Are tobacco taxes regressive? Recent evidence from Armenia Rouselle F. Lavado (HNP GP) Moritz Meyer (Poverty and Equity GP) November 6, 2018

Higher taxes on tobacco are financially regressive: financial burden of excises reflects consumption behavior Simulated impact of increases in excises for tobacco: Relative change in net income as a share of disposable income, by disposable income decile. Behavioral approach: Under assumption that demand for tobacco is price elastic and poor respond more, increase in excise is less regressive. Notes: Results from Fiscal Incidence Analysis (CEQ approach) in Armenia. Simulations are based on the following scheme for tobacco excises: 16.67 percent VAT + 15 percent Excise but no less that AMD 6325 per 1000 pieces.

What does this mean for policy design and welfare measurement? Key considerations on tax policy Revenues: Enhance revenue collection from taxes and excises Equity: Strengthen fairness by focusing on ability to pay and need for transfers Externalities: Minimize harmful behavior with negative impact for others Broader definition of welfare Welfare: monetary measure does not account for quality of life Time horizon: neglects future well-being and life expectancy (also future health costs) Externalities: focuses on household welfare and excludes harm to society (health and public expenditure) Box 2. What guides optimal tax policy? Under the Twin Goals, the World Bank is promoting policies which eradicate absolute poverty and boost the income growth of the bottom 40 percent of the welfare distribution. Applying these goals into practice implies that policy recommendations pay special attention to the distributional impact of any reform to ensure that the relatively poor in the population are not adversely hit either by higher costs or lower benefits. Tax policy provides multiple examples where considerations of equity influence the definition of the tax base and the design of tax rates. For instance, a personal income tax with multiple brackets and increasing marginal tax rates ensures that households which show a higher ability to pay also contribute more to tax collection. However, equity is not the only consideration which should guide policy makers in the design of tax policies. The literature on public finance establishes at least four major considerations which should guide the optimal design of tax policy: Revenue collection: mobilize revenues which ensure financial and fiscal sustainability of the government budget. Accordingly, any proposal to change tax base or tax rates needs to be evaluated in terms of gains or losses of revenues. Efficiency: minimize dead weight loss of taxation by taxing goods that are inelastic in demand. Under this principle tax policy should aim to reduce distortions to taxpayers’ decisions. Equity: Tax policy is fair if all individuals in society contribute (bear the burden of the taxes) according to their ability to pay. Under this consideration, taxes would contribute to reducing inequality. Externalities imposed by consumption of some goods and services: discourage harmful behavior which has negative externalities for other members of society. For instance, higher excises on health damaging addictive products triggers a reduction in their consumption, therefore benefiting society as a whole. Each of these considerations support policy makers to evaluate the potential welfare implications of taxes from an ex-ante perspective. However, there are numerous trade-offs among these objectives, which require policy choices depending on overall development goals and priorities. For example, an excise tax on tobacco must be designed taking into account all these objectives, using a medium term horizon, in order to make a policy choice that is consistent with broader development goals. Here, possible behavioral changes and inter-temporal choices (with private and public gains), but also the elimination of negative externalities should further influence the optimal decision of policy makers.

Conceptual framework for modeling the health and financial impact of higher excise taxes on tobacco products in Armenia Higher Price Reduced consumption of tobacco products [higher reduction among the poorer wealth quintiles] Lower incidence of tobacco-related diseases Averted premature mortality Lower OOP health spending on tobacco-related diseases Additional financing for health and other sectors Fewer cases of impoverishment as a result of OOP spending Incremental governmental revenues Lower government health spending on tobacco-related diseases Higher Excise Taxes Fewer cases of catastrophic health spending

ECEA results for a 75% excise tobacco tax (equivalent to a 45% price increase) Total Q1 Q2 Q3 Q4 Q5 Premature deaths averted (1000s) 88 21 23 22 13 9 Out-of-pocket expenditures related to tobacco-related diseases averted (million USD) 63 10 19 12 Government savings related to tobacco-related diseases averted (million USD) 26 7 6 4 2 Poverty cases averted (1000s) 8 5 3 Catastrophic health care expenditures (>10% of consumption) cases averted (1000s) 33 Note: no poverty cases are averted in the poorest consumption quintile given that 30% of the population is already below the poverty line; time horizon is 50 years

Key Findings An increase in excise on tobacco is slightly regressive in financial terms; yet, this neglects behavioral response. Results from the extended cost-effectiveness analysis (ECEA) show that higher excise taxes on tobacco would lead to: Lower numbers of premature deaths Lower OOP on tobacco-related diseases Government expenditures on tobacco-related diseases averted Decrease in poverty and catastrophic health expenditures due to lower out- of-pocket health expenditure related to tobacco-induced diseases Overall, increased excise rate on tobacco is expected to trigger health and financial benefits to Armenian households; the net effect of tobacco tax increase in Armenia is pro-poor.

THANK YOU rlavado@worldbank.org mmeyer3@worldbank.org

Broader definition of welfare: Turning losers into winners Broader definition of welfare: Turning losers into winners. Smoking prevalence: Share of Population Using Tobacco Across Welfare Distribution and Budget Shares of Tobacco Across Welfare Distribution Share of consumption expenditure on tobacco (by decile, conditional on smoking) Share of households (by decile of the welfare distribution) which report tobacco consumption Note: Horizontal axis shows decile of the welfare distribution (from poorest to richest). Data sources: Global consumption data base, ILCS Armenia Note: Horizontal axis shows decile of the welfare distribution (from poorest to richest). Data sources: Global consumption data base, ILCS Armenia

11/6/2018 Under assumption that demand for tobacco is price elastic and poor respond more, increase in excise is less regressive Behavioral approach: demand elasticities equal to -1 for the poorest decile, -0.9 for the second, up to -0.1 for the richest. Distributional Impact: Change in Excise Duty for Tobacco Inelastic demand Kakwani index -0.095 Net effect on budget (ILCS) 0.15% Distributional Impact: Change in Excise Duty for Tobacco Elastic demand Kakwani index -0.068 Net effect on budget (ILCS) -0.08% South Caucasus Poverty Team, The World Bank