Business World, 23 October 2012


If I were to rewrite the changes in the taxes on cigarettes and liquor, I would do the following: simplify the law; impose equal if not higher taxes on liquor and distilled spirits than on cigarettes; and reduce the deadweight loss (the loss in efficiency associated with any tax except lump sum tax). I would also delete the section on earmarking of tax proceeds.

The committees on ways and means of the House and the Senate have no business allocating a huge chunk of potential public resources in the near and long-term future. Earmarking, by and large, has not worked here and elsewhere. First, because funds are fungible, meaning additions from one source of funding could be offset by reductions from other sources of fund. Second, under existing budget rules, the President can impound appropriations at will. He can even arbitrarily retrieve allotments that have been previously released to state agencies.

Both the House and Senate bills suffer from the following deficiencies:

First, both versions are still specific (based on per pack, per liter, etc) in nature and complicated. If I were to redesign the sin tax system, I would make it ad valorem (based on value) and unitary (one rate for cigarettes regardless of price and quality, and one rate for liquor and distilled spirit).

A “good” tax system is one that is simple or easy to implement. In this sense, ad valorem taxation is superior to specific taxation because the former is simpler to implement. A complicated tax system is haven for corrupt tax collectors, the best lawyers and accountants money can buy, and tax-evading industrialists. Ad valorem taxation is responsive to changes in economic condition.

As part of the 1986 tax reform program, Mrs. Aquino reformed the tax system for cigarettes and liquor by making it ad valorem rather than specific. The reform was a major departure from Mr. Marcos’ specific tax system.

The advantage of ad valorem taxation is that tax proceeds adjust with inflation — automatically and without need for new legislation. As production cost increases due to higher input costs, output cost increases, and tax take increases.

Recognizing how difficult it is to pass tax legislation that increases tax burden, ad valorem taxation appeared to be an attractive option. Removing from Congress the role of frequently tinkering with the tax law is one of the strongest arguments for making the tax system ad valorem. This is also one of the arguments for the introduction of the value added tax (VAT) in our tax system.

But during the time of President Ramos, Congress, at request of the President’s tax reform group, shifted the tax on cigarettes and liquor back to specific taxation. The shift was meant to cure the perceived loophole in the tax system which allowed the top manufacturer of cigarettes to engage in transfer pricing (selling to his subsidiary at less than x-factory cost to reduce tax liability).

The shift was a monumental mistake. The first-best solution should have been to amend the law defining what constitutes as transfer pricing and propose heavy penalty for it.

The problem with specific taxation is that rates remain fixed until amended. If the specific tax per pack of cigarettes were set low (say, 7.56 per medium quality cigarettes) from the start, the tax will remain low until the law is amended. In the meantime the value of the specific tax is eaten up by inflation.

Recognizing this inherent weakness of specific taxation system, the law provided for periodic adjustment of the rates based on a survey to be conducted by Congress. The survey was never done. And for 17 years, the specific rates were unchanged; the tax yield was progressive eroded by inflation.

Indeed, a classic case of a cure worse than the disease.

In addition, the Ramos reform brought about different product classification — low, medium, high, and premium — which further complicated the tax system. Ex-factory price or landed costs in the case of imported products should be the best basis for taxation. This assumes, of course, that transfer pricing will be cured by a clear definition of the concept in the law.

Second, both the House and Senate versions of the bill totally ignored the deadweight loss or loss in efficiency as a result of taxation. Whenever a tax is imposed, there is always a loss in efficiency, except in the case of a lump sum tax. Economists call this excess burden or deadweight loss (DWL). The magnitude of the DWL depends on the elasticity of demand (the responsiveness of the consumer to changes in prices) for a commodity, the level of consumer spending on the commodity, and the tax rates.

Policy makers and tax reform designers should try to minimize DWL, except in a few cases. For a given revenue target, if the objective is to minimize DWL, the rule is: impose a higher tax on commodities which are inelastic in demand: the more inelastic the higher the tax; the less inelastic the lower the tax.

The price elasticity of demand is 0.584 for tobacco, 0.236 for distilled spirits, and 0.23 for fermented liquor, according to the Department of Finance (DoF). If we follow the so-called inverse elasticity rule, the tax on distilled spirits (DS) and fermented liquor (FL) should be higher (in the order of 2.48 times) than the tax on cigarettes. But, contrary to the rule, both the House and Senate versions of the bill propose to tax cigarettes more than distilled spirits and fermented liquor.

If I were to redesign the sin tax system, I would impose higher taxes on liquor than on cigarettes. DWL would be lower and incremental revenues would be higher.

Why should the tax be higher for distilled spirits and fermented liquor? Because the DWL (as of 2011) for distilled spirits and fermented liquor are lower — 220 million and 56 million, respectively — compared with that of tobacco products, which is about 1.63 billion. The loss of inefficiency is much less by taxing DS and FL more than tobacco. The total DWL in 2011 is estimated at 2.41 billion.

What’s the implication if we increase the tax rates? By doubling the tax rates for cigarettes, DS and FL, the DWL would quadruple: up to 6.52 billion for cigarettes, 0.870 billion for distilled spirits and 2.25 billion for fermented liquor. As a result of the doubling of the tax, DWL would rise to 9.64 billion.

But what if the tax rates were quadrupled? Then the DWL will increase by 16-fold: 26.1 billion for cigarettes, 3.5 billion for DS, and 9.0 billion for FL. The DWL will then total 38.5 billion, approximately equal to the compromised 40-billion incremental revenues for the sin taxes!

There’s are two important lessons here. First, the DWL increases exponentially, not linearly, with increases in tax rates: doubling the rate will quadruple the DWL; quadrupling the rate will increase the DWL 16-fold.

Second, since the DWL increases with the rate, and since lower DWL is better, then the higher proposed rates on tobacco product should be reduced. This can be done by increasing the proposed tax rates on liquor and distilled spirits. Or the tax base can be broadened by imposing “corrective taxes’ on other commodities such as, for example, soft drinks and bottled water. With a broader tax base, tax rates may be lowered.

To be continued