The effectiveness of a tax increase in reducing tobacco use depends on the extent to which the tobacco industry passes on the tax increase to consumers. It is well-known by now that the industry absorbs tax increases more commonly for cheaper brands, for which demand is more price sensitive and holding prices down is critical to recruiting new smokers. The tendency to raise price by the full amount of or more than the tax increase applies to the expensive brands for which smokers are typically less price sensitive. The incentive to apply differential pricing strategy across price segments derives from the industry’s profit maximization motive—raising the profit from the higher end and expanding sales volume at the lower end of prices. Such incentive can exist even under a government-regulated pricing mechanism, as shown in a recent report jointly published by the American Cancer Society, the International Tobacco Control Policy Evaluation Project of the University of Waterloo (Canada), the University of Dhaka (Bangladesh), and the World Health Organization. Indeed, the research demonstrates that a multi-tiered tax system with preferential tax rates for cheaper brands supports such a supply side response.
Comparing market prices with government-administered prices by brands in a nationally representative price survey over two waves, the study observes that cigarette manufacturers in Bangladesh raise market prices higher than the government recommended prices for higher-price brands, while lowering the relative price of cheaper brands. This strategy allows tobacco companies to attract more price-sensitive smokers to buy cheaper brands and to expand overall demand, while avoiding payment of tax on the extra profit margin derived from higher-price brands. Smokers in turn are encouraged to switch down to cheaper brands instead of quitting or reducing consumption when tax and price increase.
Figure 1: In only five years, the market share of low-price cigarette brands rose dramatically from 61.7% to 79.5%.
Note: The medium-price segment was eliminated by the government order since 2015-16.
The policy implication is relatively straightforward: simplify the tax structure through the unification of multiple tax rates to eliminate the opportunity for the tobacco industry to manipulate price and undermine tobacco tax policy.