A leading American economist warned that the Philippines’ tobacco excise tax rate had reached a “prohibitive range,” as evidenced by declining government revenue.
“Based on the Philippines’ experience with ever-increasing tobacco tax rates and subsequent revenue declines, 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. Arthur Laffer, founder and chairman of Laffer Associates, an economic research and consulting firm.
Laffer, a former member of President Ronald Reagan’s Economic Policy Advisory Board, is 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 e-mailed 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 explained 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.
He said the price elasticity of demand for a given good would impact the shape of the Laffer Curve and dictate the revenue-maximizing point on the curve. If elastic, the revenue-maximizing tax rate will be lower, as consumers will be more sensitive to price increases. If inelastic, the revenue-maximizing tax rate will be higher, as consumers will be less sensitive to price increases.
“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 warned that high tax rates on commodities can fuel the growth of illicit trade. “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 noted that the nature of tobacco as a commodity, coupled with varying price and tax structures across different countries or regions, can incentivize illicit trade. “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.
While praising the Philippines’ efforts to simplify its tobacco tax system, Laffer cautioned against excessive tax rate increases. “The mechanism that has resulted in continuous annual tax rate increases in order to achieve continuous revenue growth has clearly taken tax rates too high and has 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 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.
“Unlike other tobacco and nicotine products, e-cigarettes are taxed under a two-tiered system in the Philippines, which is leading to significant enforcement issues. Reforming e-cigarette taxation into a simplified uniform rate — as has been done for other tobacco and nicotine products — should be an immediate priority,” he said.
Under Republic Act No. 11346 or the Tobacco Tax Law of 2019, cigarette excise rose to P50 per pack effective Jan. 1, 2021 subject to 5-percent increase annually and is currently at P63. Vapor products are taxed differently at P54.6/ml for nicotine salt and P63/10 ml for freebase.
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. Other areas in which to consider simplifying and rationalizing are regulations for capital markets and the fiscal regime surrounding the mining sector,” he said.
