Economics Commentary

Article
Proposed U.S. tax increase a credit drag for cigarette makers.
April 15 | Mon Apr 15, 2013 11:27am EDT

(Reuters) - President Barack Obama's proposal to nearly double federal excise taxes to $1.95 on each pack of cigarettes would likely knock down sales volume 7 percent to 8 percent and is a credit negative for U.S. tobacco companies, Moody's Investors Service said on Monday. "The proposed tax hike amounts to an increase of more than 16 percent in the national average price per pack to nearly $7, and it would affect roughly 42 million U.S. consumers who smoke cigarettes," the Wall Street agency said in a commentary. Moody's said the tax proposal could accelerate a decline in the sale of cigarettes 7 to 8 percent, up from what is considered a secular decline of between 2 percent and 4 percent. Drops in cigarette sales in recent years have hurt revenue paid to state governments that back tobacco-settlement bonds. Tobacco bonds are popular high-yield municipal bonds and were created after a late 1990s deal between state governments and tobacco companies to settle lawsuits over the costs to state governments of treating sick smokers. Cigarette prices have been steady for two years because few states have lifted their tariffs and the federal government last raised the excise tax to $1.01 per pack from 39 cents in 2009, Moody's said. The increase, which was proposed last week in the president's budget plan, would be a credit negative for U.S. tobacco manufacturers Altria Group Inc, Reynolds American Inc, Lorillard Tobacco Company, Vector Group Ltd and North Atlantic Trading Co Inc, according to Moody's.

Commentary
The president of America Barak Obama imposed high rate of excise duty on Tabaco/cigarette this brought down the sales figure of Tabaco companies as well as government revenues. The state government sorted out the problem of reduction of revenue through issuing Tabaco settlement bonds (yield municipal bond created during 1990s) because the constant drop in sales figure of cigarette hurt revenues received by the government. The cigarette price remain steady for few years and finally the state government lifted their tariff by $1.01 per pack from the tariff of 39 cents. As stated in the article the consumption of alcohol and Tabaco generate negative externalities (it refers to those activities which harms to other and decrease welfare such as factories are producing goods and services to satisfy he need of the people but at the same time creating pollution of water, air, noise and land for example Yamuna river is one of the latest example which is right now drain this proves that the negative externalities is a bad activity but they are not penalized) in the economy such as it reduces the productivity of an individual, people need to spend huge amount on medicines and even the government also need to spend lot of money to be aware about the harmful effects of alcohol and Tabaco. When the government imposes high taxes on such commodities this will force the people to reduce their consumption as a result it will decrease marginal propensity to consume (MPC) and increase marginal propensity to save (MPS) or intensity to save rather than consumption of such commodity. The consequences of raising taxes will increases the price of commodity as a result the consumer prefer to buy less quantity of commodity, though from business point of view it is not healthier but from economic point of view it will accelerate social welfare of the society.

Since, Tabaco and alcohol are highly inelastic goods which means the proportionate of change in price does not affect the proportionate of change in its demand. Thus we can conclude that those consumer who are addicted towards such goods will not reduce their consumption and demand remains same. On the other hand, some of the consumer who are occasionally consume alcohol and Tabaco would prefer to avoid consumption because of rise in its price so this would bring social welfare in the economy. We must notice that the proportionate of addicted people are greater than the proportionate of people who occasionally consume which bring no effect of rising high rate of excise duty. It means the consumption of alcohol and Tabaco consume by addicted people will not reduce therefore from the producer point of view, the sales figure of alcohol and cigarette will knock down but total revenue will remain same or might be greater than the previous one.

Negative externalities due to tobacco

P,Q (Price and quantity before taxes) P1,Q1 (Price after tax) Popt,Qopt (Optimum Price and quantity)

As shown in the diagram, marginal propensity to consume (MPC) and marginal private benefit (MPB) intersect with each other, where OP is the price and OQ is the quantity of commodity (before tax).the interaction of MPC and MPB brings huge amount of negative externalities in the economy because people increases the consumption of alcohol and Tabaco to derive more satisfaction rather than thinking about the negative aspect of consumption. As we know the above condition is not going to be appropriate for the economy therefore the government has no option but hikes excise duty on alcohol and Tabaco as a result price increase from OP to OP1 whereas the quantity of commodity decreases from OQ to OQ1, when the price of commodity increases, the people in the society will reduce their consumption this will bring marginal propensity to consume (MPC) curve shift leftward from MPC to MPC1. The above situation specifies that when the government hikes the tax rate on alcohol and Tabaco this will reduce the negative externalities because at higher price people will consume less or save their money. In order to reduce the impact of negative externalities than marginal propensity to consume (MPC) must intersect with marginal social benefit (MSB). At this situation Popt is the ideal price and Qopt is the ideal quantity, the above situation not only helps in reducing the negative externalities but also accelerate growth and development on an economy.