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Tobacco taxes and government revenue in South Africa

University of Cape Town, Cape Town, South Africa, and University of York, York, UK
Keywords Tobacco, Taxation, Revenue, Control Abstract The South African government's objectives relating to tobacco, primarily deterrence and revenue generation, have since the early 1970s not been maintained. The real value of tobacco taxes fell over the 20-year period 1970 to 1990 and, as a result, consumption steadily increased. Since 1990, however, the government has, despite vociferous opposition from the industry, embarked on a stronger programme of tobacco control and has increased excise taxes in real terms. Uses a simulation model of the government's non-optimal tax policy to show that revenue could have increased by 2 per cent, had the government maintained the real value of excise duties. These findings suggest that, despite government moves in the right direction, there is still much room for a stronger tobacco taxation policy in South Africa that will enhance government revenue and contain consumption.

Tobacco taxes and government revenue 397

Iraj Abedian

Rowena Jacobs

Introduction Since the early 1990s the South African government has made a commitment to tobacco control initiatives such as increased taxation, the carrying of health warnings on packs, the prohibition of smoking in public places and a ban on tobacco advertising. If one views these policy changes in a historic context, however, they appear to be long overdue. The real value of tobacco taxes fell over the 20-year period 1970 to 1990, leading to a fall in the real price of cigarettes and, together with no advertising regulation, this resulted in higher consumption. Since the implementation of the tobacco control initiatives in the 1990s, however, consumption has declined. These initiatives are in line with comparative international experiences, which have succeeded in reducing consumption patterns. The aim of this paper is to provide a policy context for reviewing what has happened in South Africa with regard to tobacco control and in particular tobacco taxation, and the potential course of future policies. Government policy directed towards cigarette taxation may be intended to satisfy three objectives: revenue, efficiency, and deterrence (Zimring and Nelson, 1995). Tobacco is often susceptible to high tax rates and is a popular source of government revenue. Tobacco tax is also a well-documented and effective policy measure with which to discourage smoking (Warner, 1987). If
Financial support from the International Tobacco Initiative (ITI), and the University of Cape Town (UCT) is gratefully acknowledged. The authors would also like to thank two anonymous referees for their helpful comments. The views represented here are those of the authors and not necessarily those of their funding organisations.
Journal of Economic Studies, Vol. 28 No. 6, 2001, pp. 397-407. # MCB University Press, 0144-3585

Journal of Economic Studies 28,6 398

efficiency in taxation were a distinct goal of government, this could be achieved by setting the tax at a level which reflects the social cost of cigarette consumption (Grossman, 1989). These objectives to some extent overlap as well as diverge. Within a certain range, as the tax rises, government raises its revenue and achieves its goal of containing consumption (deterrence), hence the objectives converge. At some point this would also mean that total revenue extracted from an optimal efficient tax would be equal to the total social cost generated. It is possible, however, that the tax rate that is optimal as a deterrent factor does not necessarily generate maximum revenue for the state and may never be efficient, if total social cost always exceeds revenue. At the extreme, the tax level that may be justified as a deterrent factor may lead to a total collapse of the industry, something which is not optimal from a revenue maximisation perspective. Because these objectives are often conflicting, optimal tax levels have to be set within these constraints. This paper examines the revenue and deterrence objectives for South African taxation policy. Sets out to show how tobacco taxation policy has historically not fulfilled its revenue objective and has, as a result, not fulfilled its deterrence objective either. A simulation model of an optimal tax policy is used to show how government has failed to fulfil these objectives. The first part of the paper discusses the debate around tobacco control that has taken place in South Africa, particularly relating to taxation policy, and the tobacco industry's response. The second part of the paper shows basic statistical trends in the industry, followed by a discussion of the methodology used to simulate an optimal tax policy and the impact on revenue generation. The paper concludes with policy issues that flow from the findings and the implications thereof. The South African debate around the tobacco control In 1988 the South African Medical Research Council (SAMRC, 1988) put out a report recommending the abolition of the tobacco industry on the grounds that the costs of the tobacco industry to society outweigh the economic benefits. They argued that smoking-related diseases had already reached pandemic proportions in South Africa, and that the costs of disease in terms of premature death, high morbidity, treatment costs in and out of hospital, absenteeism from work, and lost productivity were very high. In 1992 Yach et al. (1992) produced an updated version of this MRC report, quantifying the costs and benefits of the tobacco industry. Their estimations were that the costs to society outweigh the benefits by a ratio of nearly 4:1. Following these reports, Reekie and Wang (1992) and Reekie (1994) contested the Medical Research Council findings. They argued, using statedependent decision theory, that smokers have already discounted the hazards associated with smoking. This means that the decision to smoke or not is influenced, on the one hand, by the expected utility or satisfaction obtained from smoking and, on the other hand, by the probability of knowing that one could contract a smoking-induced illness or even die. Smokers have already

discounted the latter in their decision to smoke. In addition, using public choice Tobacco taxes theory and utilitarian economic analysis, Reekie argued that smoking does not and government impose net costs on society. He estimated that, even with the most conservative revenue assumptions, consumers would still receive substantial benefits from smoking. The results of these studies provided the South African Tobacco Institute with useful support for its cause, namely that the industry does not impose net costs 399 on society. Abedian and Dorrington (1994) strongly refuted the findings from Reekie's studies on the basis that state-dependent utility theory fails as a model, particularly in the presence of an addictive product. Consumers are not as rational and capable of processing information as the standard theory leads one to believe. In addition, the technical and empirical fit of the model and the specification used by Reekie, examining the demand for cigarettes in South Africa, were found to be seriously flawed. Van Walbeek (1996) did not enter this debate, but also attempted to empirically investigate the demand for cigarettes in South Africa. He looked at the potential of increasing excise taxes, not because smoking is detrimental to society per se, but because it represents a potential source of revenue for government. His results suggested that there was substantial scope for government to increase revenue from excise taxes, that this would lead to a rise in the real price of cigarettes and a commensurate fall in consumption. Smoking has become an increasingly debated issue in South Africa in the lay press, media, and academic circles. Pressure from the anti-tobacco lobby has grown and since 1990 has resulted in new legislation restricting smoking in public places and on public transport. It has also resulted in anti-tobacco advertising being carried out in cinemas for the first time since 1990. From May 1995 regulations were imposed based on the Tobacco Products Control Act of 1993. Policy measures have included health warnings on all cigarette packets and on print and visual advertising. The year 1998 saw the introduction of a comprehensive act to ban tobacco advertising and sponsorship. People have become more aware of the potential detrimental consequences of smoking and public attitudes appear to have changed. In a national survey completed in March 1992, the majority of people in both rural and urban areas were aware that smoking is a health hazard (Martin et al., 1992). In recent years the medical community has also emphasised the harmful impact. This has led to a strong anti-tobacco lobby and resistance to smoking, particularly from the non-smoking community. In May 1991 the three principal voluntary organisations with an interest in controlling smoking the Council Against Smoking, the National Cancer Association, and the Heart Foundation of South Africa formed a coalition, the Tobacco Action Group, to co-ordinate their antismoking activities. Given the changing public attitudes and the increasing strength of lobby groups, as well as the negative health outcomes associated with smoking, a tax on the consumption of tobacco is seen as fair and acceptable by large sections of the population. This form of government revenue thus implies only a small

Journal of Economic Studies 28,6 400

political opportunity cost. It is easy raising excise duties from the consumer's (demand) side (Van Walbeek, 1996) but, given the high degree of economic concentration in the tobacco industry, such government action has been met by fierce opposition from the producers' (supply) side. Following the Minister of Finance's 1997 Budget Speech (Department of Finance, 1997) announcing an increase in tobacco duty, the Tobacco Institute wrote in an open letter to the Government that an increase in duty on cigarettes would not materially affect overall consumption, but would lead instead to ``reduced government income'' (Sunday Times, 1997). Despite these claims, however, the government has been resolute in increasing excise taxes, which reflects changing attitudes about cigarettes, smoking and public health. Basic statistical trends in the South African tobacco industry Basic relevant trends of the industry are summarised in Table I. Over the period 1970 to 1997 the real price of cigarettes has declined noticeably.
Year 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Price 100 103 100 97 92 92 93 92 89 84 77 71 75 73 73 69 68 64 63 64 66 70 71 73 72 81 85 90 Consumption 100 100 102 109 115 120 125 114 116 125 135 142 147 143 144 140 140 147 151 148 151 165 135 119 119 105 95 76 Percent excise tax 45.70 40.37 43.32 41.80 41.27 46.48 46.54 41.26 38.55 38.65 39.86 48.13 38.26 39.06 34.62 31.19 28.29 26.11 27.15 23.61 21.90 23.85 21.70 20.05 27.57 23.78 32.00 50.00

Table I. Indices of the real retail cigarette price, per capita cigarette consumption, and the percentage of excise Source: Central Statistical Service (CSS) South African Statistics, South African Reserve tax per cigarette in Bank (SARB) Quarterly Bulletin, and the Tobacco Board Annual Report South Africa: 1970-1997

Compared with 1970 the real price index declined from 100 to 90 after a low of Tobacco taxes 63 in 1988. Concurrently, the consumption index increased from 100 in 1970 to and government a high of 165 in 1991. The decline in per capita consumption from 1991 revenue coincides with the introduction of anti-smoking campaigns. A distinctive trend in the South African cigarette industry is the decline in real cigarette excise taxes since 1970. In 1970, the real excise tax was 46 per cent of the selling price. 401 In 1993 this figure had fallen to a low of 20 per cent. This suggests that cigarette tax rates have not kept pace with inflation. Not only has government not optimised revenue from this source but also, by allowing a continuous decline in tobacco taxes, it has in effect encouraged consumption. Only in 1996 and 1997 has that trend been reversing. The low duties on cigarettes have been the strongest contributor to the low real price of cigarettes. The low real price, as a result, has also had the strongest influence on rising consumption up to 1991. The low real price of cigarettes can be contrasted with international price levels, as in shown Figure 1 (World Health Organisation, 1996). Although this is not a perfect comparison, given exchange rate fluctuations, real income effect and different input prices in various countries, it is still indicative that South Africa had a very low relative international price of less than US$1 for a pack of 20 cigarettes. It would appear that countries that have maintained higher excise taxes have also been able to reduce consumption, through higher cigarette prices. The cigarette excise tax levied in 1995 was 24 per cent of the retail price. Although the excise duty has increased substantially to 50 per cent of the retail price in 1997, the real price of cigarettes in South Africa relative to other countries is still extremely low. This would be somewhat moderated if adjustments for relative real incomes were made.

Figure 1. Average price of 20 cigarettes in US$ for selected countries, 1995

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The methodology used to simulate potential tax revenue and the results This section uses the trend data from the tobacco industry to develop a model to simulate the tax revenue that government has lost from not operating an optimal tax policy. In order to run this model an estimate of the price elasticity of demand for cigarette consumption was used. Several statistical studies in South Africa have estimated the impact of higher prices on cigarette consumption. The price elasticity of demand shows how sensitive consumption would be to a price increase, all other factors remaining constant. Reekie (1994) found an elasticity of 0.87 for South Africa, and Van Walbeek (1996) found an estimate of 0.66 on the same data. Reekie's estimate would therefore appear to be high. The statistical and empirical fit of Reekie's model was also criticised by Abedian and Dorrington (1994). The Economics of Tobacco Control Project (1996) found a price elasticity of 0.57. This estimate was developed from an integrated supply and demand model of the South African tobacco industry. Abedian and Annett (1997), using cointegration analysis, found a price elasticity estimate of 0.59 in the short run and 0.69 in the long run. For the purposes of the simulation exercise, the model by Abedian and Annett was used with an elasticity of 0.59, as the estimate of Reekie was considered too high. For most developed countries the price elasticity of demand is around 0.4, that is, a 10 percent increase in price leads to a 4 per cent decline in consumption. To provide an international comparative perspective for the South African price elasticity estimates, Table II shows a survey of these estimates similar to Zimring and Nelson (1995). Table II shows that for most developing countries, including South Africa, the estimates appear to be slightly higher, suggesting a greater sensitivity to prices than by consumers in developed countries. Like the results from Papua New Guinea (Chapman and Richardson, 1990), it appears that the estimates in South Africa are more price-elastic than in developed countries. This underscores the fact that, in developing countries, excise taxes are a more potent weapon for governments to reduce consumption than other non-tax measures. The level of excise is an important and practical instrument for the control of consumption, particularly as consumption is most prevalent in the lower income population groups in South Africa. To examine the government's loss of revenue from not operating an optimal tax policy, the following simulation was performed: Max Rt Qt TAXt s:t: QDt 1 Yt 2 Pt where R is real tax revenue (1990 Rands), Q is the total quantity of cigarettes consumed, TAX is the total tax paid on cigarettes (including General Sales Tax/Value Added Tax) expressed in 1990 prices, QD is per capita cigarette

Date 1980 1982 1984 1985 1985 1988 1990 1993 1994 1994 1995 1996

Reference Fujii Lewit and Coate

Country studied USA USA

Elasticity estimate 0.45 0.42

Comments

1996

1997

Time-series 1929-1973 1976 Health Interview Survey gives elasticity by age and sex Leu Switzerland 0.50 1954-1981 sales data Bishop and Yoo USA 0.45 Time-series aggregate data 1954-1980 Radfar UK 0.23 (SR) Quarterly aggregate sales 0.39 (LR) data 1965-1980 Godfrey and Maynard UK 0.56 1956-1984 aggregated sales data Chapman and Papua New 0.71 Excise elasticity for Richardson Guinea 0.50 cigarettes and for noncigarette tobacco 1973-1986 Keeler et al. California 0.3 to 0.5 (SR) Monthly time-series 0.5 to 0.6 (LR) consumption data, 1980-1990 Sung et al. 11 US states 0.40 (SR) 1967-1990 panel data 0.48 (LR) Reekie SA 0.877 1970-1989 Time-series consumption data Tremblay and USA 0.4 Time-series 1955-1990 Tremblay 1972-1990 Tobacco Board Van Walbeek SA 0.32 (SR) data 0.53 (LR) 1971-1989 Reekie's data 0.66 (SR) 1.52 (LR) Economics of Tobacco SA 0.57 1970-1995 Time-series Control Project consumption data, integrated supply and demand Abedian and Annett SA 0.59 (SR) 1970-95 Time-series 0.69 (LR) consumption data

Tobacco taxes and government revenue 403

Table II. Comparison of price elasticity estimates for cigarette consumption for selected countries

consumption, Y is per capita disposable income, and P is the real retail price per cigarette (in 1990 Rands). The maximisation problem implies the following assumptions: (1) Tax rates were maximised over the period. This assumption requires government to be able to perfectly forecast future consumption and income in period t + 1 at time t. (2) The cigarette industry is able to pass the entire excise tax on to the consumer. Theory would suggest that the tax burden is shared between consumers of cigarettes, who have to pay more for each packet of cigarettes, and suppliers, who receive less for each packet of cigarettes. Traditional microeconomic analysis also tells us that firms cannot increase the retail price by more than the excise tax increase. However, many studies (Barzel, 1976; Sung et al., 1994; Barnett et al., 1995) have found that,

Journal of Economic Studies 28,6 404

because of the oligopoly structure of the industry, they are able to increase the retail price by more than the size of the tax increase. The simplifying assumption was, however, necessary, as it is not known by how much cigarette manufacturers in South Africa can increase the retail price and how much of the tax burden can be passed on to consumers. Using these assumptions, the optimisation was solved using 0.59 as a price estimate and 1.62 as an income estimate for 2 and 1 respectively. The results of the maximisation simulation are given in Table III. Note that the results do not consider the effects that reduced consumption from an optimal taxation policy could have on production, and therefore corporate tax receipts. Nor does it calculate the future savings in the health sector from lower costs incurred from treating patients for fewer smoking-related illnesses. The simulation indicates that excise tax revenue could have been 157 per cent higher in the first half of the 1990s. This translates into approximately 1.2 billion (1990 Rands) of additional receipts or 2 per cent of total government revenue. If the tax revenue was used specifically for health expenditure, approximately 10 per cent more funds on average could have been allocated to the health budget. The actual and simulated maximum real excise revenue, in 1990 Rands, is shown in Figure 2.
Period Q 5.304 7.685 12.044 15.455 15.819 Per cent change 29.3 33.4 39.2 43.6 42.2 R 200 372 809 1.176 1.131 Per cent change 21.3 34.0 71.7 148.2 157.0

Table III. The impact of excise tax increases on consumption and revenue in South Africa: 1970-1995

1970-1974 1975-1979 1980-1984 1985-1989 1990-1995

Note: R is the change in real revenue measured in 1990 prices

Figure 2. Actual and forgone real government excise revenue from cigarettes in South Africa: 1970-1995

The trend highlights the increasing loss of government revenue over the 1980s, Tobacco taxes reaching its maximum in 1990 and 1991. This suggests that the taxation and government objectives of revenue and deterrence have not been accomplished in South revenue Africa over this period, because excise tax rates have not kept pace with inflation, thus allowing real cigarette prices to decline. With regard to increases in excise taxes as a percentage of the price of 405 cigarettes, South Africa still clearly has the potential to increase its duties. Figure 3 shows an international comparison of excise taxes on cigarettes for 1995 (World Health Organisation, 1996). As shown in Figure 3, in 1995 excise tax as a percentage of price in South Africa was only 24 per cent, which was much lower than many other countries. The government has now increased the percentage share of tax to 50 per cent. This means that, within the two-year period 1995 to 1997, South Africa has made a significant improvement with regard to excise taxes. Considering the historical decline in the real value of taxes, however, this new taxation policy seems long overdue. Government has been practising a non-optimal tax policy for a very long time, and the objectives of revenue generation and deterrence have not been achieved historically. It could be argued that there still exists scope to increase excise taxes above the current 50 per cent of selling price. Historically, any increase in excise tax has led to an increase in revenue, which suggests that a maximum tax rate has not yet been achieved. Because of the inelasticity of demand, the tax rate can still be increased, particularly in terms of the government's revenue objective. At no point in the last 25 years has a high tax led to a fall in consumption, which has resulted in revenues falling, even in the 1970s when tax rates were around 45 per cent. In other words, the optimal tax may very well be above the current 50 per cent. This would suggest that there is scope in South Africa to increase taxes to the extent that the industry still remains viable or profitable, and maximum revenues can be collected. Van Walbeek (1996) reached a similar conclusion, suggesting that increasing the excise rate to at least 110 per cent of the producer price of tobacco would

Figure 3. Tax as a percentage of the price of 20 cigarettes for selected countries, 1995

Journal of Economic Studies 28,6 406

increase cigarette excise revenues to at least double those currently being generated. This would suggest that in terms of the government's objectives to maximise revenue and contain consumption, there is still scope to increase tax rates. This conclusion suggests that the government can achieve the objectives of good public health and revenue generation, through an optimal taxation policy on the tobacco industry that would suggest setting the tax at a level higher than the current 50 per cent. Conclusions: policy implications The South African government has recently committed itself to a stronger policy of tobacco control, particularly with strong support from the Health and Finance Ministries. The government has, therefore, proposed tax increases greater than expected inflation to adjust the effective duty to 50 per cent of the retail price in 1997. In spite of this significant increase, however, it would appear that the government still has much room for increasing excise tax rates to levels that are similar to those of many developed countries. This paper's analysis of the tobacco industry in South Africa offers the following key finding: there was a declining trend in the real value of tobacco taxes over the period 1970 to 1995. In particular, the results show a steady decline in the selling price over the period, which is caused primarily by a decrease in the tax component. A declining real value of tobacco taxes implies the government's failure to maximise revenue from this source. More importantly, it highlights an ironic demand stimulation of a product with wellknown negative consumption consequences. The decrease in consumption since 1990 in Table I appears to be mostly attributable to the increase in excise tax and the resultant increase in price. It would thus appear that increased excise tax is the strongest mechanism to control tobacco consumption. This conclusion appears to be similar to other developing countries, where cigarette consumption appears to be more priceresponsive than in developed countries. An optimal tobacco control policy in South Africa should, therefore, be based on an appropriate tax on cigarette consumption. There is within this ambit still ample scope for stronger tobacco control policies in South Africa.
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