Business World, 22 August 2012


Yesterday I talked about deadweight loss (DWL) or loss in efficiency as a result of taxation. At an optimum, marginal DWL on each commodity will be the same; at the optimum, the price of tax revenue — DWL/REV — must be equal for all taxes. The best possible tax rate for a commodity is thus inversely proportional to its elasticity (the responsiveness of the consumer to a change in price). This is the so-called inverse elasticity rule.

Tax rates should differ only to the extent that elasticities differ. For example, if the demand for cigarettes is more inelastic compared to the demand for liquor, then cigarettes should be taxed more than liquor.

Another example: if demand elasticity for any type of cigarettes is the same, then uniform tax rates may be optimal. In the absence of separate estimates of elasticity of demand for a particular blend of cigarettes (premium, high, medium or low) then uniform ad valorem tax rates may be appropriate.

However, if the elasticities of demand for any two commodities are equal, then both commodities should be taxed uniformly.

The efficient tax theory has unwanted policy implications. It may be inappropriate to apply the rule on commodities whose consumption has distributional effects. For example, demand for food may be inelastic, and thus should be taxed more consistent with the inverse elasticity rule. Yet, because of its distributional effects it does not make good policy sense to tax food heavily.

Another unwanted consequence of the efficient tax rule is that it might lead to too high rates. What if there is too much focus on a few inelastic products? It might lead to taxing the few products at relatively high rates. However, since DWL increases by the square of the tax rate, all tax rates should be as low as possible.

And how can we keep tax rates as low as possible for a given tax revenue goal? The short answer is by broadening the tax base. Let R be the revenue goal, t the tax rate, and B, the tax base. Hence, R=tB. For a fixed R, the only way the tax rate, t, can be lowered is by broadening the tax base, B. Hence, as discussed earlier, most successful tax reforms focus on broadening the tax base — not narrowing it or raising tax rates.

For example, the corporate income tax rates may be reduced and made more aligned with the country’s competitors, if income holidays and other tax perks for select industries can be phased out. Withdrawing fiscal incentives for a few favored firms may allow lower corporate income tax rates, which favor all existing and potential firms. It may also lead to higher tax revenues from corporations in the future.

If more workers are mandated by law to pay taxes, rather than a major chunk of workers are exempted from paying taxes, then the personal income tax rates may be lowered. This will remove the disincentive to work, another sign of the inefficiency of the tax system.

A desirable characteristic of of an ideal tax system is where the tax rates are not too high. And the best way to achieve this is by broadening the tax base.

There is another problem when tax rates are set too high. It leads to tax evasion or smuggling. Higher tax rates on cigarettes and liquor may provide incentives for not paying the legally mandated taxes.

Suppose an individual taxpayer is concerned with maximizing expected income. His goal is to choose H, which is the amount that is hidden from tax authorities.

The marginal benefit of hiding the income is the tax rate, t. Assume that tax authorities randomly check transactions with probability, p. The penalty increases as the amount hidden rises. Optimal underreporting happens when the expected marginal benefit (t), exceeds the marginal cost. Evasion or smuggling increases with tax rates and decreases with stricter enforcement.

The important lesson is that tax rates should not be set too high, otherwise it might lead to tax evasion or smuggling. There are many cases globally and in recent history where setting rates too high has resulted in smuggling or illicit trading.

Brunei, a Southeast Asian country, is now having a serious cigarette smuggling problem as a result of the government’s decision to increase the excise tax on cigarettes in November 2010, from BND 60 per kilogram to BND 250/1,000 sticks. The effective tax increase was about 360%. As a consequence of higher excise taxes, retail selling prices of cigarettes rose sharply: the price of a 20-pack Marbolo cigarettes shot up from BND 3.10 to BND 7.40; the lower-priced pack of 20 Alpine cigarettes soared from BND 2.00 to BND 6.30. The response of the cigarette industry was shift and nearly fatal. Retail sales of cigarettes plummeted by about 80%. And the industry has yet to recover. The fall in production was not because of a significant drop in smoking. Rather it was because of a phenomenal increase in smuggling. The volume of smuggled cigarettes seized rose 21 times between 2009 and 2011.

Other jurisdictions have shown how quickly illicit trade market can emerge in response to very high increases in tax rates on cigarettes. In Malaysia, Romania, and New York, illicit trade reached between 25 and 40 percentage of consumption.

Sharp increases in tax rates on cigarettes usually led to short-term rise in government revenues. But this short-term response was followed by a period of revenue stagnation or fall, unless enforcement efforts to lessen smuggling were improved.

Economic theory and country experiences suggest that tax evasion and smuggling decline as enforcement improves. But precisely this combination of high rates and weak enforcement efforts could be a problem. How much of a consumer response to higher taxes on cigarettes and liquor has been estimated by the Department of Finance (DoF)? And what level of confidence has the DoF attached on the ability of the Bureau of Customs to enforce the law serious, sustainably, and unbiasedly?

For 2012 alone, the Finance department projects additional revenues from its version of the sin tax bill totaling P60.6 billion, broken down as follows: P30.1 billion for cigarettes, P11.2 billion for fermented spirits and P19.3 billion for fermented liquor. From 2012 to 2016, the DoF projects a staggering incremental revenues from sin tax reforms totaling P531.2 billion. That’s one for Ripley’s Believe it or Not.

Reforming the tax system is not a walk in the park. Once tax rates are set, rates may not be easy to undo. Setting the appropriate tax rates requires reliable information on how consumers would react to various price levels. It also requires a realistic assessment of the quality of the tax collection machinery. In brief, the challenge is for the government to set the tax rates right, balancing the need to meet its revenue goals without provoking the emergence of an illicit market.