Microeconomics

Pakistanis consume 80 billion cigarettes annually

Abrar Hamza August 30, 2016

KARACHI: Pakistan should adopt a simpler structure of taxation and strengthen administrative
efforts against smuggling and illicit domestic production of cigarette, said Serhan Cevik, a Senior
Economist at International Monetary Fund (IMF).
Pakistan is a major tobacco-producing country with historically high smoking prevalence rates.
About 40 percent of the male population and 9 percent of the female population smoke regularly,
consume over 82 billion cigarettes on an annual basis.
"Tax policy and administration should take into account cigarette market conditions across the price
spectrum and challenges in addressing illicit trade. The structure of cigarette taxes is critical in
determining the relative prices of different tobacco products and brands across the price spectrum
and thereby influencing the behavior of consumers within a country" Cevik recommends in a
working paper, prepared for IMF.
While tax policy can help reduce negative externalities associated with tobacco consumption, the
taxation model needs to avoid providing incentives to switch down to cheaper cigarette brands in
response to tax related and other price increases, the paper adds.
Furthermore, consumers' price sensitivity and brand switching behavior and manufacturers' pricing
strategy, including brand repositioning, differential tax shifting and cross-brand price subsidy, can
have potential consequences of tax revenue collection at an aggregate level. "To this end, Pakistan
should adopt a simpler structure of taxation without tiers to have a greater influence on the relative
prices of different tobacco products across the price bands and strengthen administrative efforts
against smuggling and illicit domestic production of cigarette".
A one-rupee increase in cigarette taxes is found to lead to an increase of only Rs 0.8 in retail
cigarette prices, on average. In other words, cigarette taxes in Pakistan are under shifted by tobacco
manufacturers to the prices paid by consumers. The working paper estimates the magnitude and
speed of tax pass-through across tobacco products at different price points in Pakistan by using a
novel dataset of monthly observations on cigarette prices in 50 cities during the period 2004-2015.
The pass-through of cigarette taxes to retail prices is found to occur within two months, but is
mostly incomplete in magnitude. On average, a one-rupee tax increase is estimated to lead to an
increase of only Rs 0.8 in retail cigarette prices.
Celvic said, 'This is driven by the fact that tobacco manufacturers absorb a significant part of the tax
increase. For the premium brand, however, I observe a pass through, indicating possibilities of
different demand elasticizes across product tiers'. These findings are likely to be attributable to
competitive market pressures, especially at the budget end of the price spectrum, possibly stemming
from changing consumption patterns with greater awareness of health risks as well as the impact of
illicit domestic production.
While the share of excise taxes have declined from about 30 percent of total tax revenue in 1990 to
5.5 percent in 2016, the tobacco sector still accounts for 4 percent of sales tax and excises collected
at the federal level, and the share of tobacco excises stands at 56 percent of total excise taxes (up
from 36 percent in 2010).
(Adapted from DailyTimes.com; http://dailytimes.com.pk/pakistan/31-Aug-16/pakistanis-consume-
80-billion-cigarettes-annually)
Indirect tax is the amount of money collected per unit of goods or services sold in a form of
specific or percentage tax. Unlike the direct taxes, indirect taxes do not affect the income of people,
they affect prices.

Negative externalities belong to the group of market failures. Negative externalities of

consumption occur when the marginal benefit for the society is less than the marginal private
benefit and are usually bound to demerit goods.

The article focuses on an issue of negative externalities. Cigarettes are usually bound to the
microeconomic concept of negative externalities of consumption. Such externalities cause the
additional costs to the whole society. In such cases, the marginal social benefit is less than the
marginal private benefit. The main issue associated with the cigarette consumers is its influence on
the health of the consumers and the passive smokers at all. The additional social costs then may
come in form of greater healthcare expenses.

Graph 1: Negative externalities of consumption

Negative externalities of consumption are caused by the lack of marginal social benefit as
compared to the marginal private benefit. Too high consumption of cigarettes causes the
additional costs to the whole society. On the diagram the marginal social benefit is much less than
the marginal private benefit. The recent quantity demanded is determined by the position of E1,
however the socially sufficient level is E2 with lower prices and lower quantity demanded as well.

Imposing taxes aims to increase the costs of production as producers are required to count with the
additional amount of expenditures to the government. Rising costs of production reduce the ability
to produce as much cigarettes at the same price level as in case of no taxation imposed.
 Graph 2: Solution to the negative externalities of consumption by
imposing an indirect tax
As the marginal social benefit suggests, Q2 is the socially sustainable quantity demanded, unlike
the actual recent level at Q1. Imposing an indirect tax leads to the decrease in quantity demanded,
ideally back to the level of Q2. However, costs of production are likely to rise and therefore the
price of cigarettes grow from P1 to P3. To summarize the diagram, imposed taxes may reduce the
quantity from more than 80 billions per year demanded up to the point of a socially sufficient level.
Unfortunately the prices will be led to grow from around 160 Karachi.

As Pakistani's government is aiming to develop the tax policy, it has to resolve some of the issues
they may be facing. Some issues are the „illicit trade“ and the brands selling without taxation. The
economic theory expects market to be fair to all producers and hence affecting the whole market of
cigarettes, not leaving a sufficient space for the cheap production of cigarettes. Hence in such cases
it is vital to ensure the support of economic policies together with the efficient legal system to
reduce the influence of black markets.

Pakistani's intention to promote the taxation is the reaction to the great extent of negative
externalities of consumption of cigarettes. As the demand for cigarettes is usually less elastic, the
quantity demanded is usually not very much affected by the price fluctuations. Relatively inelastic
goods are often associated with necessities or addictive products. These goods are so important to
their consumers that they are not willing to give them up even though they are more expensive now.
Thus high prices of cigarettes will not lead to a drastic decrease in the annual amount sold.
Moreover, the author implies „a one-rupee tax increase is estimated to lead to an increase of only Rs
0.8 in retail cigarette prices“. The approach of government to tax the production of cigarettes will
state higher burdens to both producers and consumers, but won't be much effective in reducing the
general addiction. On the other hand, it may bring revenues to the national budget.

Considering the short-term effect of taxes, the demand for cigarettes will tend to experience a slight
drop as the average price will grow. However, in the long-run, there is an expected development of
'black market' on the price levels close to the original prices. According to some alternative
approaches, Pakistani's government may opt for negative advertisements or the nationalization of
the cigarette production. However, negative ads will require the government to pay and do not
mean there certainly will be a change. The nationalization then requires money accompanied with
a tremendous amount of time. Hence taxation seems to be the best method of resolving the issue of
tobacco products, ideally in pair with the effective legislation and the active fight against the 'black
market'.
(748 words)