Industry responses to the
rapid excise tax increases in
South Africa since 1994
Departmental seminar,
School of Economics,
1 August 2005
Corné van Walbeek
1
Background
• Between 1970 and early 1990s:
– Sharp decrease in real price of cigarettes
– Primarily the result of decrease in real excise
tax on cigarettes
• 1994 Budget announcement:
– Government to raise the tax on cigarettes to
50 per cent of retail price
– Rationale: public health
– To be phased in over a number of years
2
2000
1800
1600
1400
1200
1000
800
600
400
200
0
800
600
400
200
Real price of cigarettes
2004
2000
1996
1992
1988
1984
1980
1976
1972
1968
1964
0
Cigarette consumption
(millions of packs)
1000
1960
Real price per pack of 20
( in constant 2000 cents)
Trends in cigarette consumption
and real prices
Consumption of cigarettes
3
Between 1993 and 2004…
• Aggregate cigarette consumption decreased by
33 per cent
• Per capita (aged 15+) cigarette consumption
decreased by 46 per cent
• Smoking prevalence decreased from 32 to 24
per cent
• Average cigarette consumption per smoker
decreased from 230 packs to 160 packs p.a.
• Real government revenue from cigarette excise
taxes more than doubled
4
Industry structure
• Highly concentrated cigarette
manufacturing industry
• Rothmans-BAT merger in 1999 created a
near-monopoly with nearly 95 per cent
market share
• Near-monopoly industry structure →
significant control over retail price
5
Decomposing the retail price of
cigarettes
• Three components:
– VAT/GST
– Excise tax
– “Industry price”
• “Industry price” is result of substantial value
chain:
– Suppliers of inputs (esp. raw tobacco and paper
products)
– Cigarette manufacturing industry
– Wholesalers and retailers
6
Decomposition of the real retail
price of cigarettes
800
600
400
200
Industry price
Excise tax
Sales tax (GST/VAT)
2001
1997
1993
1989
1985
1981
1977
1973
1969
1965
0
1961
Cents/pack
(constant 2000 prices)
1000
7
2000
6000
1500
5000
4000
1000
3000
2000
500
1000
2003
2000
1997
1994
1991
1988
1985
1982
1979
1976
1973
1970
1967
0
1964
0
Cigarette consumption
(million packs)
7000
1961
Industry revenue (R million,
constant 2000 prices)
The impact on real industry
revenue
Real industry revenue (R million, constant 2000 prices, LH scale)
Cigarette consumption (million packs, RH scale)
8
Explaining the rapid increase in the
industry price of cigarettes
Cost factors:
– Raw tobacco
– Paper products
– Labour
9
Real price of raw tobacco
2500
2000
1500
1000
500
98/99
96/97
94/95
92/93
90/91
88/89
86/87
84/85
82/83
80/81
78/79
76/77
74/75
72/73
70/71
68/69
0
66/67
Cents/kg (Constant 1995 prices)
3000
Marketing year
Flue-cured (AAS)
Flue-cured (TB)
Dark air-cured (AAS)
Dark-air cured (TB)
10
120
500
100
400
80
300
60
200
40
100
20
2001
1998
1995
1992
1989
1986
1983
1980
1977
0
1974
0
Real PPI of paper and paper
products
600
1971
Real industry price of cigarettes
(cents/pack of 20, constant 1995
prices)
Real price of paper and paper
products
Industry price of cigarettes (Cents per pack, constant 2000 prices, LH scale)
Real production cost of paper and paper products (Index value, 2000 = 100, RH scale)
11
Employment and cost of employment in
the cigarette manufacturing industry
25
Peak consumption
5000
20
4000
Merger
15
3000
10
2000
2001
1998
1995
1992
1989
0
1986
0
1983
5
1980
1000
1977
Number of employees
6000
Average monthly wage bill (R
millions, constant 2000 prices)
Peak employment
Number of employees (LH scale)
Average monthly wage bill (R millions, constant 2000 prices, 3-year MA, RH scale)
12
Changes in profitability?
• “Allan Gray went back, and asked which companies
have done well over the past 30 years. And the company
that won by a long shot was Rembrandt….It has done
better for its shareholders than any other company in
Africa.”
Simon Marais (chairman, Allan Gray, June 2004)
• London-listed BAT’s average annual return between Jan.
1994 and Dec. 2003 = 13.3 %, compared to 6.0 % return
for average of FTSE 100
13
Why so profitable?
• Three factors:
– Monopoly pricing power
– Addiction
– Low price elasticity of demand
• Explanation within rational addiction framework:
– Set price where MR < MC, as long as consumption is addictive
– Future profits are enhanced when current prices are lower since
greater current consumption raises future consumption
– If future demand decreases (e.g. increase in excise tax or TC
legislation) rationale for lower current prices disappears
– Rational monopolist would raise the price
14
The future
• Industry’s past pricing strategy has been
– Very advantageous to the industry
– Very good for public health
– Slightly detrimental to government revenue in short
term, positive in long term
– Make cigarettes more expensive than increases in
excise taxes alone
• Industry’s future pricing strategy depends on
– Price elasticity of demand
– Government’s excise tax policy
15
The model of price determination
Retail price (RP) determined as follows:
RPt = (IPt + EXCISEt) x (1 + VATt)
(1)
EXCISEt = RPt-1 x [TARGETt – {VATt/(1 – VATt)}]
(2)
Government controls TARGET and VAT
Industry controls IP (industry price)
16
Inputs into the model
(1) growth in personal disposable income (3 %),
(2) growth in the real industry price (subject to
assumptions),
(3) income elasticity of demand (εY = 1.00),
(4) VAT rate (14 %),
(5) tax burden (currently 52 %, but variable in the
model), and
(6) price elasticity of demand (εP = -0.80)
17
Outputs of the model
(1) cigarette consumption,
(2) real excise tax,
(3) real industry price,
(4) real retail price of cigarettes,
(5) government excise tax revenue from
cigarettes, and
(6) industry revenue
18
Simulated values after five years, assuming no change in
real industry price, εP = -0.80, PDI growing at 3 %
Tax burden (%
of retail price)
2004 values
45%
46%
47%
48%
49%
50%
51%
52%
53%
54%
55%
56%
57%
58%
59%
60%
61%
62%
63%
64%
65%
66%
67%
Real excise
tax (cents)
327
308
323
339
355
372
390
408
427
446
466
487
509
531
555
579
604
630
657
685
714
745
776
809
Real retail
price (cents)
963
942
959
977
996
1015
1035
1056
1077
1099
1122
1146
1171
1196
1223
1251
1279
1309
1340
1372
1405
1439
1475
1512
Quantity
(million packs)
1201
1403
1382
1362
1342
1321
1301
1281
1260
1240
1220
1199
1179
1159
1139
1119
1099
1079
1059
1040
1020
1001
982
963
Real excise
revenue (R m)
3927
4325
4472
4620
4770
4920
5072
5224
5378
5532
5687
5843
6000
6158
6317
6477
6637
6799
6961
7124
7288
7452
7618
7784
Real industry
revenue (R m)
6221
7266
7161
7056
6950
6845
6739
6634
6528
6423
6317
6212
6107
6003
5899
5795
5692
5589
5486
5385
5284
5184
5085 19
4986
Implications
• Given assumptions, cigarette consumption
may increase slightly if tax burden stays at
52 per cent (because of increase in PDI)
• Government revenue increases as tax rate
increases
• Taxes harm industry revenues
• Implications hold irrespective of values of
εY and εP
20
Impact of changes in the industry
price on industry revenues
• Assumption: Real industry price increases
by 6 per cent p.a.
– 2004: R5.18/pack
– 2009: R6.93/pack
– 2014: R9.28/pack
• All other variables remain the same
21
Simulated values after five years, assuming real industry
price increasing at 6 % p.a., εP = -0.80, PDI growing at 3 %
Tax burden (%
of retail
price)
Real excise tax
(cents)
Real retail price
(cents)
2004 values
45%
46%
47%
48%
49%
50%
51%
52%
53%
54%
55%
56%
57%
58%
59%
60%
61%
62%
63%
64%
65%
66%
67%
327
377
395
413
432
452
473
494
516
538
562
586
611
637
664
692
720
750
781
813
846
880
916
952
963
1220
1240
1261
1283
1306
1329
1353
1378
1404
1431
1458
1487
1516
1547
1579
1611
1645
1681
1717
1755
1794
1834
1876
Quantity (million
packs)
Real excise
revenue
(R m)
Real industry
revenue
(R m)
1201
1141
1126
1111
1096
1081
1066
1051
1036
1021
1006
991
976
961
946
931
916
901
886
872
857
843
828
814
3927
4299
4445
4592
4740
4889
5039
5190
5342
5495
5650
5805
5961
6119
6277
6437
6598
6760
6923
7086
7252
7418
7585
7753
6221
7911
7806
7702
7597
7493
7388
7284
7179
7075
6970
6866
6762
6659
6555
6452
6349
6247
6145
6043
5943
5842
5743
5644
22
Implications of raising the industry
price
• After five years, with 52 per cent tax burden…
Changes in…
With 6 %
increase in real
industry price
With constant
real industry
price
R13.78
R5.16
R10.77
R4.27
1036 mill.
1260 mill.
Real government
revenue
R5342 mill.
R5378 mill.
Real industry revenue
R7179 mill.
R6528 mill.
Real retail price
Real excise tax/pack
Cigarette consumption
23
Sensitivity analysis
• With εP = -0.8, industry benefits from
increasing industry price
• If demand is more price elastic, the benefit
decreases
• “Tipping point” εP at between -1.1 and -1.2
24
Conclusion
• Despite all the rhetoric and the restrictions, the
industry has done well
• Cigarette industry is more profitable now than
ever before
• Through its pricing strategy, the cigarette
industry aided the cause of the tobacco control
lobby
• Price elasticity of demand has a huge impact on
the industry’s future pricing strategy
25