Australia's Future Tax System

Final Report: Detailed Analysis

Chapter E: Enhancing social and market outcomes

E6. Tobacco taxation

E6–3 Excise rates should be higher

Recommendation 73:

The existing regime for tobacco taxation in Australia should be retained, with the rates of tax substantially increased, depending on further evidence on the costs of harm from tobacco smoking.

Recommendation 74:

Tobacco excise should be indexed to a broad measure of wages rather than CPI.

Recommendation 75:

There should be no duty free allowance on tobacco for international travellers entering Australia.

Consistent with the broad approach to goods and services taxation taken in this report, the principal issues for tobacco taxes are whether government policy should seek to contain the very heavy mortality and morbidity costs borne by smokers and, if so, whether taxes are an effective means of doing so.

The strongly addictive properties of tobacco, together with the time-inconsistent preferences that characterise addicted consumers, are sufficient to make an in-principle case for government intervention. Taxation is not, however, the only effective policy instrument available to government. A range of other measures could help to reduce the costs of smoking borne by smokers: banning point-of-sale advertising; banning the promotion of tobacco companies; prohibiting marketing on packaging; limiting the places at which tobacco products can be sold; subsidising nicotine replacement therapies; imposing heavier penalties for, and improving the enforcement of prohibitions on providing tobacco products to minors. Limitations on where people are allowed to smoke can significantly reduce the external costs of smoking.

The Review Panel believes that governments should continue to use non-tax policy instruments to address the costs of smoking. Nevertheless, higher prices for tobacco can significantly reduce tobacco consumption and, therefore, the negative effects of smoking on smokers and others.

There are significant empirical difficulties in calculating an optimal level of taxation in a market where consumers have time-inconsistent preferences. The greatest practical difficulty is to estimate the strength of the extra weighting that consumers give to current period costs and benefits. Spillover costs need to be taken into account but are small compared with the costs borne by smokers themselves.

A model of tobacco consumption that incorporates time-inconsistent preferences, with plausible parameters, suggests that tobacco excise rates could be increased substantially (see Box E6–1; Gruber & Koszegi 2008). There are, however, considerable uncertainties surrounding these calculations: they should be treated only as indicative.

Box E6–1: A model of tobacco consumption with time-inconsistent preferences

Economists have developed a formal model of tobacco consumption that takes into account the time-inconsistent preferences that most addicted smokers display (Gruber & Köszegi 2001). The model allows the calculation of an ideal tax rate that would correct for the self-control problems that smokers experience.

The ideal tax rate depends on a number of parameters. It depends on how strongly smokers privilege current costs and benefits over future costs and benefits. The stronger the current period preference, the harder smokers find it to carry out plans to stop smoking and the higher the tax needs to be to help them overcome their self-control problems. The more harm is done by current smoking, the higher the tax needs to be to limit the damage suffered by smokers with self-control problems. The ideal tax rate also depends on whether the smoker understands their self-control problem — that is, whether they are 'naïve' or 'sophisticated'. A naïve smoker does not realise they have a self-control problem.

Estimating the Gruber and Köszegi model with Australian data, where available, suggests that tobacco tax rates could be either side of current levels (see Table E6–1). In the table, the value representing the strength of smokers' current period preference can range from 0 to 1. A value of 0 would mean that current period preference is absolute, so that a smoker places no weight at all on what happens in future. A value of 1 would mean that there is no current period preference, so that a smoker recognises the full costs of smoking, and can make a rational decision about their current smoking on that basis. The values tested in the table cover the mid-range of empirical estimates.

Table E6–1: Range of optimal tobacco tax rates for Australia ($ per stick)

  Strength of current period preference
  0.60 0.65 0.70 0.75 0.80
Sophisticated smokers 0.31 0.27 0.22 0.18 0.14
Naïve smokers 0.47 0.41 0.35 0.29 0.23

Note: The optimal tax rates for naïve smokers do not take into account behavioural responses that may somewhat offset their self-control problems. Gruber and Koszegi do not derive the optimal tax taking this effect into account as they focus on the case of sophisticated smokers. The parameter for current period preference lies between 0 and 1; the lower the value, the higher the preference accorded to the current period. The current per stick tax is $0.25.

While this is an attractive model that explains much actual smoking behaviour, there are a number of reasons not to place too much confidence in the estimates it generates.

  • It is very difficult to measure the strength of an individual's current period preference.
  • Different groups may vary in the strength of their current period preference. If so, a uniform tax will overtax some and under-tax others. In particular, young people underestimate their chance of becoming addicted and their smoking responds more to price changes, so estimates for sophisticated smokers may underestimate the appropriate overall rate.
  • It is difficult to estimate the value of life-years lost through smoking and of the other harms that smoking causes.
  • Not all smokers are the same but they all pay the same tax. High tobacco taxes impose costs on the small proportion of occasional smokers who are at little risk of harm.

As Australia's tobacco taxes are low by international standards, it is feasible to increase them substantially. Doing so would encourage smokers to quit — a 10 per cent increase in the price of cigarettes would reduce the number of people who smoke by about 2½ per cent and would decrease total tobacco consumption by around four per cent (Chaloupka & Warner 1999). The degree of responsiveness among young people, low income people and men is higher than among older people, higher income people and women. As around three million Australians smoke and each long term smoker loses, on average, around six years of life, a substantial increase in the price of cigarettes could considerably reduce the number of life years lost by Australian smokers.

It is difficult to determine the right rate of tax for tobacco products. Assessment of the rate would be easier if we had better evidence about the marginal costs of tobacco use — that is, the costs of one more or less cigarette smoked — rather than just the average costs of tobacco use. More information about the strength of smokers' current period preference would also be useful.

There is, however, a good case for a substantial increase beyond those that would be entailed by the changes to indexation arrangements discussed below (see Recommendation 73).

Tobacco excise should be indexed to wages, not CPI

Since the main public policy purpose of tobacco taxation is to reduce the harm smokers suffer from smoking by keeping prices high, the Review Panel believes it would be appropriate to index tobacco excise to wages rather than consumer prices. Wages tend to increase more rapidly than consumer prices, largely as a result of increased productivity, so tobacco excise, which is currently indexed to CPI, tends to decline as a proportion of average wages. Over time, this makes cigarettes more accessible to wage earners and others, such as pensioners, whose incomes are tied to wages. To maintain the value of tobacco excise as a proportion of average wages and hence, indirectly, as a proportion of household incomes, the Review recommends indexation to a broad measure of wages in the Australian economy (see Recommendation 74).

Higher taxes and illicit tobacco

In 2005, it was estimated that one in 17 cigarettes consumed in Australia contained illegal 'chop chop' diverted from legal tobacco production (PwC 2005). This proportion is likely to have fallen since the end of legal tobacco growing in Australia in 2007. Importation of 'counterfeit' cigarettes — factory made and presenting as legally produced and distributed cigarettes — is relatively limited in scope.

Heavy taxation of any commodity increases incentives for the illegal supply of that commodity. For tobacco, this is a relatively minor problem at current levels of tax. However, if taxes rose significantly, there would be more incentives for illegal production and importation. This makes it more important for policy makers to use instruments other than taxation to address the costs of tobacco consumption. It is, however, unlikely that any feasible increase in taxation would see an increase in illegal supply sufficient to undermine the effectiveness of the existing taxation arrangements.

Duty free tobacco should be abolished

The duty free tobacco allowance undermines the objectives of tobacco taxation and involves a significant revenue loss (in the order of $200 million per year). There is no reason why international travellers should enjoy a tax concession on cigarettes smoked in Australia. The Review Panel believes that inbound duty-free arrangements should be abolished (see Recommendation 75). People could be allowed to bring into the country up to 25 cigarettes or their equivalent duty-free, so that smokers would not have to pay duty on their daily supply.