Cigarette taxes are levied with the same purpose, as on any other commodity. The government is the only authority in a country that has the power to collect taxes with the intention of raising revenues to the state budget to fund activity of the government or to regulate prices, demand, and supply of commodities and services. Cigarettes are a type of merchandise as well, and it is one of the most heavily consumed products in the world. At the same time, the adverse effect of tobacco consumption on human health, people’s income, and the environment are a well-known fact, and it is also considered in the tax policy. Therefore, the primary theoretical reasoning for cigarette tax is the intention to raise funds to the national budget and restrict tobacco consumption through a rise in prices to reduce negative impact. While levying taxes on cigarettes is associated with benefits for the government, as the final receiver of revenues from such policy, there are also drawbacks for consumers; among the drawbacks for consumers are increased prices and decreased consumer surplus, as a result of decreased quantity consumed. The cigarette tax is seen both as an effective response to the need to control tobacco consumption and reduce the related risks and an unfair policy, which presupposes the levy of higher tax rates to this commodity because of the implied social responsibility of consumers. Nevertheless, cigarette tax has more advantages than it has drawbacks, as it is an integral part of national and international trade policies and a health system that targets the reduction of harmful factors, impacting the national human capital, which is valued in the globalized economy.
How It Works
History of Cigarette Tax
Before analyzing the mechanism of cigarette taxation, as well as its principles and effects, it is important to review the background of cigarette tax. The first document that levied taxes on tobacco products was the ordinance issued by the British king James I, who increased the import tax by four thousand percent (Borio n.d.). All of the subsequent documents of that time, issued by other states, followed the same principle. It is important to indicate that taxes of that time were levied for protectionist purposes, which were popular in the political spheres, because the states were trying to discourage foreign traders from entering their economies to stimulate domestic production. However, there were no changes to the principles of cigarette and tobacco taxation until the end of 19th century when the United States issued a new type of policy. In 1864, the U.S. levied a federal tax on the production of cigarettes, which was intended to serve as a source of additional income to the budget during times of the Civil War (Tax Foundation 2017). Therefore, the history of cigarette tax has experienced a significant shift in theoretical principles of taxation, which occurred in 19th century.
However, it was only 20th century that tobacco taxation became a popular policy. In the United States, it was back in 1969 when all the states of the Union had this tax in act (Tax Foundation 2017). However, at that time, it was still levied for budget revenue purposes because until the middle of 20th century, smoking was not seen as a hazard to one’s health. When the negative effects were discouraged, tobacco taxes started pursuing the goal of discouraging cigarette consumption through the regulation of prices. Consequently, the modern cigarette tax is a complex policy that pursues a number of goals.
Cigarette tax is a complex policy that pursues several goals and consists of several constituents. What is commonly referred to as a tobacco tax, indeed is made up of excise, sales, duty, and value added taxes. A duty tax is a tax that is levied on transactions and products, instead of country’s citizens. A value added tax is imposed on producers and commodities themselves, in case any value is added when producing products. A sales tax is levied on retailers and consumers as a consumption tax, and it comes into action at the point, when a person purchases tobacco products. Finally, the excise tax is imposed on producers, although it is indirectly levied on consumers, since it is included in price for cigarettes. Therefore, since tobacco products are processed and manufactured, the value is added during this process. Besides, it is sold by retailers and purchased by consumers, which means that there are points of sale. Thus, all these transactions are subjects to governmental control and taxation. These four types of taxes are commonly referred to as tobacco tax, and they unite suppliers, manufacturers, retailers, and consumers into a single complex system; the government has the power to affect every party individually through taxes to achieve certain goals. Besides, cigarette tax is a sin tax, which means that it pertains commodities that are harmful to people (Minton 2017). Tobacco taxes are often higher than taxes on other products because it is supposed that tobacco consumers need to bear the social costs and pay more for consuming products that are harmful.
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How Cigarette Tax Works
In the simplest terms, the mechanism of taxation involves governmental authorities who require the manufacturers of tobacco products to pay some part of value of the product to the national budget. Chaloupka, Yurekli and Fong (2012) indicate that taxes are levied on such categories of tobacco products as tobacco leaves that have not been processed, exports and imports of such leaves, and the tobacco products that have been processed and are ready to be sold in the market. Besides, taxes are imposed on consumers, either directly or indirectly. While it is suggested that the sales tax is imposed on consumers directly, other three types of taxes included in tobacco tax are also indirectly levied on smokers, and this is the basis of taxation mechanism. Specifically, the ultimate goal of every manufacturer is to make profits. At the same time, every economic unit is obliged to adhere to the law and pay certain amount of revenues and value added to the national budget. However, to compensate expenditures on taxes and receive a certain return on investment, manufacturers include the amount of tax in the market price for cigarettes. As a result, the final consumers bear costs of tobacco taxes because they pay for these products. Globally, the rate of cigarette tax is 40-65.5% of a pack’s price (Chaloupka et al. 2012).
Besides, tobacco taxes are based on specific models, such as deadweight loss, price elasticity, considerations of equity, and optimal taxation. The consideration of deadweight loss allows determining the rate to which the raised revenue is exceeded by welfare raised (Hindriks & Myles 2013, p. 506). In practice, this model incorporates consumer surplus. Since an increase in tax rate leads to an equal increase in price, the volumes of demand and consumption decrease due to law of demand and supply. While some part of consumption is turned into revenues generated by tobacco tax, there is some part of consumption that does not transform neither into revenues from taxes nor into revenues for manufacturers, and it is referred to as a deadweight loss (Hindriks & Myles 2013, pp. 506-507). When levying tobacco taxes, this model needs to be considered to achieve maximum efficiency.
Price elasticity is also an important aspect to be considered in the tax mechanism. It stands for maximum change in price that will not affect the volume of demand and consumption. In case of tobacco products, it is -0.65 for those consumers that are under age, while for adults it is -0.4 (UCSF 2014). The price elasticity is high, which can be explained by fact that cigarettes cause addiction and people will be purchasing them even when the change in price is significant.
The taxation mechanism is also based on consideration of equity and optimal taxation principles. These principles presuppose that since taxes cause changes to the volume of demand for commodity, the government should consider how that quantity of taxed product will change, while the alterations of price should not be taken into consideration (Hindriks & Myles 2013, p. 520). At the same time, the taxation mechanism may not be effective and optimal if there is no information on social marginal utilities of income, since they determine what quantity is demanded before the tax is levied and how it will change after levying.
Therefore, cigarette taxes are not levied only with the consideration to increase revenues to national budget or discourage consumers from consuming tobacco. Instead, there is a wide variety of principles and data samples that need to be incorporated in the calculation of taxes to ensure effectiveness and optimality.
Examples from the United States
Tobacco tax is widely applied in the world, and its rates are frequently changed and adjusted, although usually, the authorities tend to increase it, rather than decrease. For instance, over the period from 1995 through 2009, there were three increases in tobacco tax rules (CDC 2009). Overall, it has been found that the increase in federal excise tax levied on cigarettes was as big as 321%, while the average increase in the tax applied by the fifty states was 267% (CDC 2009). The most significant rise in the cigarette tax occurred in 2009, when the United States introduced a health care reform, known as “Children’s Health Insurance Reform.” To introduce the reform, the government decided to refer to sin tax and social responsibility of tobacco consumer and use tobacco tax - a source of funding of the new policy. In section 701 of the document, it is described what changes are to be applied to the national taxation system, as well as sanctions for the violation of newly established regulation (Congress.gov 2009, pp. 100-101). This example demonstrates how the United States used cigarette tax to raise revenues for budget, fund a socially beneficial program, and affect the volume of tobacco consumption (which will be scrutinized later in the paper). Overall, this governmental act is a demonstration of flexibility of cigarette taxation and various purposes of its application.
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Advantages and Disadvantages of Cigarette Tax
Similarly to any other policy, cigarette tax has its advantages and drawbacks. On one hand, the disadvantages are generally related to consumers because it is they, who pay the costs of smoking, while manufacturers redirect financial pressure of taxes through prices. On the other hand, advantages of tobacco tax are for government and people’s health.
One of the great advantages of cigarette tax is the revenue for government. Since it is a widely popular consumer commodity, the taxes on tobacco products are generally higher than those on other commodities. Secondly, this type of taxes is predictable and stable because it may be calculated based on demand, and sensitivity in price changes is low (‘Taxation and Price: Types of Taxes’ 2012). Thirdly, the tax is not affected by inflation because it is tied to the price of commodity, which is adjusted by manufacturers, when the value of money alters. Fourthly, by levying taxes on tobacco products, the government is able to control consumption of tobacco products because people get demotivated to spend much money on this commodity (‘Tobacco Tax’ 2012). Finally, it may be concluded that this policy saves many lives because smoking is associated with many diseases and high mortality rate.
At the same time, cigarette tax is associated with certain drawbacks. First of all, by raising taxes, the government urges manufacturers to increase prices, and consumers have to pay more for tobacco products. Secondly, the effects of taxes on manufacturers might be mitigated if the tax is levied on the specific form of tobacco products. For instance, if it is levied on a pack or a stick only, manufacturers could increase the size of a stick or their number in one package (‘Taxation and Price: Types of Taxes’ 2012). Thirdly, cigarette taxes are regressive, which means that individuals with lower income pay more than those, who make more (Grier, 2013).
Nevertheless, tobacco tax has more advantages than disadvantages, at least because this policy has positive implications for people’s health, especially in the long term. At the same time, the disadvantages may be mitigated because they generally relate to consumers, paying more for a commodity that is hazardous to them.
Opinions on Cigarette Tax
Cigarette tax is generally viewed as a positive policy because of its advantages for health and national budget. However, there are also some critical opinions that are related to the mechanism of taxation. Lynch and Bonnie (1994) indicate that a major drawback of tobacco tax is their failure to consider inflation. They suggest that because of the fact that they are usually levied on units of tobacco products, inflation diminishes the real value of taxes. As a result, the real price of cigarettes is higher today than it used to be in the past, while the value of tax is lower. Therefore, they express the opinion that it is the manufacturers, who drive the increase in price for tobacco products, while the effect of taxes on cigarettes is much smaller because of inflation.
Another opinion is that tobacco tax is favored by the government because it is an effective source of revenues. While sales taxes account for large amount of money, generated by the government, the taxes on tobacco products may be used to generate even larger revenues because they are sin taxes and, therefore, can be higher than others. As it is seen in Figures 1 and 2, the size of both state and federal taxes was growing simultaneously with the consumption of tobacco products. Therefore, the government was taking advantage of people’s addiction, although the levy of tax on cigarettes also allowed them to regulate the demand for them.
Finally, McCann (2017) expressed an opinion that the government fails in attempts to discourage people from smoking by raising taxes. He suggested that people who already consume tobacco products will not refuse from doing so, even when the prices rise. Therefore, the government is only taking advantage of this habit to raise billions of dollars of revenues. In fact, this opinion appears to be based on some factual evidence because the elasticity of demand for tobacco products in indeed high, and price might by as much as 65% before it impacts the demand.
Effects of Tobacco Taxes
While the government levies cigarette taxes to raise revenues to the national budget, this policy also has some other short-run and long-run effects. They include a decrease in consumption of tobacco products and changes to the volume of exports and imports of this commodity.
Tobacco Consumption Decrease Through Taxes
One of the major indirect effects of cigarette tax is the decrease in consumption of tobacco products. When the government sets a certain tax, it forces the manufacturers to pay a certain percentage of their value added and sales to the budget. However, to compensate these expenditures, the latter include the amount of tax paid in the price for their product, and it is the ultimate consumers, who are impacted by tobacco taxes. On one hand, the elasticity of demand for cigarettes is higher than that for many other commodities because this product causes addiction. However, on the other hand, there is also a certain price limit, when consumers become aware of costs of consuming tobacco products, and the demand decreases. It has been found that in case every pack of cigarettes costs more by one dollar, there would be 8% less smokers aged 18-24 (Marr & Huang 2014). Besides, the mortality from tobacco-related diseases would decrease.
However, the effect of cigarette tax is both short- and long term. In the short run, there is no substantial positive health effect because of the piling. It means that the retailers still have the tobacco products at old prices in stock and consumers do not spend more. However, in the long run, the higher tax rate leads to higher prices. As a result, consumers have less incentives to pay large costs of smoking, and the demand and consumption of cigarettes decreases for financial reasons.
An important characteristic of tobacco tax effect is its progressive nature, which means that people with smaller income are more affected by the policy, as compared to those who have larger incomes. In other words, the higher prices for tobacco products ultimately make up a large proportion of the income of people who have small salaries. Therefore, the decrease in tobacco consumption is associated with the lower social class, rather than the middle and higher ones.
Nevertheless, by levying taxes on tobacco products, the government is still able to control their consumption and decrease mortality from smoking-related diseases.
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Effect on Import and Export
Apart from effects on health, cigarette tax affect the volume of imports and exports. Since this policy pertains both suppliers and manufacturers, the high rate of tax discourages large volumes of trade of unprocessed or already manufactured products. As a result, the supply of tobacco in the market decreases, and it also makes a positive impact on people’s health in the long run.
Cigarette tax is an effective mechanism that the government used to generate revenues to the national budget and control the consumption of tobacco products. Although it was first applied in 19th century, its modern application was shaped relatively recently. Cigarette tax is a complex system that consists of several different taxes. Although the subjects for taxation are the manufacturers and suppliers, it is the consumers who bear the costs because the expenses on tax are included in price. Tobacco tax has more advantages than drawbacks, because the latter are generally related to consumers facing higher prices. This policy has some short- and long run effects on health and exports and imports. Although the elasticity of demand for cigarettes is high, high prices eventually urge the consumers to refuse from purchasing tobacco products. As a result, the mortality from smoking-related diseases decreases. Besides, higher taxes on unprocessed and ready-to-consume tobacco products discourage trade and lead to a decreased supply and consumption.