Many governments around the world keep a close eye on the use of tobacco – mostly used in cigarettes. Many countries increase taxes over time to reduce its consumption – the classic demand theory where increase in price of a commodity decreases its demand.
Pakistan has also been trying to reduce the consumption of cigarettes for its harmful effects on health albeit unsuccessfully by increasing taxes, subsequently price. The consumption doesn’t reduce with the increase in the price of cigarettes.
To a student of economics, this phenomenon seems a bit of a reflection of a Giffen Paradox. Giffen Paradox works on a few commodities, called Giffen goods, which defy tried and tested demand and price relationship, which creates a relationship where demand and price are inversely proportional. When prices go up, demand decreases and vice versa.
This relationship is very basic and doesn’t take into account many things like demand at the moment for everything has gone down significantly due to the ongoing Covid-19 pandemic. Economic theories, like almost all other sciences, assume many other variables, which also impact trends in demand and supply, except those under study to be static or constant for beginners at least.
However, Giffen Paradox goes against this basic demand and price theory. The Giffen Paradox is that the decrease in price of an inferior good, also called Giffen Good, will decrease its demand. And increase in price increases its demand.
The theory is that the decrease in price of a Giffen good will increase the real income of a person or family, as they will save money buying cheaper goods, and the person or family will substitute it with a better substitute. When the consumption of a substitute is increased, the consumption of Giffen Good will subsequently come down.
To an inexperienced student of economics, the tobacco industry or cigarettes will give an impression of a Giffen Paradox. But the case of the tobacco industry can easily be understood.
It is simpler to understand than the Giffen Paradox. The state is unable to bring the whole industry under its tax umbrella or documentation. According to a survey by Oxford Economics, around 40% of the tobacco market is operated by undocumented local manufacturers. It means when the government tries to curtail the use of tobacco by increasing taxes, the 40% illicit tobacco manufacturers are not affected.
In fact it gives them an edge against legal players as they will have the price edge because they will be able to sell at lower price than legal players, who will be selling at increased rates due to addition of taxes.
The whole practice of increasing tax to reduce tobacco consumption leads to more business to undocumented and illicit manufacturers and traders. The presence of the illicit manufacturers, which is by the way, one of the largest illicit cigarette trade markets in Asia, is causing a loss of Rs44 billion annually to the exchequer besides making the government toothless against the tobacco consumption.
According to a speech by Prime Minister Imran Khan, Philip Morris and BAT, the two multinational companies have contributed around Rs113 billion, USD 726 million in excise duties and taxes during fiscal year 2018-19. This constitutes to 98% of the total cigarette excise revenue in spite of having 65% of the market share.
During the fiscal budget in May 2018 and subsequent supplementary budget in September 2018, the excise duty was increased by almost 56% thus further widening the price gap between legal and tax-evaded cigarettes.
In theory, higher taxes should have led to tobacco cessation, the total consumption of cigarettes in Pakistan continues to remain constant during the past five years at 80 to 85 billion sticks per annum and some even say as much as 90 billion sticks – thus indicating towards our Giffen Paradox.
However, cigarettes are not a Giffen Good. The demand has dropped for taxed cigarettes. But the overall consumption has not decreased. The volumes of the two biggest manufacturers, PMPKL and BAT, are declining. So who is fulfilling this gap? Certainly the tax-evading local manufacturers and smugglers.
With low disposable income, the consumers of legal cigarettes are unable to absorb multiple tax and price increases and shift their consumption to cheap, poor quality, illicit cigarettes which are sold for as low as Rs 25 or Rs 30 per pack or to higher quality smuggled brands that are rendered cheaper than local brands.
These low quality cigarette manufacturers often don’t follow advertising policies and sometimes don’t even have the health warning on them, made mandatory by the state. The policy makers in the country, as seen in many other industries, seem to script policy in their drawing rooms with a basic economic book in their hand (I doubt they may be having that too) and to reduce tobacco use, increase the price of cigarettes to reduce its demands.
Too naïve. To be honest, these policy makers are aiding the illicit tobacco sector to grow and endangering the people more as they tend to switch to lower quality cigarettes, which means more dangerous. Meanwhile, it is also affecting revenue in taxes to the government, which may come handy for a struggling economy of the country especially during the ongoing Covid-19 pandemic.
The economic theories don’t fit well in a country like Pakistan where there are many loopholes. From undocumented business to porous borders, which gives rise to smuggling. No, policymaker can get desired results by following simple theories.
They need to get to the ground and straighten things up, document all industries completely, stop smuggling and provide level playing fields. The same argument stands for the tobacco industry and imports if they want to see demand-price curve work efficiently and their efforts be fruitful.Bilal Hussain, "Tobacco industry – Pakistan’s Giffen Paradox?," Business Recorder. 2020-05-17.
Keywords: Economics , Economic growth , Tobacco industry , Giffen Paradox , Giffen goods , Economic theories , Oxford Economics , Tobacco manufacturers , Cigarette trade , PM Imran Khan , Philip Morris , Pakistan , BAT , USD , 2018