Introduction:

Externality occurs when the production or consumption of a particular good or service

causes a benefit or cost to an individual or to a society who were not directly involved in the

process of production or consumption of the good or service (Begg, 2009). The externalities

of smoking of tobacco products cause adverse effects to the individual and to society by

means of making non smokers becoming passive smokers. We find that in US almost 12

million people have died over the 40 years due to smoking of cigarette and other tobacco

products (Kay, 2007), which clearly indicates that smoking of tobacco products are injurious

to the health.

In western countries, a 10 percent price raise causes decrease of 3 to 5 percent in

consumption of cigarettes (van Baal et al, 2007). We can evidence that price rise in tobacco

products caused by increased taxation leads to the reduced consumption of cigarettes and

other tobacco products. Increased tax revenues, reduced consumption of cigarettes, gain in

life years of individual, reduction in the cost of health care expenditures are the outcomes of

the taxation on smoking of tobacco products. In this essay we consider the effectiveness of

taxation on smoking of tobacco products to the society and to the government.

Effectiveness of Taxation:

Taxation and subsidies are inefficient without the presence of externality (Rapanos,

1992). It can be seen that the taxation can be used as a tool to remove the inefficiencies

caused by externalities in an economy. Since smoking of tobacco products causes a negative

externality government raise the prices of cigarette and other tobacco products through

increase in taxation. The impact of taxation can be seen in reduced smoking prevalence in

youngsters and adults, reduced absenteeism to work, attainment of healthy life, reduced

mortality (Reed, 2010). As taxes being increased people are less willing to smoke cigarette
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and this influences several age groups to either reduce the frequency of smoking or to quit

smoking. Taxation indirectly leads to the reduction in absenteeism to work, which again

reflects in the gain of economy of a nation.

Responsiveness to the price rise is dependent on the age, income level of individual,

geographic location and the alternatives of tobacco (Doran et al, 2010). Theoretical model of

rational addiction by Becker (1988) suggests that younger people are more responsive to the

price rise in cigarettes than the highly educated, high income group adults. Income level is

indirectly related to the price sensitivity of tobacco products which is evidenced more in the

young individuals as they would not be able to spend as much as the spending of adults.

Adults in the age group of 45 to 59 are also sensitive to price raise and show reduced

prevalence in smoking of cigarettes (DeCicca, 2008). Adults are more concerned about the

health consequences than the change in prices. Cancer, chronic heart failure and stroke are the

major diseases that are arising as a result of smoking of tobacco products. With all these

health factors being as a negative effect due to the smoking of harmful tobacco one can

logically conclude that any means to reduce the consumption of tobacco would be benefit to

the society and using taxation as a tool to achieve it would be one of the effective ways.

Geographic location also plays a vital role in the smoking behaviour of a person. Evans and

Farrelly (1998) evidenced from their research that states with high tax rates for tobacco

products showed that people involving in high consumption of Nicotine due to long length of

smoking the cigarette when compared to states with lower taxes. Disadvantage of the taxation

is that due to the limitation to afford for the tobacco products, young individuals are involved

in unhealthy activities like deep inhaling and leaving shorter butt in the cigarette while

smoking. These kinds of activities are spoiling the health and the environment as well.

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 Apart from social concerns the government also implement the taxation to generate

tax revenues. On imposing a 40% tax induced price rise on cigarettes, leads to a revenue gain

of $365 billion for the US government (Ahmad, 2008). Governments can use these generated

tax revenues to educate the public on the harmful effects of the tobacco products, to conduct

health check-up and also to implement social welfare programmes which can be an effective

way to communicate the necessity to quit smoking to a large number of people. It can also be

seen that due to the availability of substitute products of tobacco the taxation on cigarette

makes people to involve in higher consumption of the alternatives available. Cigars, loose

tobacco are the main alternatives consumed in Vietnam due to the price raise in cigarette

packs (Doran et al, 2010). Smuggling becomes the other alternative to get access to the

tobacco products. Due to the price differentials and informal distribution networks smuggling

prevails. Government must take actions in order to curb the smuggling process by enacting

severe regulations over smuggling of tobacco.

Taxes are the major proportion in the price of cigarettes. In UK, the price of a 20 pack

cigarette is above 6 pounds in which 76% of the price is formed by the tax component alone.

A price raise of 5% in UK shows that smoking level decreases from 21% to 20.63% which

adds up to 190,000 adults who quit smoking (Reed, 2010). Excise tax, ad Valorem tax and

Value added tax are the three major components involved in the pricing of a product. The ad

Valorem tax is at the rate of 24% of the retail price and VAT is at the level of 17.5% in UK

(Reed, 2010). As these taxes increase, the price of the cigarettes is increased in turn causing

reduced consumption. Cessation in smoking leads to more revenue generated to the

government as people are able to work healthily for more number of years and thereby

paying more taxes on their incomes which is another benefit to the economy of the country.

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 Tax increase should be uniform to all products of tobacco rather only to cigarette. The

uneven taxation may lead to reduced consumption of cigarette and higher consumption of

other available alternatives.

Medical expenditure on the smoking related diseases have been reduced over the

imposition of the tax on the tobacco products. Medical costs decrease by $317 million and tax

revenue increases by $365 billion on average per year resulting in savings of $682 billion in

US due to 40% rise in price driven by taxation (Ahmad et al, 2008). Savings in medical

expenditures and tax revenues are contributing to the total economic gain. Consumption of

tobacco products could also be due to difference in prices in the market. Firms that are

operating in an oligopolistic market should bring up the changes in prices at the same time in

order to reduce the consumption of cigarette. In a long run basis the taxation leads to a chain

reaction. Due to the implementation of taxes on tobacco products the consumption reduces

which makes the producers to produce in smaller quantity’s thereby driving manufacturers to

pay lesser taxes.

Warner (1990) in his research shows us that demand for cigarettes are less sensitive to

price in developed countries and whereas it is two or more times sensitive to price in

developing countries than the developed ones. Since the income levels in the developing

countries are comparatively low when compared to the developed ones, we get to see the high

prevalence of price elasticity’s for tobacco products in developing countries. Taxation and

subsidies together reduces the total economic surplus, but government in view of social

benefits to the society impose the taxes on tobacco products. Subsidies are given to firms that

are not causing any negative externality to the society.

Conclusion:
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 Finally we can conclude the essay with the following observations. As a result of

taxation on smoking of tobacco products we have both the benefits and costs to the people of

the society. Effectiveness of these tax policies are seen in the reduction of smoking behaviour

in young individuals and adults, reduction in absenteeism to work, gain in life years, reduced

expenditures on medical grounds and reduced mortality. Smoking prevalence is reduced

drastically and also the increased cessation to smoking in adults is due to the health

consequences. Tax revenues are the benefits obtained by the government from the consumers

of tobacco products. Whether it is a priority of social welfare or revenue generation the

motive of reducing the consumption of all tobacco products are achieved as a result of

taxation.