Question

Cigarettes in Australia have long been subject to excise tax – a per cigarette tax levied on the suppliers of cigarettes. (The tax applies to all tobacco products, however for the purposes of this exam assume cigarette and tobacco consumption are the same thing). In 2016 the federal government announced that the excise tax rate for cigarettes would rise by 12.5% a year for the next 4 years. Over this period tax revenue collected from the sale of cigarettes has increased considerably. Legal cigarette consumption has fallen to an all-time low in Australia due to a combination of the tax on cigarettes, and public health initiatives such as plain packaging, health warnings and banning advertisements

Part (b) Consider the following quotation:

“When a tax is levied on a good, a share of it is paid by both the consumer and
producer. In the case of cigarettes however much more of the burden of the tax is
paid by consumers, even though the tax is levied on the suppliers of cigarettes.”
Why might this be the case? In your answer explain both parts (sentences) of this
statement.
If the price of a packet of cigarettes increased by 10%, and in light of your
explanation of the quotation, would you expect the quantity of cigarettes consumed
to increase or decrease, and by more or less than 10%? Explain your answer.

Answer 1

Let us jot down a few key-readings from the question:

1. "cigarette tax is levied on the suppliers of cigarettes"
2. "tax revenue collected from the sale of cigarettes has increased considerably"
3. "Legal cigarette consumption has fallen to an all-time low in Australia"

Now, let's first find out the price elasticity of demand in case of cigarettes. Refer to the point no. 2 and 3 above. With a combined reading of both the points, we get to know that Tax revenue has increased despite fall in cigarette consumption. What does it mean? Well, it means that in response to 12.5% rise in price (due to tax increment given in question), the demanded quantity has fallen only less than 12.5%. To put it differently, after the prices rose by 12.5%, had the quantity fallen by the same percentage, then total expenditure on cigarettes would have remained the same and so the case with taxes too, But here tax revenue has increased; clearly meaning that the demanded quantity of cigarettes has fallen less than 12.5%. This is the reason, the total expenditure has increased, and so has the tax revenue in hands of government.

What the above imply? Well, it implies that price elasticity of demand for cigarettes is less than one. Or say: E_d < 1. Or say, people are badly addicted to cigarettes. They cannot refrain from it, even if the cost is rising.


Now, come to the question particularly asked:

Consider the following quotation: “When a tax is levied on a good, a share of it is paid by both the consumer and
producer. In the case of cigarettes however much more of the burden of the tax is paid by consumers, even though the tax is levied on the suppliers of cigarettes.” Why might this be the case? In your answer explain both parts (sentences) of this statement.

Answer to above: Actually cigarette producers know the helplessness of their consumers. Consumers can't stay away from smoking and producers take advantage out of it. When government levies tax on cigarettes on the producers, they do not lower their own 'base price' for keeping the 'price after tax' unchanged for the consumers. Instead they keep their base price unchanged, hence their profits also unchanged, but add the new tax amount over and above. They pass the whole cost (or a very substantial part) of the taxes upon the consumers, because they know that what they are selling, has a E_d < 1.

For example, if a cigarette pack was selling earlier for $10 (base price) + $2 (tax) = $12, then what happens when government raises tax from $2 to $4 per pack? The cigarette producers will revise their pricing to: $10 (base price) + $4 (tax) = $14. In this way, producer keep their base price unchanged at $10, and pass on the entire tax burden upon the consumers.


Now, let us attend the last part of the question:

If the price of a packet of cigarettes increased by 10%, and in light of your explanation of the quotation, would you expect the quantity of cigarettes consumed to increase or decrease, and by more or less than 10%?

Answer to above: When cigarettes prices rise, demand will not rise for sure. Why? It's because of the combination of the tax on cigarettes, and public health initiatives such as plain packaging, health warnings and banning advertisements.

Sure, if not rise, demand for cigarettes will fall. But more than 10% or less than 10% (in response to the 10% rise in prices)?

Well, in the first section of this answer, we learnt that price elasticity of demand for cigarettes is less than one (E_d < 1). Going by this, percentage change in demand will be less than percentage change in price (remember the E_d formula under percentage method?). Now we can say that decrease in demand for cigarettes will be less than 10%.