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 question 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 (a) Consider the following two policies aimed at reducing cigarette smoking:

(i) A tax on the suppliers of cigarettes, and

(ii) The public health campaign initiatives.

Illustrate both of these policies separately using a fully labelled and explained demand and supply diagram for each of parts (i) and (ii). Do not use actual numbers; this is intended as a theoretical exercise.

Compare and contrast the impact on equilibrium price and quantity of cigarettes of each of these policies, explaining your answer with reference to the diagrams. Consider the impact of each policy on government revenue. Explain your answer. Can the impact on government revenue be illustrated on either of your diagrams? If so, indicate and explain the area on the diagram/s that represents government revenue.

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 1:

i. Tax on the suppliers of cigarettes: When a tax is imposed on the sellers, then it increases cost of production for the seller and reduces the profit of the seller due to which quantity supplied decreases at each price level and this leads to leftward shift of the supply curve in the market for cigarettes. In the diagram below, the equilibrium moves from point E1 to point E2 where equilibrium price of cigarettes has increased and equilibrium quantity demanded and supplied of cigarettes has decreased to Q2.

When government levies taxes on sellers, then it can earn revenue which is represented by the green shaded area which is equal to the Tax Amount * Amount of cigaretters supplied and consumed after tax is levied. Thus, government can earn revenue when supply side tax policy is imposed.

ii. The public health campaign initiatives.

The health campaign initiatives of the government will increase awaresness about the harmfull effects of consumption of cigarettes and this will help in changing tastes and preferences of consumer such that demand curve will shift leftwards to D'D'and new equilibrium in the market for cigarettes occurs at point E2 where both prices and quantity of cigarettes has decreased. This can be depicted in panel ii of the diagram above.

Since it involves decrease in demand and price of the good, this policy will not lead to earning of any revenue by the government unlike former case where government could earn revenue.