stamp down on illicit trade, rather than being held hostage by such trade and some poorly specified notion of smuggling.

Earmarking can help. Generally, public finance practitioners do not like earmarking, as it can contradict the general efficiency objectives of the public budgeting process. But this is one area where I am prepared to support earmarking in its soft form.

Earmarking can assist in making the argument for sin taxes compelling to the public; it can build trust in the public budgeting system, something which is needed in many countries in East Asia. Definitions concerning the soft and hard forms of earmarking are not uniform. In fact, earmarking as an idea seems to be malleable and ductile. These are strengths, not weaknesses. Institutional development has shown numerous cases where jurisdictions have started with earmarking, but through time have moved away from that, as confidence has emerged in their public budgeting processes. Health promotion – based on the idea that prevention is better than cure – sprang to life in the 1980s; it has made a valuable contribution to public health and should be supported by earmarked taxes. Earmarked taxes can also be applied for general public health purposes. For example, Philippines, Thailand, Egypt, and the UK earmark sin taxes for health.

Tax design matters a bit. It is desirable to have automatic annual adjusters built into the law so that excise taxes keep pace with rising incomes and aspirations. It is also noteworthy, that as with many taxes, more tiers create more tears. In other words, the more tiers for differentiating the types of tobacco products (maybe origin, price or quality) the more complicated the tax structure and the more wiggle room given to the tobacco industry for maneuver. Indonesia probably has the most complex (and industry-friendly) tobacco excise regimes in the world. Specific design features can make practices like ‘front-loading’ more difficult for the tobacco companies to sponsor. The challenge to reduce smoking requires numerous other interventions, as well as the use of taxation.

Build an evaluation system into the reform package. The public sector worldwide is beset by good ideas, but around which governments often fail to build tracking systems to measure the changes in behaviors (good and bad). The best time to design these systems is at the start; the Philippines is a good example of doing that. Their sin tax reform is controversial; one way to manage that controversy is with good data about the effects of these reforms. This means building into the reform package, evaluation and data collection on both the effects on the taxation side and also the spending side.

It’s a special time for tobacco taxes. The global move toward universal health coverage, the growing awareness associated with smokers’ health, the revenue need and the institutional appetite for these forms of taxes have probably never been stronger. Cigarette taxes can boost tax intake considerably. Even at current low rates, Indonesia collects more than 1% of GDP in cigarette tax revenue. For countries looking at the transition from lower middle-income status to higher income status – to escape the so-called middle-income trap – arguably, it is a reform that shows institutional maturity and a society that is making the transition to the generally higher performing public institutions associated with higher incomes. The Philippines case showed that, notwithstanding an entrenched industry and integration with growers, real reform can take hold.