US economist says high tobacco tax incentivizes illicit trade in PH

Dr. Arthur Laffer, an American economist and founder and chairman of Laffer Associates

Excessive tax rate increase on tobacco products can incentivize illicit trade, resulting in lower government revenues, according to a noted American economist.

Dr. Arthur Laffer, founder and chairman of Laffer Associates, an economic research and consulting firm, lauded the Philippines’ efforts to simplify its tobacco tax system but cautioned against excessive tax rate increases.

“When a commodity becomes too expensive for consumers due to taxation, they will reduce consumption of that commodity or substitute away from that highly taxed commodity in part through consumption of illicit goods,” he said.

He said the mechanism that resulted in continuous annual tax rate increases to achieve continuous revenue growth has clearly taken tax rates too high and failed to generate the anticipated revenue. “Due to declining tax revenue and increased growth in the illicit trade of tobacco, it is time to reevaluate the optimal cigarette tax rate,” he said.

Laffer said the potential profit opportunities for smugglers — and savings for consumers — must be weighed against the likelihood and consequences of enforcement. “In this sense, the proliferation of illicit trade is a function of high tax rates coupled with low affordability and likelihood of enforcement,” he said.

READ: Four-month tax take from tobacco products drops by P6.6B 

Following the passage of Republic Act No. 11346, the Tobacco Tax Law of 2019, the excise tax on cigarettes rose to P50 per pack on January 1, 2021, with a 5 percent annual increase, now at P63. Vapor products are taxed differently: P54.6/ml for nicotine salt and P63/10 ml for freebase.

Laffer said the Philippines’ tobacco excise tax rate reached a “prohibitive range” based on declining government revenue. “It seems that tax rates have exceeded the revenue-maximizing rate and ventured into what is known as the ‘prohibitive range’ of taxation,” said Dr. Laffer, a former member of President Ronald Reagan’s Economic Policy Advisory Board and the author of the Laffer Curve theory, which illustrates the relationship between tax rates and government revenue.

“The phenomenon of declining tobacco tax collections in the Philippines can be explained using the Laffer Curve — the relationship between tax rates and tax revenue. Tax revenues increase with increasing tax rates until a revenue-maximizing point is reached, after which further increases in tax rates result in declining tax revenue,” Laffer said in an interview.

“Of course, the government should take steps to realign tobacco tax rates closer to the revenue-maximizing rate. Doubling down with further revenue-losing tax rate increases is never a sensible solution to a tax revenue loss,” he said.

Laffer said that changes in a tax rate have two effects: an arithmetic effect and an economic effect. “Arithmetically, if a tax rate decreases, tax revenue will also decrease. Economically, however, a lower tax rate further incentivizes output, employment, production, and consumption, which increases the tax bases to which the tax rate is applied. The opposite is true for a tax rate increase. In all cases, the arithmetic effect and the economic effect are opposing forces,” he said.

“As previously discussed with declining tobacco tax revenues after successive tobacco tax rate increases, it seems that the Philippines has pushed tobacco tax rates past the point of revenue maximization on the Laffer Curve, and any further increases to the tax rate at this time would likely result in further revenue declines and increases in illicit trade,” he said.

Laffer also commended the Philippines’ approach to taxing novel tobacco and nicotine products like heated tobacco products and nicotine pouches. However, he urged the government to simplify its tax structure for e-cigarettes.

Laffer is advocating for a tax system that raises necessary revenue while minimizing economic damage. “By coupling tax base expansion with tax rate decreases, the Philippines can bolster and diversify tax revenue collection without jeopardizing economic growth,” he said.