Will tax hike reduce tobacco consumption in India?

The Union Health Minister, Dr. Harsh Vardhan, recently said he “supports” higher taxes on cigarettes and other tobacco products. But even if he were to substantially increase the tax rates, will it make cigarettes and other tobacco products very expensive and hence reduce consumption?

In the case of India, as per the current taxation practices, increasing the tax component is quite unlikely to reduce consumption drastically. This is unlike the situation in the developed countries.

The paradox becomes clear only if certain basic elements are understood. Ever wondered why cigarettes are available in five different lengths (<65 mm; 65-70 mm; 70-75 mm; 75-85 mm; > 85 mm) in India? Or, why chewing tobacco products (such as pan masala) are available in different quantities? Why nearly 98 per cent of beedis available in the market are handmade though mechanisation is possible? Why the number of small-scale beedi manufacturers has reduced by more than 50 per cent with a concomitant increase in households involved in beedi rolling? Or why tobacco products have become a lot more affordable in the last decade despite tax increase?

Behold! Tobacco companies have remarkable ingenuity and lobbying to make sure their customer base remains intact even when taxes are raised. After all, high tax rates lead to reduced consumption, and they are fully aware of it. Hence, the tax structure for tobacco products in India has been made complex and provides much leeway for companies to escape the brunt of any tax hike.

Historically, taxes have been low for beedis compared with other tobacco products. Handmade beedis are taxed just Rs.12 per 1,000 sticks, machine-made ones are taxed Rs.30 per 1,000 beedis. It is therefore not surprising that handmade beedis constitute nearly 98 per cent of those sold in India.

The inconsequential tax rate on beedis goes against the grain of reducing consumption through higher taxation. That probably is the reason why beedi consumption in India constitutes 35-40 per cent of the total tobacco consumption. Its consumption is far greater than that of cigarettes.

Besides the low tax incentive, beedi manufacturers also enjoy the benefit of not paying any tax if they produce less than two million beedis per year. According to a 2010 International Union Against Tuberculosis and Lung Disease (The Union) report (“The economics of tobacco and tobacco taxation in India”), “52 per cent to 70 per cent of all beedis consumed in India have no taxes paid either due to non-compliance” or because the manufacturers supposedly produce less than two million beedis per year.

That is the reason why beedi production is being outsourced to households.

In the case of cigarettes, unlike the system followed abroad, the taxation in India is based on the length of the cigarette. Cigarettes of various lengths are taxed at different specific rates. As a result, longer cigarettes attract the most tax. This taxation structure encourages a company to manufacture cigarettes of varying lengths.

“Since longer cigarettes attract more tax, consumers shift from longer cigarettes to shorter ones to escape higher taxes,” said Dr. Rijo John, Assistant Professor, IIT Jodhpur. “Increase in tax is not uniform across lengths. Because of that, all kinds of product substitution take place.”

According to Dr. John, the tax on cigarettes is about 43 per cent of the retail price. This is way below the WHO’s recommended excise duty of 70 per cent of the retail price. “There is huge room for the government to increase cigarette tax,” he said.

But any increase in tax will translate to higher prices and lower consumption only if the number of tiers based on cigarette length is reduced. “There should be taxes based on just one or two lengths,” said Dr. Sarit Rout, Research Scientist at the Delhi-based Public Health Foundation of India. Dr. John said “There should be a uniform tax for cigarettes immaterial of their lengths. That would simplify the tax structure.”

The taxation structure in India is not linked to income growth and inflation and this makes any increase in tax less relevant. As a result, tobacco products become cheaper relative to income affordability. What is required is an “annual systematic inflation-adjusted increase built into the process,” notes the 2010 report.

While beedis and cigarettes have ‘specific excise taxes,’ chewing tobacco products are taxed ad valorem (at a percentage rate based on retail price). As the ad valorem system is linked to the retail price, the tax component can be reduced by making the products cheaper. “For several reasons, it is difficult to propose a uniform tax for chewing tobacco. So ad valorem can be computed from specific tax levied for cigarettes,” Dr. John said.

Consumption can be reduced substantially through taxation only if India changes the taxation structure. The first challenge is to ensure that excise duty is “consistent across tobacco products” so as to prevent product substitution. Second, taxation of all tobacco products should be inflation-adjusted and corrected annually. As a rule tobacco products should be taxed higher relative to other goods. Third, is putting in place a “simple and enforceable system to tax and prevent revenue leakage.” Fourth comes removing the differential tax system between handmade and machine-made beedis. Fifth, is to have a long-term plan to remove the tax exemption to those who produce less than two million beedis a year.

But tinkering with the beedi taxation system and increasing taxes on beedis will be the most difficult part. However, huge gains will accrue if that is done. “People from the lower socio-economic stratum consume beedis. Consumption will come down if beedi prices are increased,” Dr. John noted.

All these measures are needed as India is the second highest consumer of tobacco products in the world — nearly 35 per cent of the adult population consumes tobacco products. Tobacco consumption kills one million Indians annually; the global burden is 5.5 million.

Published in The Hindu on June 5, 2014