Cigarettes are consumed all over the world and are considered to be the most sophisticated form of tobacco consumption. In most parts of the world, they constitute an overwhelming proportion of about 80 to 90 per cent of the total tobacco consumption. In India, however, they account for barely a sixth of total tobacco consumption. It is not that smoking is not popular in India. Indeed, the proportion of tobacco smoked is constantly rising and currently stands at 71 per cent of the tobacco consumed in the country. Within the smoking segment, however, it is bidis which have been growing at the expense of cigarettes both relatively and absolutely. Table 1 shows the trends in the tobacco consumption in India over the period 1971-94.
Table 1
Tobacco Consumption in India
(in million kg)
Tobacco Used In
1
1971-2
2
1991-2
3
1993-4
4
Cigarettes
71
82
66
Bidis
91
202
231
Smoking
162
284
297
Total
309
404
417SOURCE: Tobacco Excise Tariff Committee and Indian Tobacco Statistics
Such a trend in tobacco consumption has several implications for the government's excise policy in this sector. The principal objective of the government's excise policy seems to be revenue generation. This is because it is one of those products where government is neither interested in increasing the domestic consumption nor appears to be seriously interested in curbing consumption. As a matter of fact, tobacco used for smoking has been increasing in India at the annual compound rate of 2.8 per cent over a period 1971-2 to 1993-94 (See Table 1).
After the withdrawal of duty on leaf tobacco in 1979, the government had little option but to raise duty on final products to bridge the revenue gap. The nature of the final products in Indian tobacco sector restricts the government's options. Cigarettes in India are produced only by a few companies in the large-scale registered manufacturing sector which makes it very cost effective to collect excise. Bidis, on the contrary, are produced in the informal sector on a small scale by a very large number of units widely dispersed geographically. Moreover, since they are handmade, they are not uniform. All this makes bidis extremely cost inefficient to collect excise. It does not mean that the government cannot levy taxes on bidis. Rather, it is difficult to raise net revenue by doing so. Most of the tobacco products in the non-smoking segment share such features with bidis. Thus, cigarettes were considered the most relevant tax base in the tobacco sector. Table 2 shows that cigarettes are virtually the only tax-base in the Indian tobacco sector.
Table 2
Tax-Base of the Indian Tobacco Sector
Year
1
Excise from
Tobacco
(Rs. Crores)
2
Cigarettes as a percentage in
Tobacco
Volume %
3
Excise %
4
1971-2
227.5
23
70
1981-2
834.8
21
82
1993-4
3140.0
16
87
SOURCE: Tobacco Excise Tariff Committee and Budget Documents.
The table clearly shows that the tax-base in the tobacco sector is shrinking rapidly over time. The diminishing tax-base is being burdened with larger and larger contribution of excise revenue in both absolute and relative terms. This implies a very high incidence of taxation which gives rise to the equity issue. The inequality of tax incidence in the tobacco sector is significantly higher than all possible measures of income inequality in the country. Only 12 per cent of the tobacco users who are cigarette smokers contribute as much as 87 per cent of the excise revenue from the sector, the remaining 88 per cent of the tobacco users contribute only13 per cent. In terms of the excise revenue per kilogram of tobacco used, cigarettes yield Rs. 415 whereas bidis yield only Rs. 19. Such a high incidence of taxation and inequality is likely to encourage tax evasion and smuggling that would go against the interest of the government, industry, and the consumers alike. It needs correction sooner than later considering the potential for growth and exports by the Indian cigarette industry.
At present when the Finance Ministry is putting emphasis on expansion of tax-base rather the increasing tax rates in order to achieve growth in tax revenue, the issue of a rapidly shrinking tobacco tax-base in the tobacco sector cannot be ignored. This situation has primarily arisen because the Indian government chose the easier option of almost continuously raising excise duty in order to garner increased excise revenue from cigarettes. Currently the excise on cigarettes has crossed the level of 150 percent of the price net of excise. It is time to question whether cigarettes in India are overtaxed. If they are, any further increase in the excise rate would lead to decline rather than a rise in the excise revenue.
The basic assumption behind following the policy of steep and continuous increase in excise duty on cigarettes is that the demand for cigarette is price inelastic. This implies that in response to increase in excise duty and hence in price, the demand for cigarettes would not fall proportionately and therefore yield higher tax revenue. However, whether cigarettes in India are price inelastic or not is an empirical question which can be scientifically addressed.
There are two ways of estimating the elasticity of demand for cigarettes in India: (1) By taking annual changes in the price and quantity demanded of cigarettes over the recent period and apply the Arc Elasticity formula to calculate the elasticity of demand relevant for the current period and, (2) Estimating the demand function for cigarettes using long-term time series data and obtaining an estimate of the elasticity of demand for the current period based on the regression equation. Both the methods are used here so that the most conservative estimates of the price elasticity of demand for cigarettes in India can be obtained.
Arc Elasticity
The advantages of the Arc Elasticity method are:
It requires annual averages over short periods of time and therefore effectively uses the most recent data, capturing the current trends in the price responsivene3ss of the commodity.
Since estimation is over a short period of time, the long-term influences such as changes in consumer taste and preferences in favour of or against the commodity in question are not likely to play a significant role.
In comparison to the alternative Point Elasticity measure the Arc Elasticity measure, always gives a lower (and hence more conservative) estimate at higher price and lower quantity consumed. In the Indian cigarette industry, the volumes have been consistently declining since 1991-2.
The principal limitation of the Arc Elasticity measure is that it is a direct method, not capable of separating the influence of some important factors such as price of a close substitute (bidis) or real income of the consumers. However, the influence of some other variables such as seasonal variations, population growth and general inflation on the demand for the commodity can be neutralized by measuring the volume of cigarettes as a monthly average on a per capita basis, and the price of cigarettes as a real price which I obtained by deflating the nominal price by the consumer price index.
The Arc Elasticity formula utilizes the concept of average percentage changes in the demand and price over the interval, i.e.,
Arc Elasticity = X2 - X 1 x P2 + P1
X2 + X1 P2 - P1
Where, (P2, X2) and (P1, X1) are the observed values of price (P) and volume (X) for the year 2 and 1 respectively. Using this formula, and the data from Table3, estimates of the price elasticity of demand for cigarettes are obtained for consecutive periods from 1991-2.
Table 3
Monthly Average Consumption and Price/1000 Cigarettes
Year
1
Total
Volume*
(million cigs.)
2
Per Capita
Volume
(in sticks)
3
Average
Price in Rs.
4
Real Price
In Rs.
5
1991-2
7145
8.346
505.55
276.26
1992-3
6681
7.653
588.90
291.53
1993-4
6514
7.311
634.65
293.82
1994-5**
6322
6.955
667.70
284.13
* Excluding minors.
** Based on the period March to Aug. 1994
SOURCE: i. For volume and consumer price of cigarettes: Cigarette industry sources in India.
ii. CPI is for urban non-manual workers, obtained from CMIE, Aug. 1994.
Period
Arc Elasticity of Demand for
Cigarettes
1991-2 to 1992-3
..................
1991-2 to 1993-4
…………..
1991-2 to 1994-5
…………...
Observation: ………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………
These estimates imply that a one per cent reduction in the price of cigarette would result in minimum increase of two per cent in the total consumption of cigarettes. In other words demand for cigarettes in India is price elastic (perhaps highly price elastic). The statistical evidence does not support the belief that the demand for cigarettes is price elastic in India. Thus estimate for India may be compared with that obtained for the US by the Nobel laureate Gary Becker and his colleagues (American Economic Review, June 1994) who found that the price elasticity of demand for cigarettes in the US is (-)0.4 in the short run and (-)0.75 in the long-run.
It may be noted here that in spite of the fairly inelastic demand for cigarettes, in the US both in the short-run and long-run, the US Federal rate of excise on cigarettes is less than 12 percent (total tax being 35 percent) of consumer pack price as compared to an average of about 60 per cent in India. There was a proposal by some Congressmen in the US that Federal tax rate should be raised substantially from the prudent rate of 24 cents to $1.24 per pack of cigarettes. Professor Gary Becker had warned against such a move arguing that it would amount to unnecessarily high taxation. According to his estimates, the tax revenue from cigarettes would be maximized when the tax rate increased from 24 to 95 cents. Thereafter, the tax revenue would fall as the tax rate was increased further. It is learnt that the US Government has since deferred the proposal, taking cognizance of Professor Becker's warning.
Professor Gary Becker's argument is based on a well known proposition in price theory that price elasticity increases as the price rises. Thus, ceteris paribus, there is always an optimal rate of excise duty that maximizes the excise revenue from the commodity. (See Fig. 1). Any higher rate of tax would make it an overtaxed commodity hurting the interest of everybody involved in it.
Excise Revenue
Excise Rate
Figure 1
Que. 1. When is a commodity considered overtaxed?
Que. 2. Why is the demand for cigarettes in India elastic and inelastic in the US?
Que.3. What should be the optimal tax rate on cigarettes in India (refer figure 1)?
Que. 4. As the Finance Minister of India, how will you levy the taxes on commodities and what factors would you take into consideration?
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