WELFARE ANALYSIS OF CONTROLLING INDOOR AIR
POLLUTION
(THE CASE OF URBAN ETHIOPIA)
By: Wondwossen Tsegaye Aselet
E-mail: wendsentsgay@yahoo.com
1
Content
Page
Abstract
CHAPTER ONE
Introduction
1.1Bakground………………………………………………………………………….4
1.2 Statement of the Problem………………………………………………………….5
1.3 Significance of the Study………………………………………………………….6
1.4 Objectives of the study…………………………………………………………….7
CHAPTER TWO
Literature Review
2.1Theoretical Literature………………………………………………………………9
2.2 Empirical literature……….. …………………………………………………….15
CHAPTER THREE
Methodology of the study
3.1 Model Specification……………………………………………………………..18
3.2 Data collection…………………………………………………………………..22
CHAPTER FOUR
Empirical Results………………………………………………………………….23
CHAPTER FIVE
Summary and Conclusion………………………………………………………..25
References
2
Abstract
The main reason for the failure of many policy measures in developing countries is the
fact that interaction of different social as well as economic activities are not taken in to
consideration before they are being implemented. It is important that governments in
these countries should focus on addressing welfare, environmental and social aspect of
their policy measures before implementing them. Thus, mainly this paper focuses on
introducing welfare analysis by taking a single policy measure, which helps to control
indoor air pollution.
This study by using the marginal tax reform approach attempts to analyze the welfare
effect of indoor air pollution control in urban Ethiopia. No study has been done regarding
this issue, thus the study tries to show one way of analyzing welfare on the
implementation of pollution-controlling-policy instrument. Hence, the 2000 urban
household socio-economic data collected by the Department of Economics of the Addis
Ababa University is used in order to identify goods that are heavily concentrated in the
consumption of poor households.
Accordingly, the study found that introducing or increasing tax on commodities which
are the main sources of air pollution (kerosene, charcoal) would affect the welfare of the
urban households as the consumption of these commodities are more concentrated on
poor than rich households. Differently, the study has found that a tax increase or
introduction on commodities such as fuel wood and Cigarettes would not have a
significant welfare loss for the urban society.
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CHAPTER ONE
I. Introduction
1.1 Background
There are three broad sources of air pollution from human activities; stationary or point,
mobile, and indoor air polution (Kathuria, V. 2001). Industries, power plants, etc are the
causes of stationary air pollution, where as indoor air pollution refers to pollutions from
open fires for cooking and heating. It is mostly a problem in developing countries, and its
effect become intense in rural areas. Mobile or Vehicular air pollution is particularly a
serious problem in urban areas.
Since most economic activities or transactions are concentrated in urban Ethiopia, the air
pollution that resulted from these three sources is a serious problem. However, it seems
that, in Ethiopia, compared to other developed countries, there is no serious problem
related to air pollution. But this is only because of the fact that no body gives a serious
attention to the effects of air pollution. Moreover, there is no study or reliable data
regarding the effects of air pollution on the health condition of the people living in the
country. In now days, in Addis, vehicles are increasing alarmingly. Ethiopians (mostly
students and trainees), who have been in other western countries, have a legal- right to
import any cars from the country where they have been. Following this legal- right most
of them import second hand cars (old cars). It is known that these vehicles contribute
much for air pollution than the new ones. However from the government side there is no
measure taken to regulate or decrease the importation of these polluting vehicles.
Indoor air pollution, which is mostly ignored by the people affected by and government
as well has a serious effect on the health of children as well as residents in the house. In
urban areas of Ethiopia, where large part of the population is using fuel wood, charcoals,
and kerosene for cooking purposes in their daily life, it is unreasonable to ignore the air
pollution that results from these burnings. Almost more than 85 % of the people in urban
areas of the country use fuel wood, charcoals and kerosene for cooking as well as for
other daily activities. Thus the contribution of this process to the environment pollution
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should not be treated as insignificant. Nevertheless, controlling the air pollution resulting
from these sources is also a problem in connection with their effect on the living
condition of the people. For instance, taxing or charging these commodities is one
method of controlling the air pollution by discouraging the consumption of these
commodities. But, since the consumption of these commodities may be more
concentrated on poor households than the rich ones the effect of taxing or charging the
commodities should be analyzed first.
1.2. Statement of the Problem
Policies that affect consumer and producer prices have an impact on welfare. According
to Duclos et al. (2000), most governments use indirect taxes; mainly VAT, to raise tax
revenues thus affecting consumer and producer prices. An increase or a decrease in the
tax of a good will have an effect on producer or consumer prices and this in turn would
entails a decline or an improvement in the welfare of an individual. Policy analysts must
routinely evaluate the impact of such polices on social welfare.
Marginal social cost of revenue from the tax on a particular good depends on the rate at
which household welfare falls as the tax rate increases, and on the rate at which public
revenue rises (Ahmad and Stern 1984). If many people consume more of a particular
good and the less responsive is government revenue to a tax increase, then policy makers
should focus on decreasing the tax rate on that good.
If any reform of indirect taxes is to be welfare improving, it requires detailed empirical
analysis. In Ethiopia, where per capita income is one of the lowest in the world, indirect
tax reform should not only focus on targeting higher revenue, but the tasks of tax reform
should also include analyzing whether the directions of the reform would not aggravate
the poverty of the people.
In almost all developing countries, the livelihood of the society is dependent on products
that are obtained from the environment. Based on this fact, it could be argued that there is
5
a need to control for the rapid environmental deprivation, such as reduction in air quality,
deforestation, soil degradation and noise pollution. Nevertheless, In these countries,
where most part of the population is living under the poverty line, environmental assets
protection only may not be the crucial thing that government should focus on, rather
government or policy makers should also give due emphasis for the improvement of the
living condition of the society.
In this regard, the study attempts to demonstrate empirically the possible welfare impact
of introducing tax on indoor pollution sources (fire wood, kerosene and charcoal). Hence,
the main task of this paper is to pave a way for making welfare analysis before any tax
policy instrument is used for controlling negative environmental impacts. Thus, the
paper, specifically, focuses on making welfare analysis on an increase or decrease of tax
or charge on indoor air pollution sources (fuel wood, kerosene and charcoal) by
calculating the distribution characteristics of these commodities. The study attempts to
measure the distributional characteristics, which reassure how heavily the consumption of
each good is concentrated on the poor. This measure helps to answer which item should
have to have a tax increase or a tax decrease on the ground of distributional equity and
poverty alleviation. it also helps to identify goods that are good candidate for introducing
a new tax.
1.3 Significance of the Study
Ahmad and Stern (1991) have pointed out that the main purpose of taxation is to
raise resources to finance government expenditure. They underline the problem of tax
design as one of finding a way of raising resources in a manner which is administratively
and politically feasible and which promotes equity and efficiency.
In a similar vein, a recent publication by the IMF (cited in Islam 2003) notes that
taxation creates distortions and the main objective of tax policy is to design a system that
raises enough revenue while minimizing the level of associated distortions.
.
Ethiopia is currently implementing a Tax Reform Program, which includes the
replacement of single stage sales tax by Value Added Tax (VAT). The indirect tax
reform mainly focuses on raising more revenue, facilitating the economy and
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modernizing the tax administration. However, little is known about the likely effects of
the tax reform on the welfare of the society. Despite its significance, no study has been
done in analyzing the welfare effect of a tax reform in Ethiopia.
In Ethiopia, particularly in urban areas, air pollution is increasing surprisingly. Though
there is no reliable figure of the effects of air pollution on health, it would not be difficult
to see that air pollution is a serious problem in urban areas. In Ethiopia, where Per Capital
Income of the population is below the thresholds that people should have for a living, it
seems ridiculous to discus environmental issues. This is because of the fact that no body
gives attention to the effects of pollution, rather they prefer to focus on how to improve
their living conditions. No study has been conducted regarding the welfare effects of air
pollution in urban areas. Hence the paper is a pioneer by attempting to investigate
whether applying policy instruments, particularly; tax policy to decrease air pollution in
the urban Ethiopia would lead to welfare gain.
This study by using marginal tax reform approach introduces for the first time how
welfare analysis should be done before policy instruments are applied for the purpose of
curbing environmental damage. This would help especially the governments in
developing countries to check first the effect of the policy on the welfare of the society
and tries to compare whether the gain from the implementation of the environmental
policy does compensate the welfare loss. Hence, this study by showing the need to make
welfare analysis before implementing any policy for the purpose of controlling
environmental hazards, addresses the issue of streamlining economic development with
environment.
1.4 Objectives of the Study
The main objectives of the paper are:
 To see empirically the welfare effects of controlling indoor air
pollution in urban Ethiopia. Hence, the paper tries to investigate
whether an attempt for controlling air pollution using taxation or
charging the source may result in welfare loss of the people.This
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would be done by identifying goods whose consumption is more
heavily concentrated on poor households.
 The paper attempts to introduce ways of analyzing welfare in an
attempt of controlling negative environmental impacts, particularly air
pollution.
 To identify or recommend other ways of controlling indoors air
pollution, which may not result in serious welfare loss for the society.
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CHAPTER TWO
Literature Review
2.1.
Theoretical Literature
2.1.1. Welfare Measurements
Most people would agree that, other things being equal, increased
consumption of goods and services raises individuals’ levels of welfare. There may be
other factors other than the consumption of goods and services that affect welfare, but
since these tend to be much more difficult to measure, economists usually restrict
themselves to that portion of human welfare which is attributable to consumption.
In welfare economics the starting point for measuring welfare is the utility
function (Glewwe and Twum 1998). It asserts that welfare rises as the consumption of
various goods and services increases. But, most consumption and household data are
collected at the household level and thus require analysis using a household level utility
function rather than individual. Hence one should assume:
i)
A household’s utility is a function of the consumption of goods and services and
the composition of household members. The composition is needed to account for
the fact that house holds with different compositions require different
consumption levels to attain the same level of welfare (for example, house- holds
with large number of members need more goods and services to attain the same
welfare level as households with small household size.
ii)
Each household possesses the same household utility function in order to compare
the welfare of different households. If they posses different welfare function it
would be impossible or meaning less to compare welfare among different
categories of people.
iii)
Since one does not know the distribution of welfare with in the household, one
has to assume that all household members enjoy the same level of welfare
(Glewwe and Twum 1998)
When government wants to impose an indirect tax on a commodity it may be
better first to find out whether such tax may not significantly increase the price of the
9
commodity and therefore substantially reduce the welfare of people. Similar information
may be needed with respect to imposition of indirect tax on commodities. This
necessitates a welfare measure that could help governments or policy makers in their
decision on the policy measures.
Several welfare measures have shown great progress in the last twenty-five years.
Consumer Surplus: It is the difference of the total amount that an individual is willing
to pay and the amount he actually pays. Consumer surplus is used to measure individual
welfare and social welfare based on its unweighted sum over the population.
According to Slesnick (1991), consumer surplus is the overwhelming choice as a
welfare indicator, because it is an intuitive concept with modest data requirement.
Slesnick (1991) has shown that in the simplest case of a change in the price of a single
good say, a commodity from P01 to P11, the change in consumers surplus simply is the
negative of the change in the area under the demand curve.
0
P
1
CSk=

x1(t,p2.........pn,Mk,Ak) dt
1
P
1
Where Mk= the level of expenditure of the kth household
P= (P1,P2, ..................Pn) is a vector of prices
Ak= is a vector of demographic characteristics
Xi (P1,Mk,Ak) = the demand function for good i
The use of Marshallian consumer surplus as a measure of welfare change is problematic
for the following reasons.
i)
It works only for one price change. If several price changes or price and
income changes, we need a more potent approach for estimating the welfare
implication.
ii)
Even for the case of a single price change Marshallian consumer surplus, as a
measure of welfare change is problematic on account of maintaining the
marginal utility of income as constant.
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The validity of consumer surplus as welfare measure has been questioned and
John Hicks developed two approaches to welfare measurement, which do not have the
same shortcomings as consumer surplus.
These two welfare measures are (Creedy 1999):
Compensation Variation (CV): It is the amount of money that must be given to
a loser, or taken from a gainer in order to keep the individual on the initial indifference
curve. If prices change from Po to P1 as a result of the imposition of indirect taxes then
individual utility changes from Uo to U1 (after the associated change in consumption).
In terms of the expenditure function E(P,U) it can be written as:
CV = E (P1, Uo) – E (Po, Uo)
Equivalent Variation (EV): is the amount of income that must be given to the
consumer in the initial situation in order to attain a new (higher) indifference curve.
Equivalently, it can be thought of as the minimum amount of income the consumer
would be willing to accept in order to forgo the move from the status quo to the new
situation.
EV=E (P1, U1) – E (Po, U1)
The Hicksian demand function (XiH (P,U) ) can be obtain from the expenditure function
XiH (P,U) = E (P,U)
Pi
The welfare changes defined by compensating and equivalent variation are represented
by areas to the left of the Hicksian demand curves between price Pio & Pi1, for Uo and
U1 respectively.
P i1
CV =  XiH (P, Uo) dpi
Pio
Pi1
EV=  XiH (P,U1)dpi
Pio
The two welfare measures resolve the conceptual problem of welfare
measurement, but they do not help the practitioner because the two measures depend on
compensated demand and therefore they are not observable.
Robert Willig made the first attempt to tackle this problem by demonstrating that, “in
the case of a single price change, (observable) estimates of consumer’s surplus can be
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used to provide a good approximation to the equivalent or compensating variation.
Since these welfare indicators provide upper and lower bounds for consumer’s surplus,
the accuracy of the approximation depends on the magnitude of the income effect”.
(Slesnick 1991, p. 2112)
2.1.2. Marginal Tax Reform Approach
Tax reform, as defined by John and Smolensky (1994), may take variety of
forms. It can cover increase or decrease in tax rates, brackets or thresholds and changes
in the tax base, the introduction of new taxes and the abolition of new taxes, and
changes in the tax mix. Tax reform loosely speaking deals with improving welfare by
making marginal changes in tax design and structure.
The theory of tax reform is concerned with small departure from an existing
tax structure. The marginal tax reform method, pioneered by Feldstein (1972) and
extended by Ahmad and Stern (1984), involves comparing for each commodity, the
marginal change in social welfare arising from a tax change with the small change in total
tax revenue. Newberry and Stern (1987) have tried to make clear the theory of marginal
tax reform. According to them the theory shows that the social welfare effect of a
marginal tax change is given by the weighted sum of each household’s consumption of
the good. The weight reflects the social marginal value of consumption by each
household. “The social welfare impact of a tax or price change therefore depends on the
total level of consumption of the good and (if social weights differ across households) the
distribution of that consumption amongst the population” (Gibson 1998, pp. 4).
Deaton (1997) contrasts this view with the theory of optimum taxes. The
optimal tax theory, as explained by Deaton, focuses on the prices that maximize a social
welfare function subject to budgetary behavioral constraints. That is, it is a constrained
optimization of a social welfare function by the social planner, given the revenue
constraint, available tax instruments and the influence of these instruments on private
behavior. It provides a systematic and essential framework for thinking about the
standard issue of distribution and economic efficiency that are the basis for any
intelligent discussion of price and tax reform.
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The main criticisms against optimal tax theory are as follows:
(i)
The model could not describe the social and political equilibrium that exist in
developing countries, because of its unrealistic assumptions (Deaton 1997).
(ii)
Calculation of optimal indirect tax rates requires a great deal of data about
preferences and demand patterns (Creedy 1999).
The theory of marginal tax reform solves the above problems faced by the
optimal tax theory. Especially its limited data requirement makes it easy to apply even in
developing countries. In real life it is rarely possible to reach optimal tax rate
immediately. Thus, its practical applicability attracts policy makers in analyzing a tax
system using marginal tax reform approach. This paper mainly follows this approach in
analyzing the direction of the tax reform in Ethiopia.
The approach to the analysis of marginal indirect tax reform is based on the use
of social welfare function representing the value judgments of a decision maker or judge.
The social welfare function (w) is a function of the individual welfare value u,
which, in turn is given by the value of the indirect utility functions that gives the
maximum attainable welfare in terms of prices (p) and outlays (yh).
Uh =  (yh, p)
W = V(u1, u2,….uN)
A simplistic model of price determination assumes that the consumer price
is the sum of a fixed price and the tax or subsidy (Deaton 1997), so that
Pi = pio + ti
Where ti = tax
Government revenue is the sum over all goods and all households of tax
payments:
M
R= 
i=1
H
 ti qih
h=1
Where qih = amount of good i purchased by household h and there are M goods in
all.
The theory assumes that;
i) A change in the tax rate is equivalent to a change in the price
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ii) Any change in the tax or price
is fully transferred or passed on to
consumers.
Hence revenue with respect to tax change is
H
H
R/t =  qih + 
h=1
h=1
M

tj qih/pi
i=1
A given change in the tax rate will produce a large revenue effect, the greater is
the aggregate consumption of a good and the less the substitution away from the taxed
good.
The welfare effect for marginal tax change is given by the weighted sum of each
household’s consumption of the good.
H
W/ti = h = 1qih
Where
η = W . h = w
uh
yh
yh
‘η’ reflects the social marginal utility of income for each household, h. It
measures the increase in welfare (W) resulting from a change in the households’ income.
The social weights(η ) are estimated as follows. Suppose that we use the Atkinson
social welfare function where there are ‘n’ individuals in house hold h.
W = (Ch) (1 – e)
1-e
W = 1n(Ch)
e > 0 and e  1
Where W = is the value that one judge places on the income distribution
Ch = consumption level for household h
e= coefficient of inequality aversion.
With this social welfare function, the social weight applied to consumption by
household h is given by the social marginal utility of consumption.
Bh = (Ch) -e
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“Different values of the coefficient e reflect different judgment about the
desirability of making transfers to reduce income inequality. Because of this, a range
of values for e is commonly used to see whether conclusions are robust to practical
ethical judgments” (Ahmad and Stern 1991). The source of behavioral estimates of e is
the information contained in the patterns of private transfers between households. An
increase in the inequality aversion parameter (e) would imply an increasing weight
toward the consumption of the poor.
Therefore, the cost - benefit ratio of tax is:
Where
i = W/ti
R/ti
w/ti =the change in welfare with a marginal increase in tax
R/ti
.
= the change in revenue with a marginal increase in the
tax rate
After substituting the value of W/ti and R/ti
i = W/ti =
R/ti
we get;
H
 qih
j=1
H
 qi +   ti qih/Pi
j=1
i is the social cost of raising one unit of government revenue by increasing the
tax on good i.
It measures the change in social welfare per birr of extra tax revenue resulting
from a marginal change in the tax. For an optimal tax system, the marginal revenue cost
of reform must be equal for all goods. Hence the direction of a marginal tax reform is
indicated by relative magnitudes of this ratio for each commodity group. The rule for
optimal tax reform is therefore to lower ti relative to tj, if i is greater than j (Ahmad
and Stern 1984)
2.2.
Empirical Literature Review
As it has been explained in the above discussion, since this study is a pioneer in
attempting to use the marginal tax reform approach for the purpose of analyzing welfare
15
impact of applying pollution controlling policy instruments, the empirical literatures
may not directly related to the objective of this paper. In spit of this, it is better to raise
some studies that have been made using marginal tax reform approach.
Ahmad and Stern (1984) have developed the theory of marginal tax reform and
empirically tested for India. They found that i (the social cost to benefit ratio) for cereals
ranks lower than that of all other commodity groups with the exception of milk and milk
products. This suggests an increase in tax on cereals relative to the other groups and a
decrease in the tax on the clothing group relative to all others.
In their empirical analysis they also found that for moderate level of inequality aversion,
e = 1, i for cereals is greater than for all commodities except fuel and light and that for
clothing has dropped to the third lowest position. For highest level of inequality aversion,
say e = 5, i for fuel and light and cereals ranking highest and clothing dropped to the
second lowest position. Thus they concluded that for the value judgment represented by e
= 1, increasing the tax on clothing by an amount sufficient to raise revenue and
decreasing taxes on cereals by a corresponding amount increases social welfare.
Creedy (1998) has examined indirect tax reform in Australia using the method developed
by Ahmad and Stern (1984). He calculated the marginal revenue cost for 16 commodity
categories. He found a change in the ranking as inequality aversion (e), which indicates
higher social value for poor household, is increased from a zero level to a positive level.
Gibson (1998) made empirical analysis on the distributional effect of indirect tax reform
in Papua New Guinea. He used nationally representative household survey data to
identify the items that are consumed mainly by poor household in Papua New Guinea. By
using the distributional characteristics formula for a good, which is defined by Newberry
(1995), he calculated the distributional characteristics for 87 goods and services.
The study showed that at both low and high level of inequality aversion, sago is the food
whose consumption is most heavily skewed towards the poor households. When the
16
lowest level of inequality aversion (v = 0.5) is used in the calculation, among the items
that have to be purchased and hence could be taxed, axes, bush knifes, and other garden
tools, school fees, children's clothing, pots and pans, salt, rice, and finned fish have
consumption most heavily skewed towards the poor. Adult clothing joins the list when
higher level of inequality aversion is used.
In our country, though much work has not been done regarding the welfare aspect of
indirect tax reform, a paper by Munoz and Cho (2003) addressed the poverty and social
impact of replacing Ethiopia's sales tax with a value-added tax (VAT).
In their study, the calculation of the distributional characteristics of exempted goods
showed that health expenditure and public transport, which are exempted items, ranked
lowest. This showed that these items are not much consumed by the poor. The goods
disproportionably consumed by the poor were primarily basic food items and traditional
fuel sources such as dung cakes and firewood. From these results Munoz and Cho (2003)
concluded that exempted goods and services do not properly serve the purpose of
alleviating poverty or improving inequality.
Marginal tax reform approach, after its empirical analysis pioneered by Ahmad and Stern
(1984), has got acceptance from many researchers and policy makers for identifying
welfare effects of indirect tax reforms. The study by Munoz and Cho (2003) compared
the value added tax with the replaced sales tax, in their impact on the poor. However, by
following the marginal tax reform approach, the current study tries to identify how a tax
increase or decrease on environmentally bad items should be directed to improve the
welfare of the society.
Vinish Kathuria(2001), attempted to investigate whether the enactment of policy
instruments and efforts have led to commensurate fall in pollution in Delhi or not. His
results and analysis showed that the imposition has not resulted in concomitant
improvement in air quality. He found that enacting a policy instruments has not lead to
any fall in the air pollution as none of the coefficients attain significance, though
coefficients for all the parameter s have the correct sign.
17
CHAPTER THREE
Methodology And Data Source
3.1. Model Specification
This study mainly follows the marginal tax reform approach which was initially
developed by Feldstein (1972 cited in Ahmad and Stern 1984) and empirically applied
first by Ahmad and Stern (1984). This helps to identify the possible directions of
indirect tax or subsidy reforms on environmentally bad commodities that would improve
the welfare of the society.
In this study, calculation of the distributional characteristics for 75 items is done. This
approach follows Deaton A. (1997) theory of marginal tax reform. Using this approach
the paper attempts to identify whether a tax increase on a specific commodity, such as on
fuel wood, kerosene and charcoals, to control air pollution could be effective policy
instrument. Its effectiveness depends on whether it will decrease pollution with out
affecting the welfare of the society. If it affects the welfare of the society by increasing
the price of the commodities then its effectiveness is questionable. Hence alternative
policy instruments should be recommended. This kind of analysis is necessary especially
in developing countries, to asses the issue that a policy change would not lead to an
increase in the cost of the living for poor households.
The social welfare function (w) is a function of the individual welfare value u, which, in
turn is given by the value of the indirect utility functions that gives the maximum
attainable welfare in terms of prices (p) and Outlays (yh) is:
Uh =  (yh, p)
W = V(u1, u2,….uN)
18
A simplistic model of price determination,(Deaton (1997)), assumes that
the consumer price is the sum of a fixed (for example, world) price and the tax or
subsidy, so that
Pi = pio + Ri
Where Ri = tax or subsidy rate
Government revenue (GR) is the sum over all goods and all households of tax
payments:
M
GR =

i=1
H
 Ri qih
i=1
Where qih = amount of good i purchased by household h and there are m goods
Hence revenue with respect to tax change is
R/ti =  qir + i= 1
i=1

Ri qih/pi
j=1
The effect of social welfare is
W/ti=  qih
j=1
Where
 = v . h = w ,is the marginal utility of income
uh
xh
xh
The cost - benefit ratio of tax is:
i = W/ti =
R/ti
H
 qih
j=1
H
 qi +   ti qih/Pi
j=1
i is the social cost of raising one unit of government revenue by increasing the
tax on good i.
This figure gives us whether an increase in the tax rate on environmentally bad
commodities in order to decrease air pollution would result in welfare decline.
19
If this ratio is large, social welfare would be improved by decreasing the price of the
good either because its right price is hurting those whose incomes are socially valuable,
or because the taxation of the good is discretionary, or both. Goods with low i ratios are
those that are candidate for a tax increase. When all the ratios are the same there is no
scope for beneficial reform.
By aggregating some of the variables in the social cost benefit ratio the distributional
characteristic could be obtained. The distributional characteristic (dih) of a good is
defined by Newberry (1995) as a measure, which shows how heavily the consumption of
each good is concentrated on the poor, which is derived from the marginal tax reform
theory and is given by:
dih = h qih
*Qi
Where h = The social weight
qih = Consumption of the ith good by household
* = Average of the social weights
Qi = The aggregate consumption of good i.
The distributional characteristic will be higher, the more heavily the consumption
of good i is concentrated on the socially deserving (i.e. those with high social marginal
values of consumption, βh)
The distributional characteristics is a scale neutral measure, which makes it useful
for identifying goods that are candidate for having reduced rates of tax on equity grounds.
For this calculation, it will be possible to get information about consumption level of
each good. However the problem lies on how to calculate welfare weight (βh).
Welfare weight (βh)
According to Ahmad and Stern (1984), policy choices generally involve implicit
or explicit trade-offs of gains or losses to different group.
In practice, estimation of distributional characteristics as well as marginal
social cost benefit analysis requires some approximation to the welfare weights, rather
than deriving them from estimated preferences. The social weight applied to consumption
by household h is given by the social marginal utility of consumption.
20
And hence it is approximated by:
βh = (yh)-e
Where
Y = income, for which total expenditure can be taken as a better proxy.
The only uncertainty concerns the appropriate value for the inequality aversion
parameter, e.
Different values of the coefficient e reflect different judgment about the
desirability of making transfers to reduce income inequality. “The source of a
behavioral estimate of e is the information contained in the patterns of private transfers
between households. Inequality aversion that is equal to zero (e = 0) implies that there is
no aversion to inequality on the part of people donating transfers”(Olivia and Gibson
2003). This means that a one birr addition (transfer) to a poor household taken from the
rich one doesn’t change the welfare of the two individuals. That is the cost to the rich
individual by losing one birr is equivalent to the benefit to the poor individual, and thus
do not alter the distribution of income. Inequality aversion which is greater than zero (e >
0) implies that a one birr increase to a poor individual from the rich one would have a
higher benefit to the poor than the cost to the rich individual. In this case transfers make
the distribution more equal, implying aversion to inequality on the part of donors (e > 0).
To put it differently, for instance, when inequality aversion parameter is, say, e = 2,
taking one extra birr (indirect tax) from a poor household is judged to cause four times as
much social cost as does taking one extra birr in tax from a household with twice the
consumption level. In contrast if e = 0, taking one more birr in tax from the poorest
household has the same social cost as taking another birr in tax from the richest
household (Gibson 1998).
Since calculating this values require greater data need the paper uses, four
values of the inequality aversion parameter (e = 0.5, e = 1,e =2 and e= 5). These values
are used in many similar studies such as Ahmad and Stern (1991) , Gibson (1998) and
others.
21
3.2. Sources of Data
Urban household socio-economic survey data of year 2000 collected by the
Department of Economics of Addis Ababa University in collaboration with Goteborg
University is used for this study. Urban households are chosen because of many different
reasons, but it is mainly because of the fact that economic activity is
relatively more
concentrated (transactions are active) in urban areas and also the change in the tax reform
will mostly affect the welfare of the urban population directly rather than the rural
population. The life of the rural population follows hand to mouth subsistence economy
and hence may not actively participate in the economic activity of the country. A total of
1472 urban households were surveyed. Seven major urban centers- Addis Ababa,
Awassa, Bahr Dar, Dessie, Dire Dawa, Jimma, and Mekele were selected.
The household survey contains information about demographic characteristics and
income of the household. In addition to this information about household characteristics
and income, households were asked about their last week expenditure and consumption
of different food items from the market. The survey also collects data on non-food
expenditures over the past months and year.
22
Chapter Four
Empirical Results
By using the urban household survey the study has calculated the distributional
characteristics for 75 items. The distributional characteristics will help us to identify
which items are consumed mainly by the poor. Thus, according to the result obtained
from own calculation (see appendix), charcoal, kerosene and fuel wood, rank 9th ,6th and
35 th respectively at a higher inequality aversion (e = 5). This indicates that these items
(except fuel wood) are more heavily concentrated on the consumption of poor households
and hence it would be inequitable to levy additional or introduce a new tax on these
items. Though there are other considerations such as health and environment effects that
should be analyzed together with this, at least using this methodology, it could be clearly
seen that using tax policy instrument for controlling pollution will result in welfare loss
of the urban people in Ethiopia. Despite the above result, fuel wood, ranks 35 at higher
inequality aversion, seems more concentrated in the consumption of rich households.
This indicates that introducing tax on this commodity would not affect the welfare of the
urban society.
From the appendix, one can see that at a low inequality aversion (e = 0.5) modern
medical service rank 12th in terms of its consumption being heavily concentrated on poor
households, and ranks 33rd at a high inequality aversion (when distribution does mater).
But traditional medicine (healers) rank 70th at low inequality, and 10th at a high inequality
aversion in terms of their consumption being heavily concentrated on poor. This result
implies that at a high inequality aversion, that is when distribution favors poor
households, it is only traditional medicine (healer) that is relatively more concentrated on
poor households’ consumption. Therefore only traditional medicine (healers) deserves the
privilege of being exempted from the newly implemented value added tax. From this we
could see that even if the negative health effect of kerosene and charcoal is higher on
poor households the chance that poor households get modern medical service is much
23
lower than the rich households. Poor households prefer to go to traditional healers. Thus,
with respect to the welfare analysis and according to the result obtained from this study, it
could be concluded that government should be careful when a tax is introduced on
charcoal and increased on kerosene. Further, government should also be selective
whether to exempt modern medical service or traditional medicine and healers. From the
result it could be clearly seen that Value Added tax exemption of modern medical service
does not favor equity, since poor households use traditional medical services than the
modern ones. This result is logical in the sense that as long as one of the main objectives
of a tax policy is to maintain equitable income distribution, the good with the highest
social cost of welfare should be exempted.
Excise taxes are levied on goods and services in order to discourage the consumption of
luxuries items and goods whose consumption is not favored. Cigarettes are the main
sources of revenue from excise taxes, but are one of the commodities that could
contribute for indoor air pollution. Cigarettes ranks 63rd and 50th at the lowest and highest
inequality aversion respectively, in terms of their consumption being heavily
concentrated on poor households. Hence, this result justifies the fact that it is equitable to
increase tax on these items in addition to the need to tax them for the purpose of
controlling indoor air pollution.
24
CHAPTER FIVE
Summary And Conclusion
The main aims of the currently implemented indirect tax reform, specifically
the Value Added Tax, are to raise government revenue, to facilitate the economy and
modernize the tax administration. The current reform of indirect taxes is likely to have
considerable effects on consumer welfare. But due to small number of exempted items
under VAT compared to sales tax, VAT seems to contribute to the increase of the cost of
living for the poor. According to Gibson (1998), indirect tax reform should be designed
so as to avoid excessive increases in the cost of living for the poor.
In this study an attempt has been made to analyze empirically how indirect tax reform
should be directed so that it could increase the welfare of the society. The study applied
marginal tax reform approach for analyzing the welfare effect of introducing or
increasing tax on commodities that are the source of indoor air pollution (Kerosene, fuel
wood, charcoal and others). Distributional characteristics of 75 goods and services has
been calculated. In the paper, household urban socio-economic data of 2000 collected by
the Department of Economics of the Addis Ababa University has been used.
The results obtained from the calculation of the distributional characteristics show that
kerosene and charcoal are commodities, which have higher social cost ratio, hence from
poverty alleviation and distribution point of view these commodities deserve a tax
reduction as their consumption is concentrated more on poor households.
Further, modern medical services, which are exempted from the value added tax, have
higher ratio of distributional characteristics, thus rank lower than traditional medical
services. This implies that since only traditional medicine is concentrated on the
consumption of poor households, exempting modern medical service does not contribute
to equity and fair resource distribution objective of a tax system.
25
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28
Appendix
-The distributional characteristics of goods and services (Di)
Items
E=0
Pepper (Berbere)
0.014421
Abish (Local spice)
0.002636
Jinger (Jinjible)
0.001573
Other Spices
0.00394
Milk
0.012927
Cheese
0.005023
Butter
0.051098
Beef
0.071751
Mutton
0.075671
Chicken
0.005891
Eggs
0.007153
Fish
0.001953
Bread (Local bread)
0.000119
Bread
0.03452
Furno Duket( Wheat
flour)
0.010911
Pasta (Spaghetti)
0.017492
Enset (Popular food in
the southern Ethiopia)
0.001926
Salt
0.007998
Cooking oil
0.036647
Potatoes
0.015865
Tomatoes
0.011164
Carrot
0.006506
Gomen (Cabbage)
0.005447
Keyser (Red Potatoes)
0.001218
Karia (Green Pepper)
0.0047
Oranges
0.006264
Banana
0.005332
Papaya
0.001165
Pineapple
2.74E-05
Avocado
0.00028
Tella (Local beer)
0.002447
Tejj (Local drink)
0.001492
Araki (Local drink)
182458.4
Soft Drinks
0.012879
Beer
0.004688
Other liquor
0.000253
Coffee bean
0.035869
Tea leaves
0.009119
Chat (Stimulant leaves) 0.007348
29
Rank
29
56
64
52
32
48
6
4
5
45
42
60
76
11
E=0.5
0.002636
0.000682
0.000687
0.00115
0.002305
0.00064
0.005085
0.00779
0.00866
0.000938
0.001784
0.000388
3.62E-05
0.006969
35
24
61
39
9
26
34
43
46
66
49
44
47
67
77
73
58
65
1
33
50
75
10
36
41
Rank
28
57
56
45
33
58
16
6
7
47
38
65
76
8
E=1
0.000827
0.000319
0.000469
0.000613
0.000635
0.000138
0.000778
0.00127
0.00128
0.000215
0.000635
0.000119
1.48E-05
0.002183
Rank
33
52
48
42
40
64
34
23
24
58
40
66
75
12
E=2
5.89E-05
4.33E-05
0.000106
0.000138
2.25E-05
3.92E-06
1.08E-05
1.5E-05
1.6E-05
5.43E-06
2.84E-05
5.44E-06
9.27E-07
0.000107
Rank
36
40
31
25
50
70
59
53
54
65
45
64
75
30
E=5
4.79E-08
6.73E-09
6.26E-08
3.99E-07
7.61E-11
7.73E-12
8.76E-10
8.17E-13
8.18E-13
8.85E-12
3.26E-11
2.9E-11
4.09E-12
3.22E-09
0.001238 43
0.003366 23
0.000299
0.000909
53
30
1.08E-05
2.51E-05
58
47
4.33E-11 62
1.61E-11 66
0.00047
0.002189
0.005668
0.004712
0.003784
0.001722
0.002219
0.000584
0.002353
0.001539
0.001427
0.00031
7.41E-06
4.39E-05
0.000564
0.000254
302096.3
0.00207
0.000317
7.1E-05
0.007797
0.003132
0.001049
0.000178
0.001373
0.001433
0.002183
0.001934
0.000936
0.001294
0.000395
0.001902
0.000541
0.000538
0.000121
2.47E-06
1.23E-05
0.000222
6.67E-05
404875.1
0.000538
5.93E-05
2.72E-05
0.002512
0.001885
0.000235
60
20
19
12
15
28
22
49
16
44
45
65
77
76
57
71
1
45
72
74
10
17
56
1.35E-05
0.000297
6.08E-05
0.000182
0.000211
0.00013
0.000176
7.25E-05
0.000573
2.39E-05
2.89E-05
7.7E-06
7.27E-08
5.05E-07
1.65E-05
2.29E-06
2751855
1.79E-05
2.35E-06
1.5E-06
0.000133
0.000376
6.27E-06
56
12
34
17
16
28
19
32
6
48
44
61
77
76
52
73
1
51
72
74
27
9
63
2.04E-09 47
1.43E-07 23
5.71E-09 44
2.83E-09 46
1.18E-08 39
4.52E-08 31
4.77E-08 30
7.59E-08 26
8.52E-07 15
4.47E-11 61
9.94E-10 49
9.84E-11 57
0
77
2.72E-13 76
2.01E-10 54
5.14E-12 70
2.94E+11 1
1.88E-11 65
5.57E-11 59
4.63E-12 71
2.62E-08 34
4.96E-07 16
1.11E-11 67
64
36
12
18
20
39
35
60
32
40
42
68
77
75
62
70
1
37
67
74
5
25
46
Rank
29
43
28
18
58
69
51
74
75
68
63
64
72
45
Cigarettes
0.001672 63
0.000296 69
8.4E-05
69
4.76E-06
Sugar
0.039062 8
0.008485 4
0.002776
7
0.000148
Honey
0.008243 38
0.000938 48
0.000168
61
6.66E-06
Injera (pancake like bread) 0.18257 2
0.043943 2
0.018514
2
0.002126
Clothes /Shoes for men 0.020494 17
0.002462 31
0.000479
47
1.21E-05
Clothes
/Shoes
for
women
0.01763 22
0.002632 29
0.00064
39
2.31E-05
Clothes /Shoes for boys 0.01967 20
0.002799 27
0.000669
37
2.57E-05
Clothes /Shoes for girls 0.018411 21
0.002882 26
0.000721
36
3.34E-05
Sheets, Towels, Blanket 0.003383 53
0.000577 61
0.000146
63
4.14E-06
Kitchen Equipments
0.002544 57
0.000525 63
0.000242
55
4.6E-05
Furniture
0.00898 37
0.000621 59
0.000101
67
4.89E-06
Lamp/Torch
0.000276 74
0.000223 71
0.000273
54
0.000173
Matches
0.002396 59
0.002222 34
0.003284
4
0.003216
Batteries
0.00056 71
0.000374 66
0.000359
50
0.000136
Candles
0.001119 68
0.000906 49
0.001191
25
0.001007
Bulbs
0.001011 69
0.000841 52
0.00105
26
0.0006
Charcoal
0.016164 25
0.005137 15
0.002397
11
0.000309
Fuel wood
0.017575 23
0.004946 17
0.002013
14
0.000152
Kerosene
0.022535 15
0.006371 10
0.002573
9
0.000234
Laundry Soap
0.014527 28
0.005488 14
0.003047
6
0.000444
Toilet Soap
0.001906 62
0.000857 51
0.000609
43
0.000154
Other Personal care
0.004495 51
0.001448 41
0.000746
35
0.000115
Building Material
0.014261 30
0.000809 53
9.88E-05
68
4.81E-06
Housing maintenance
0.019775 19
0.001208 44
0.000163
62
7.93E-06
Ceremonial expenses
0.080685 3
0.006484 9
0.001358
21
6.08E-05
Contribution
to
Iddir
(association)
0.020212 18
0.006169 11
0.002746
8
0.000272
Donation to religious
service
0.003072 55
0.000891 50
0.000666
38
0.000334
Taxes (excluding income
tax)
0.007579 40
0.000776 54
0.00018
59
1.43E-05
Other contribution
0.003176 54
0.000726 55
0.000351
51
6.92E-05
Modern Medical service 0.032098 12
0.003703 21
0.000919
29
5.62E-05
Traditional Medicine and
Healers
0.000735 70
0.00017 72
7.92E-05
70
3.49E-05
School fees
0.030591 13
0.003592 22
0.000901
32
5.74E-05
Other education
0.014218 31
0.002594 30
0.000943
27
0.00016
Water bill
0.015528 27
0.005583 13
0.003071
5
0.000437
Electricity
0.047361 7
0.009947 3
0.00343
3
0.000259
Telephone bill
0.020584 16
0.003311 24
0.000904
31
4.28E-05
Rent
0.025404 14
0.004423 19
0.00175
18
0.000179
Source: Calculation based on urban socio-economic data, 2000,of Addis Ababa University
30
68
24
62
3
57
8.9E-10
1.13E-08
3.41E-08
1.61E-06
1.64E-10
50
40
32
12
55
49
46
43
69
39
66
20
2
26
4
5
11
23
15
7
22
29
67
60
35
1.01E-10
1.21E-09
8.71E-08
3.23E-12
6.96E-08
3.29E-10
2.3E-05
0.000724
4.31E-06
4.02E-05
6.06E-06
3.15E-06
1.6E-08
2.24E-05
3.3E-07
1.7E-07
1.58E-06
5.67E-10
1.33E-08
9.45E-09
56
48
25
73
27
53
5
2
8
4
7
9
35
6
20
22
13
52
38
42
13
3.14E-07 21
10
0.000288 3
55
33
38
1.42E-08 36
4.64E-07 17
2.92E-08 33
42
37
21
8
14
41
18
1.76E-06
1.02E-08
2.48E-06
3.88E-07
1.5E-06
1.34E-07
1.37E-08
11
41
10
19
14
24
37
31