Business World,  10 July 2011


The warm reception of the Duterte administration’s proposed tax reforms, even among some of the bright and the good, has lent an unexpected halo to indirect taxes of all sorts. The administration’s tax proposals, as is well known, include higher excise taxes on petroleum products, new-car purchases, and sugary drinks—all in exchange for a moderation of income taxes on the middle class.

In all this, of course, it has been easy to forget that to begin with, direct taxes—such as those on income and wealth—should be preferred on first principles to indirect taxes on commodities and transactions. The reason is that direct taxes can be adjusted to the circumstances of the individual taxpayer. By contrast, indirect taxes like excises impose the same rate whether the buyer is rich or poor, old or young, a commercial trader or a home consumer—a fact that often makes the tax inequitable, inefficient, or both.

So why—contrary to first principles—should we nudge the tax system towards more reliance on indirect than on direct taxation?

Textbooks allow two exceptions that might support a rationale. The first exception is ease of collection. Direct taxes can be notoriously difficult to collect where evasion and corruption reign—as Kim Henares of the past administration ultimately realised—so indirect taxes may be forgiven as a second-best measure. But this cannot have been the rationale for the current excise tax proposals. For if ease of collection was the problem, the better option would have been to raise a general sales tax (as India recently did), or to increase the existing value-added tax (as Japan did in 2014 and as Ben Diokno proposed in an earlier avatar). By not focusing on specific goods and transactions, general taxes such as VAT or GST can be set lower and have the redeeming feature of introducing smaller distortions in the relative prices between any two goods.

‘Pigovian tax’

The administration’s tax proposals, however, claim to be more than just lamentable-but- unavoidable second-best measures—they are actually supposed to do us good. They appeal to that second case where indirect taxes are superior to direct ones, i.e., where the former are needed to correct “negative externalities”. The latter has a specific meaning in economics: it’s when an economic transaction between A and B inadvertently harms a third party (say C, or the public in general) who is otherwise uninvolved. Someone who buys cigarettes fully pays for the tobacco but takes no heed of the damage he causes to the health of passive smokers around him. A motorist fully pays the car company for the vehicle and the oil company for the fuel but is unmindful of the congestion and pollution she inflicts on others. In such cases, the British economist A.C. Pigou thought a properly designed tax (say on cigarettes, on fuel, and on car use) would make the consumer realise the extra harm he causes others that is not adequately reflected in the market price of the product. By raising the price of the good, a “Pigovian tax” equates private cost with social cost, causing consumers to cut back on using that good and mitigating the unintended harm caused to others.

But take note: the harm a Pigovian tax seeks to meliorate is not to the buyer or the seller—who presumably already took those risks into account when they entered the transaction. Rather the concern is for possible harm to an uninvolved third party, i.e., the passive smokers, victims of pollution, commuters delayed for work. They are the reason the transaction between A and B becomes a social issue and not just a private matter.

From this viewpoint, the part of the administration’s tax reform that stands on the weakest ground is the tax on sugary drinks. Secretary Dominguez last week defended this particular proposal as “a health measure” that tries to “discourage the consumption of unhealthy products, just like cigarettes, alcohol”. But apart from the irony of this administration expressing a concern for better health and longer life, a perceptive student of Econ 11 may well ask: “Sir, where is the negative externality? Why is the solution a tax on all consumers of sugary drinks?”

First consider the science. It is true that 24 percent of Filipinos 20 years and older are overweight, with another 6.8 percent even being obese (FNRI 2015). But that also means 69 percent of Filipinos either act responsibly and do not over-consume sugar or, even if they did, they are among the lucky ones whose genetics or lifestyles dispose them not to become overweight notwithstanding. Malik, Popkin et al. (2010) report that the link between sugar-sweetened beverages and diabetes-2 or metabolic syndrome becomes evident only among those who consume 1-2 such drinks daily. Those who indulge at this level are at about 1.2 times higher risk of developing those adverse conditions. But even this is less dire than it seems. If the risk of overweight/obesity is, say, 30 percent among the general population, then it is 36 percent (30 ´ 1.2) for those who overconsume sweetened beverages. Conversely, therefore, 64 percent of those who “overindulge” will not become overweight or obese (on this ask the Reverend Bayes).

Like it or not, the facts here are similar to those on drugs: not all who take sugar-sweetened beverages will indulge to excess. And not even all who over-indulge will become obese or diabetic—indeed the vast majority, 70 percent, will turn out not so. Yet, the proposal would penalise all these people in the same way. I hate to say it: just like the war on drugs.

Second and more important, however, is whether there is even any externality involved. Where is the third party inadvertently affected by obesity—the equivalent of the passive smoker, the loser from pollution and congestion, or the victim of drunk driving? From Secretary Dominguez’s pronouncement, the only evident health motive behind the sugary drinks tax is to protect the sugar-consumer— from himself!

Dietary authoritarianism restricts free choice

One recalls the public howl over Senator Cynthia Villar’s proposal to restrict the amount of rice served in restaurants. (How dare she? We know best how to decide for ourselves.) It is curious how a similar outcry is absent when the administration now presumes to know better how much sugar we should consume. (Ironic as well, since rice is probably the larger source of excess calories in the Filipino diet than sugary drinks.) Yet the issue involved is the very same: free choice for the citizen versus paternalism by the government (one is tempted to call it dietary authoritarianism). As our favourite Scotsman put it, “Every man is, no doubt, by nature, first and principally recommended to his own care; and as he is fitter to take care of himself than of any other person, it is fit and right that it should be so.” A person’s diet, lifestyle, waistline, blood-sugar and lipid levels—with their attendant health consequences and risk of death—are all essentially his private business, and the repercussions are mainly his to bear.

The situation is different in some countries with comprehensive healthcare systems. There the availability of good-quality public health facilities and medical insurance can induce some people to become complacent about their own health. Confident that a social safety net will always catch them, some people risk making otherwise poor health choices (a.k.a. “moral hazard”), which often enough make them ill and land them in costly care. That would pose no problem if they paid their own way. Since the bill is picked up by social insurance, however, the heedlessness of some raises costs and premiums rise for everyone else. The cost of an individual’s health choices then do not fully reflect the costs to others, so that sometimes a tax or restriction on unhealthy individual behaviour may be justified. It is in this context that a sweetened drinks-tax has sometimes been tried.

However, such a situation is nowhere close to prevailing in this country where, according to the health accounts, family out-of-pocket payments are the “biggest and fastest growing” source of health spending, exceeding all public and private organized health financing combined. In short, each Filipino is “principally recommended to his own care”, not by choice or out of principle, but by necessity. This fact largely undercuts any notion that if people failed to look after their own health, then undue costs to the rest of the population might arise. Perhaps this situation may change when Philhealth reimburses at, say, half of its members’ medical bills (now still only 13 percent). Until then, however, the purely economic foundation for a Pigovian tax on sugar is built on sand.

Tax will make the poor worse off

None of these arguments on principle even delve into the question of whether the tax proposal will produce the health benefits it promises. Mexico’s two-year tax on sugary drinks did lead to a drop in consumption, but it remains unclear whose consumption dropped and whether the fact will ultimately lead to better health outcomes. In the Philippines we know that overweight/obesity is more prevalent among the richest (44 percent) than among the poorest (17 percent). But to what extent is this attributable to the sugary drinks covered by the bill? And whose demands will be more affected? Will a tax really suffice to discourage the well off, or will it just affect the poor—an equal number of whom are actually undernourished? Will it be those at risk who will cut their consumption, or those who were healthy to begin with? To what extent will a tax simply make the poor worse off by cutting off what Dr. Antonio Dans points out is a cheap source of calories. To what extent will the poor merely replace more expensive colas and 3-in-1 coffee with unsafe sugared water in plastic bags, samalamig, or home-brewed sugared coffee, none of which are covered by the tax? At the moment, especially with regard to Filipino behaviour and diets, there is simply a great deal we do not know, which is all the more reason to proceed with reserve and caution.

The Department of Finance and its clever and sincere staff have done a fine job turning the prose of raising revenues into the poetry of externalities and Pigovian taxes. They are right on most counts. But as this piece has shown, not on all counts, and there is still a good chance to improve on things. On the other hand, these arguments from first principles and a demand for evidence may ultimately prove futile.

It will not be the first time this administration and its loyal congress will proceed from a more antecedent fundamental principle that has guided them, i.e., that regardless of argument and evidence, they can do what they want, simply because no one can stop them.


E. S. de Dios is professor at the University of the Philippines School of Economics and did not enjoy writing this piece.