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 (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 a)

i) When governmnet imposes a tax on the suppliers of cigarettes, suppliers reduce their supply by the amount of tax. The supply curve shifts leftward. As a result price increases by the amount of unit tax. The price in the diagram rises from P₁ to P₂. HIke in cigarette price induce buyers to purchase less. Quantity demanded by the consumer dercreases from Q₁ to Q₂. Therefore, imposing tax on suppliers reduces cigarette consumption. Total revenue generated from the tax is TGFT₂. However, the amount accrued to the seller is TGHP₁ and revenue accrued to the government is P₁HFP₂.  

ii)

When government undertakes the public health campaign initiatives, it craetes an awerness among people for reducing cigarette consumption. Hence, a moral obligation and health consciousness induce people to reduce their consumption level of cigarette. In the disgram, it is shown that public health campaign leads to a shift of demand curve leftward. As a result price and quantity demanded for cigarette both falls. Price falls from P₁ to P₂ and quantity falls from Q₁ to Q₂. In this case, government receives no extra revenue as an external obligation is imposed on consumers and no quantitative restriction is there. Reduction in consumption is left on the choice of invidual consumer.