Discussion Paper No. 21 of 2002 on Tobacco Excise Tax in Kenya: an Appraisal

Abstract

Excise taxes form a substantial proportion of revenue for governments all over the world, and especially in low-income developing countries. Excise taxes are levied on a few goods characterised by low price elasticity of demand; there is minimal cutback in consumption of the good as price increases. Excise on tobacco falls under the category of sin taxes—taxes that are meant to discourage behaviour associated with inefficient decision-making. Using OLS, we determine both the long-run and short-run price elasticity for cigarettes which we then use to determine the tax rate that would maximise tax revenue for the government. The empirical results show that long-run responses are high, ranging between -1.78 for all cigarettes to -1.36 for filter cigarettes. Using the elasticity for all cigarettes, we find that the tax rate that would maximise tax revenue should be at 128%. This is fairly close to the current rate of 130% but the revenue maximising tax rate combines both excise tax and VAT. We conclude that in general, the price elasticity is not as low as authorities may have assumed. In the short run, the elasticity is low yet tax policy cannot be based on short-run responses but rather on long-run structural movements. Since tobacco excise tax is a sin tax, there is justification to impose high taxes, despite the high elasticity, to deter consumption. However, if set too high there will be evasion and smuggling, therefore defeating the revenue maximising goal. There is also a danger of substitution to more harmful substances.