1

Industry responses to the rapid excise tax increases in

South Africa since 1994

Departmental seminar, School of Economics,

1 August 2005

Corné van Walbeek

2

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

3

Trends in cigarette consumption and real prices

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200

400

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1000

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60

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64

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68

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72

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76

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80

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84

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88

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92

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96

20

00

20

04

Re

al

pri

ce

pe

r p

ac

k o

f 2

0

( in

co

ns

tan

t 2

00

0 c

en

ts)

0200

4006008001000

120014001600

18002000

Cig

are

tte

co

ns

um

pti

on

(m

illi

on

s o

f p

ac

ks

)

Real price of cigarettes Consumption of cigarettes

4

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

5

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

6

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

7

Decomposition of the real retail price of cigarettes

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1000

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61

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65

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69

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73

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77

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81

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85

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89

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93

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97

20

01

Cen

ts/p

ack

(co

nst

ant

2000

pri

ces)

Industry price Excise tax Sales tax (GST/VAT)

8

The impact on real industry revenue

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7000

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67

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88

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91

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94

19

97

20

00

20

03

Ind

us

try

re

ve

nu

e (

R m

illio

n,

co

ns

tan

t 2

00

0 p

ric

es

)

0

500

1000

1500

2000

Cig

are

tte

co

ns

um

pti

on

(m

illio

n p

ac

ks

)

Real industry revenue (R million, constant 2000 prices, LH scale)

Cigarette consumption (million packs, RH scale)

9

Explaining the rapid increase in the industry price of cigarettes

Cost factors:– Raw tobacco– Paper products– Labour

10

Real price of raw tobacco

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66/6

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68/6

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70/7

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76/7

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80/8

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82/8

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84/8

5

86/8

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88/8

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90/9

1

92/9

3

94/9

5

96/9

7

98/9

9

Marketing year

Cen

ts/k

g (

Co

nst

ant

1995

pri

ces)

Flue-cured (AAS) Flue-cured (TB) Dark air-cured (AAS) Dark-air cured (TB)

11

Real price of paper and paper products

0

100

200

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600

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71

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74

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77

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80

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83

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86

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89

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92

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95

19

98

20

01

Re

al i

nd

us

try

pri

ce

of

cig

are

tte

s

(ce

nts

/pa

ck

of

20

, co

ns

tan

t 1

99

5

pri

ce

s)

0

20

40

60

80

100

120

Re

al P

PI o

f p

ap

er

an

d p

ap

er

pro

du

cts

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)

12

Employment and cost of employment in the cigarette manufacturing industry

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1000

2000

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6000

1977

1980

1983

1986

1989

1992

1995

1998

2001

Nu

mb

er

of

em

plo

ye

es

0

5

10

15

20

25

Av

era

ge

mo

nth

ly w

ag

e b

ill (

R

mill

ion

s, c

on

sta

nt

20

00

pri

ce

s)

Number of employees (LH scale)

Average monthly wage bill (R millions, constant 2000 prices, 3-year MA, RH scale)

Peak employment

Peak consumption

Merger

13

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

14

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

15

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

16

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)

17

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)

18

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

19

Simulated values after five years, assuming no change in real industry price, εP = -0.80, PDI growing at 3 %

Tax burden (% of retail price)

Real excise tax (cents)

Real retail price (cents)

Quantity (million packs)

Real excise revenue (R m)

Real industry revenue (R m)

2004 values  327 963 1201 3927 622145% 308 942 1403 4325 726646% 323 959 1382 4472 716147% 339 977 1362 4620 705648% 355 996 1342 4770 695049% 372 1015 1321 4920 684550% 390 1035 1301 5072 673951% 408 1056 1281 5224 663452% 427 1077 1260 5378 652853% 446 1099 1240 5532 642354% 466 1122 1220 5687 631755% 487 1146 1199 5843 621256% 509 1171 1179 6000 610757% 531 1196 1159 6158 600358% 555 1223 1139 6317 589959% 579 1251 1119 6477 579560% 604 1279 1099 6637 569261% 630 1309 1079 6799 558962% 657 1340 1059 6961 548663% 685 1372 1040 7124 538564% 714 1405 1020 7288 528465% 745 1439 1001 7452 518466% 776 1475 982 7618 508567% 809 1512 963 7784 4986

20

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

21

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

22

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)

Quantity (million packs)

Real excise revenue

(R m)

Real industry revenue

(R m)

2004 values  327 963 1201 3927 622145% 377 1220 1141 4299 791146% 395 1240 1126 4445 780647% 413 1261 1111 4592 770248% 432 1283 1096 4740 759749% 452 1306 1081 4889 749350% 473 1329 1066 5039 738851% 494 1353 1051 5190 728452% 516 1378 1036 5342 717953% 538 1404 1021 5495 707554% 562 1431 1006 5650 697055% 586 1458 991 5805 686656% 611 1487 976 5961 676257% 637 1516 961 6119 665958% 664 1547 946 6277 655559% 692 1579 931 6437 645260% 720 1611 916 6598 634961% 750 1645 901 6760 624762% 781 1681 886 6923 614563% 813 1717 872 7086 604364% 846 1755 857 7252 594365% 880 1794 843 7418 584266% 916 1834 828 7585 574367% 952 1876 814 7753 5644

23

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

Real retail price R13.78 R10.77

Real excise tax/pack R5.16 R4.27

Cigarette consumption 1036 mill. 1260 mill.

Real government revenue

R5342 mill. R5378 mill.

Real industry revenue R7179 mill. R6528 mill.

24

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

25

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