Estimating tax incidence, market power and market conduct: The European cigarette industry

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Abstract

Recent theoretical work has shown that the incidence of ad valorem and specific taxes may differ and each may be over or under-shifted onto consumers in the presence of imperfect competition. These results are used to derive a method of estimating market power and conduct. An application is made to the European cigarette industry. Previous empirical comparison of the incidence of ad valorem and specific taxes is limited. For a group of countries with broadly similar cigarette industries, there is evidence of undershifting of both taxes, with the specific tax having a significantly greater impact on price. The extremes of both perfect competition and monopoly can be rejected. Behaviour is no less competitive than the equivalent of Cournot.

Introduction

Tax incidence is a fundamental issue in Public Economics. Identification of market power and measurement of the degree of competition are amongst the most important issues in Industrial Organisation. The taxation of cigarettes has been used to learn about each of these topics separately. (See Barzel, 1976; Johnson, 1978; Sumner and Ward, 1981 on tax incidence. See Sumner, 1981; Bulow and Pfleiderer, 1983; Sullivan, 1985; Ashenfelter and Sullivan, 1987 on market power and conduct.) In this paper, cigarette taxation is used to examine both sets of issues. Our first aim is to test the predictions of recent developments in the theory of commodity taxation (c.f. Delipalla and Keen, 1992). The second aim is to develop the literature on the estimation of market power and conduct by introducing a reduced form method which provides point estimates of the mark-up and the numbers equivalent of firms. This extends Sullivan (1985), who identified a lower bound on the latter parameter from comparative statics effects of a specific tax. Our method involves comparing the comparative static effects of specific and ad valorem commodity taxes.1 As with Sullivan (op cit), it only requires reduced form estimation. The third aim of the paper is to inform the design of cigarette tax policy and, in particular, the debate about the harmonisation of cigarette taxation in Europe.

Theoretical work on tax incidence has shown that commodity taxes may be over- or undershifted onto consumers in the presence of imperfect competition (Seade, 1985; Stern, 1987). Moreover, in such an environment, the incidence of ad valorem and specific taxes may differ, with the price effect of the former never exceeding that of the latter (Delipalla and Keen, 1992; Skeath and Trandel, 1994). Empirical comparison of the price effects of specific and ad valorem taxes is limited. The few studies which exist suffer from a lack of variation in the data, particularly with respect to the ad valorem rate (Barzel, 1976; Johnson, 1978; Sumner and Ward, 1981; Baker and Brechling, 1992). We use data from the EU, where all member states levy both a specific and an ad valorem tax on cigarettes and there is variation in both taxes across countries and time.

The new empirical industrial organisation (N.E.I.O.) literature is concerned with testing for market power and estimating the degree of competition without using accounting data on cost and/or profit (for surveys, see Geroski, 1988; Bresnahan, 1989; Carlton and Perloff, 1994). A distinction can be made between structural and reduced form approaches to the problem (Hyde and Perloff, 1995). The former is based mainly on the conjectural variations model and involves estimating a structural market demand function simultaneously with supply relation(s). Identification of the degree of market power and conduct is achieved through some variable which pivots the demand curve (Bresnahan, 1982; Lau, 1982). The advantage of the structural approach is its power. Not only can market power be tested but estimates can be made of the price–cost mark-up and the degree of competition within the industry. There are four main disadvantages. First, data must be available on price, output, input prices and both demand and cost shifters. Second, misspecification of the structural demand and/or cost function will bias the estimates, and so the tests, of market power/conduct. Third, when using industry level data, the supply relation estimated does not correspond to the first order conditions unless firms are homogeneous. Otherwise, the supply relation is, in part, ad hoc and the parameters must be interpreted as industry averages (Bresnahan, 1989, p. 1030). Finally, the conjectural variations model is vulnerable to theoretical criticism. Given this, Bresnahan (1989) claims an ‘as-if’ interpretation of the estimated conduct parameter: It indicates behaviour is as competitive ‘as-if’ firms held certain conjectures. Corts (1999) demonstrates this argument is valid only under certain conditions.2

Tests of market power which do not involve estimation of structural demand and supply relations avoid the above mentioned problems at the cost of losing power with respect to the hypotheses which can be tested and the parameters which can be estimated. Hall (1988) provides a joint test of the hypotheses of perfect competition and constant returns to scale. The joint nature of the test impedes interpretation somewhat. Estimates of the degree of market power and market conduct can be obtained only by imposing further restrictions and with additional information available (Shapiro, 1987). Panzar and Rosse (1987) are able to test the extreme cases of market conduct, perfect competition and monopoly, but do not obtain an estimate of the degree of market power or competition. Sumner (1981) claimed the impact of a unit tax in a reduced form price equation identified the industry average mark-up and the firm level elasticity. Bulow and Pfleiderer (1983) demonstrated this claim was valid only for special cases of the demand function.3 Sullivan (1985) linked the method of Panzar and Rosse (op cit) with that of Sumner (op cit) and Bulow and Pfleiderer (op cit) to show the coefficients on a specific tax in reduced forms for price and quantity can be used to identify a lower bound on the numbers equivalent of firms. This allows testing of the hypothesis of monopoly, but not competition.4

We take this literature one step further by proposing a reduced form method which allows identification of market power and conduct. The hypotheses of both perfect competition and monopoly can be tested and the degree of competition estimated. As with Sullivan (op cit), since identification comes from the comparative static effects of taxes, the method only requires estimation of reduced form functions. Non-equivalence of the price effects of specific and ad valorem taxes is an indication of market power.5 The price–cost mark-up is identified by taking the ratio of the price effects of the two taxes. Having estimated the mark-up, a parameter reflecting the conduct of the industry, that is the numbers equivalent of firms, is identified if the price elasticity of market demand is known or can be estimated.

The method offers the power of the structural conduct parameter method without imposing the data requirements or the functional form assumptions of structural estimation. Of course, it does not come without cost; to be feasible, the method requires that the econometrician can observe a component of unit costs and a variable which pivots the (perceived) demand curve. These information requirements are satisfied in industries where both specific and ad valorem taxes are imposed and may be fulfilled in other contexts. Corts (1999) demonstrates that, in general, the structural conduct parameter method generates biased estimates. Empirically, Genesove and Mullin (1998) find the structural method to be largely validated although its performance is improved if partial cost information is employed. Essentially, our method involves the use of partial cost information, obtained from taxes, to move away from a structural estimation approach.

The paper is organised as follows. The theory of the relationship between market conduct and the incidence of ad valorem and specific taxes is presented in the next section. Tax incidence, market power and conduct parameters are written in terms of the comparative static effects of the taxes. In Section 3 we describe the setting of our empirical application – the European cigarette industry. Empirical implementation of the approach and the data are described in Section 4. Estimation issues are discussed and the results presented in Section 5. Section 6 concludes.

Section snippets

Market power and the relative incidence of ad valorem and specific taxation

We consider the conjectural variations model, as in Delipalla and Keen (op. cit.), only we look at the non-symmetric equilibrium. In an industry with n firms, the after-tax profit earned by firm i is πi=[(1−v)P(X)−s]xi−c(xi),where P is the consumer price, X is the industry output, xi is the firm’s output, c(xi) is the firm’s total cost of producing the given level of output and s and v are the specific and (tax inclusive) ad valorem tax rates respectively.6

The European cigarette industry

The European cigarette industry, being highly concentrated, provides an appropriate context for trying out our method of estimating market power and to test the recent developments in the theory of tax incidence allowing for imperfect competition. The estimates are not only of interest in relation to the academic economics literature but also as a source of information for a variety of policy discussions. There has been a long running debate in Europe over the harmonisation of cigarette taxes.

Empirical implementation and data

As emphasised above, our method relies on comparative statics for identification and so only requires reduced form estimation. Specifically, we estimate reduced form price functions with the taxes and other exogenous determinants of demand and cost conditions included as right-hand-side variables. From the coefficients on the tax variables, estimates of their marginal effects are calculated and substituted for the true values in expressions , , , . The empirical counterparts of these

Results

Given our method involves reduced form estimation, our choice of specification has been empirical. That is, we have searched for the specification which best fits the data subject to the statistical properties assumed by the estimator being satisfied.

Differences in the nature of the cigarette industry across Europe were discussed in Section 3. While some of these differences can be dealt with in estimation through the inclusion of country effects, others affect not only price levels but the tax

Conclusions

This paper had three principle aims. First, to test predictions from the theory of commodity tax incidence. Second, to introduce and apply a new method of estimating market power and conduct. Third, to inform policy debates on tax harmonisation in Europe and the use of cigarette taxation as an instrument of health policy.

The results reveal that commodity taxes are not always fully shifted onto consumers. For a group of northern European countries with similar market structures and quality of

Acknowledgements

We are grateful to seminar audiences at the Institute for Fiscal Studies, City, Kent, Sussex, York, the 1998 Public Economics Weekend at Essex, and an anonymous referee of this journal.

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