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

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

8 The impact on real industry revenue

9 Explaining the rapid increase in the industry price of cigarettes Cost factors: –Raw tobacco –Paper products –Labour

10 Real price of raw tobacco

11 Real price of paper and paper products

12 Employment and cost of employment in the cigarette manufacturing industry 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 and Dec = 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: RP t = (IP t + EXCISE t ) x (1 + VAT t ) (1) EXCISE t = RP t-1 x [TARGET t – {VAT t /(1 – VAT t )}] (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 (ε Y = 1.00), (4)VAT rate (14 %), (5)tax burden (currently 52 %, but variable in the model), and (6)price elasticity of demand (ε P = -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, ε P = -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 % % % % % % % % % % % % % % % % % % % % % % %

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 ε Y and ε P

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., ε P = -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 % % % % % % % % % % % % % % % % % % % % % % %

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 priceR13.78R10.77 Real excise tax/packR5.16R4.27 Cigarette consumption1036 mill.1260 mill. Real government revenue R5342 mill.R5378 mill. Real industry revenueR7179 mill.R6528 mill.

24 Sensitivity analysis With ε P = -0.8, industry benefits from increasing industry price If demand is more price elastic, the benefit decreases “Tipping point” ε P 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