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.

Part (c) Taxation of cigarettes is often justified on the grounds that cigarette smoking creates externalities. What is meant by the term “externalities” in this context? Give two examples of externalities created by cigarette smoking and explain how a tax on cigarettes could potentially address both of these. Using a fully labelled and explained diagram explain how a tax can increase efficiency in the cigarette market. What size tax should be levied to maximise efficiency in this market? (Indicate the efficient tax size on your diagram – no actual number required).

Part (d) Is a tax on cigarettes a regressive tax or a progressive tax? Explain your answer, including a definition of both terms.

Part (e) Australia’s police forces and border forces have warned that rapid rises in the tax on cigarettes have had unintended consequences of encouraging illegal activity such as smuggling, with proceeds funding other criminal activities. Explain why this might be the case. In your answer refer to the role that elasticity of demand plays in making illegal activity more profitable.

Answer 1

Part b:

Even when a tax is levied on the supplier of the good, the major incidence of the tax falls on the consumers of the good because demand for cigarettes is relatively inelastic as compared to supply of cigarettes. And the side of the market with a relatively inelastic price elasticity will have to bear the maximum burden of the tax. In this case since demand is relatively inelastic, thus consumers have to bear the major incidence of the tax. This can be represented in the diagram below:

The above diagram shows that tax will shift the supply curve leftwards and the price paid by the consumer increases by a greater amount as compared to the fall in the prices that sellers have to receive. Thus,major incidence of the tax falls on the buyers.

Since demand for cigarettes is relatively inelastic, with an increase in the price level by 10 per cent, the number of cigarettes consumed will decrease by less than 10 per cent.

Part c;

Externality is caused by cigarette smoking because third party is harmed without being direclty involved in the act of smoking. One example of cigarette externality is passive smoking where another person has to breathe the polluted air which can cause damage to the lungs of passive smoker. Another example of cigarette externality is pollution in the atmoshpere. This increases marginal cost of smoking and Pigouvian tax needs to be levied to correct this externality. This can be represented as:

Part d:

It is regressive tax because it is not connected to income. The tax remains same no matter what is the income of the consumer and thus is a regressive tax.

Part e:

This is because since demand for cigarette is relatively inelastic and people with addition cannot live without smoking it, thus, shortage due to increase in taxes will force them to enter into black marketing and obtain other illegal ways to satisfy their consumption of cigarettes.