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Abstract
Background The complex cigarette tax system in Indonesia has created the opportunity for cigarette producers to avoid tax, which results in affordable cigarette prices. In addition to increasing cigarette tax every year, the government has adopted several policies to increase cigarette prices, such as reducing the number of tiers and applying cigarette tax based on the combined production of affiliated companies (ie, firms with a minimum 10% ownership of another cigarette company, sharing the same boards of commissioners or using input from other tobacco companies, in which a firm has at least 10% ownership).
Objective To investigate the effect of cigarette tax, affiliated company rules and changes in the number of tiers on cigarette prices produced in Indonesia.
Method Using brand level data from 2005 to 2017, we model cigarette prices as a function of cigarette tax, affiliated company rules, number of tiers, cigarette types and cigarette tax system using random effect and fixed effect estimations.
Finding We find that a percentage increase in cigarette tax increases cigarette prices by less than 1% for all cigarette types. The implementation of affiliated company rules is effective in increasing cigarette prices for both affiliated and non-affiliated firms. We also find that a fewer number of tiers are associated with a higher cigarette price. Our results suggest that a reduction in the number of tiers will increase the effectiveness of a specific tax system in making cigarettes less affordable.
- taxation
- price
- economics
- low/middle income countries
- tobacco industry
- tax pass-through
- multi tiers
- indonesia
Statistics from Altmetric.com
- taxation
- price
- economics
- low/middle income countries
- tobacco industry
- tax pass-through
- multi tiers
- indonesia
Background
Cigarette tax is considered the most effective tool to help reduce consumption.1 However, the effectiveness of cigarette taxation in reducing the consumption depends partly on the system used (ie, specific, ad valorem or mixed) and the tax structure (ie, uniform or tiered rates) because both determine the price, in terms of level and variation. When compared with other systems, an equal percentage tax increase in a specific system will lead to a higher cigarette price increase, thus making cigarettes less affordable.2 A tiered tax structure has a greater variance compared with a uniform tax, enabling consumers to switch down to cheaper cigarettes. Thus, specific and uniform cigarette taxation is considered the most effective among other tax systems because it leads to a greater price increase and lower variation.1 3 4
Although uniform specific tax is considered the most effective cigarette taxation to reduce cigarette consumption, not all countries use the uniform specific cigarette taxation. The International Agency for Research on Cancer (IARC) report suggests that many low and middle income countries have used a complicated tax structure.5 Indonesia is one of the countries that has always used a complicated tax structure in all of the cigarette systems it has used. Before 2007, Before, Indonesia used an ad valorem system. In 2007–2008, a mix of specific and ad valorem systems were used, while the specific system has been in place since 2009. The tax rate is based on four categories, namely (1) production volume, (2) production technique (ie, machine-made vs hand-made), (3) flavour (ie, with clove or kreteks vs without clove) and (4) retail prices (see table 1, see online supplementary appendix I for the complete cigarette tax rates). As the tax rates are progressive based on production volume and prices, firms may avoid taxes by limiting the production volume, creating a new brand to fall into a lower tax tier and limiting the price increase. Because the current tax system promotes a wide range of cigarette prices (thus, allowing smokers to switch to cheaper cigarettes), increases in cigarette tax rates may not have much of a health impact under such a complex cigarette tax system.6
Supplemental material
Cigarette excise tax in Indonesia, 2009 – 2012
In addition to the complex cigarette taxation, there are two additional factors that provide a higher incentive for firms to maintain low cigarette prices in Indonesia, namely the absence of a minimum retail price for cigarettes and the maximum excise tax rate allowed by the Indonesian excise law which is 57% of the retail price. Given that the market structure is oligopoly,7 cigarette firms have more flexibility in determining cigarette prices. In determining the cigarette price, each firm must apply for the banderol price (ie, producer retail price). The banderol price serves as the maximum cigarette price under which firms can sell their product instead of serving as the minimum retail price. The government rules that the proposed banderol price must not be lower than the previous banderol price. In the absence of a minimum price, firms will be more likely to maintain a small price increase for three reasons. First, as the cigarette tax is progressive based on the retail price, a higher price increase may cause a brand to fall into a higher tax tier. Second, a higher price increase will cause a greater reduction in the quantity demanded for the cigarette. Third, if the percentage price increase is higher than the percentage increase in tax, the brand’s tax-to-price ratio will fall (ie, moving away from the 57% maximum rate). A reduction in the tax-to-price ratio creates a greater opportunity for the government to impose a larger tax increase in the following year which may have a negative impact on future cigarette demands and the firm’s profit.
The cigarette firms’ strategic decision to avoid a higher tax rate has resulted in low cigarette prices. A packet of cigarettes can be bought for only US$0.45 for the cheapest brand and only US$2.16 for a premium brand.8 A study by Zheng et al 9 revealed that cigarette affordability increased during 2002–2016 because income grew faster than cigarette prices. This increase in cigarette affordability contributed to a significant increase in smoking prevalence of males aged 15 and over in Indonesia, from 60.6% in 2000 to 76.1% in 2016.10 Affordable cigarette prices may also cause youths to begin smoking. Around 3.51% of boys aged 10–14 smoke cigarettes on a daily basis which is higher than the average compared with countries with a medium Human Development Index.11 As the result of this high smoking prevalence, more than 225 700 people die every year due to tobacco related diseases.11 The fatalities due to tobacco related diseases may outweigh the annual government tax revenue from cigarettes (which is around Rp150 trillion, see online supplementary appendix II for the details).
Supplemental material
One of several of the government’s responses to the cigarette firms’ strategic decision to avoid higher tax is the mandatory price increase regulation for all brands in 2006. This decision was issued because the banderol prices were around half of the actual retail prices which resulted in a significant loss of potential tax revenue. However, since the system was ad valorem, a larger price increase would cause not only a greater reduction in cigarette demand, but also a greater tax liability, causing a reduction in firms’ profit. Thus, firms limited their cigarette price increases. This can be seen from the median of tax-to-price ratio in 2006 which was indifferent from 2005 (figure 1). The median tax-to-price ratio for all types of cigarettes is far below 70%, the benchmark that the WHO considers as an effective rate to significantly reduce cigarette consumption.12
Median tax-to-price ratio by cigarette type. SKM, Sigaret Kretek Mesin; SKT, Sigaret Kretek Tangan; SPM, Sigaret Putih Mesin.
We can see that the ratios were relatively close during 2005–2007, and then increased until 2012, before then becoming flat again (and slightly decreased) since 2013. The ratio for Sigaret Kretek Tangan (SKT) has always been lower than Sigaret Kretek Mesin (SKM) and Sigaret Putih Mesin (SPM). This lower ratio is due to efforts by the government to provide a competitive advantage to smaller, domestic firms over larger multinational tobacco companies.1 In 2012, the median of tax-to-price ratio for SKM exceeded 57% which is the maximum allowable limit. One reason for this, is a mistake by the Ministry of Finance in issuing the cigarette tax in 2012, in which the tax-to-price ratio exceeded 57% in some tiers.
Another government policy to increase cigarette prices, was the issuance of the affiliated company rule in mid-2013 (Minister of Finance Decree No. 78/2013 and No. 131/2013). A firm is considered to be affiliated with another company if it has one of the following criteria; (1) it has at least 20% ownership of the other company, or at least 10% ownership, yet it is the largest shareholder; (2) it shares the same board of commissioners and/or directors and (3) uses input from another tobacco company in which the firm has at least 10% ownership. The regulation causes the applicable tax rate to be based on the combined production of affiliated companies for each type of cigarettes. Given that the Indonesian cigarette tax structure is progressive based on (among others) production volume, affiliated firms will be applied a higher tax rate. However, identification of affiliated firms is imperfect. There are two ways of identification described by the regulation, namely (1) government identification and (2) voluntary reporting by affiliated firms. Delaying the voluntary report will not be punishable as long as a firm submits the report before the affiliation is identified by the government. Thus, firms may still have an incentive not to report voluntarily to avoid higher taxes and maintain low cigarette prices. Indeed, until February 2014, only few number of firms out of 1130 cigarette firms had submitted a voluntary report.13
This study analyses the effect of the cigarette tax on cigarette prices. We analyse how various government policies affect the degree of tax pass–through (ie, the degree of increase in cigarette tax passed on to consumers). Government policies included in this study are cigarette tax regimen changes, obligatory price increases in 2006, affiliated company rules applied since 2013 and changes in the number of tax tiers. We also take into account the price reduction policy in 2008. The price reduction policy was implemented in 2008 because the specific tax component increased significantly from IDR three per stick to IDR 35 per stick (except for the lowest tier in hand-made clove cigarettes which increased to IDR 27 per stick). We use brand level data for all cigarettes produced in Indonesia from 2005 to 2017. To the best of our knowledge, this is the first study that has investigated the effect of excise tax and the related government policies on cigarette prices in Indonesia using brand level data. Although a recent study by Adrison and Putranto14 provides an indication that tax is not fully passed on to consumers their study is unable to identify the degree of tax pass-through at the brand level, as their data set is at firm level. Given that many firms produces multiple products with different tax rates, it is possible that the degree of tax pass-through is different across brands. Additionally, changes in tax tiers and the implementation of affiliated company rules may also contribute to a different tax pass-through which has not been examined in the previous study.
Data and methods
We use transactional data of all cigarette brands produced in Indonesia between 2005 and 2017 from the Indonesian Customs (excluding roll your own cigarettes). The data consist of producers’ banderol prices, production volumes, cigarette types, the applicable tax rates and information on whether or not a firm has at least one affiliated company. The transactional data are aggregated into annual data. As cigarette prices may change during a calendar year, we calculate the average cigarette price using production volume as the weight.
We run several regressions from the most restricted to unrestricted specification to check for parameter consistency. The unrestricted empirical specification for brand i’s price in year t is given by the following equation:
Where:
: Price per stick (in natural logarithm)
: Number of tax tiers in similar cigarette type to brand i
: Applicable tax per stick (in natural logarithm)
: Dummy variable for mixed tax regimen (equals to one in 2007 and 2008, and 0 in other years)
: Dummy variable for specific tax regimen (equals to one in 2009 and the years after, and zero in other years)
: Dummy variable for machine-made clove cigarettes/SKM (equals to one if brand i is an SKM and zero otherwise)
: Dummy variable for machine-made non-clove cigarettes/SPM (equals to one if brand i is an SPM and zero otherwise)
: Dummy variable for firms with at least one affiliated company (equal to one if brand i is produced by firms with an affiliated company AND after 2013, zero otherwise)
: Dummy variable for price increase policy in 2006 (equals to one in 2006, zero in other years)
: Dummy variable for price decrease policy in 2008 (equals to one in 2008, zero in other years)
: Dummy variable for affiliated company rule (equal to one in 2013 and after, zero otherwise)
In specification 1, the explanatory variables consist of the cigarette tax and interaction terms of the tax and regimen dummy. This base specification is intended to investigate the effect of changes in the number of tax tiers and cigarette taxes in different regimens. In specification 2, we add two interaction terms between tax and cigarette type to account for the possibility that tax pass-through may be different among different types of cigarettes. As there are three types of cigarettes—that is, hand-made clove cigarettes (hereafter referred to as SKM), machine-made non-clove cigarettes (hereafter referred to as SPM) and hand-made clove cigarettes (hereafter referred to as SKT)—we use two dummy variables for cigarette types (SKM and SPM). This implies that the base group is SKT. In specification 3, to identify the direct effect of the affiliated company rule on cigarette prices, we add an interaction term between cigarette tax and dummy for firms that have been identified by the government to have at least one affiliated company. Additionally, we also use three time dummies to capture the effect of policy changes in specification 3, namely (1) price increase policy in 2006, (2) price decrease policy in 2008 and (3) the affiliated company rule in 2013 and after. The affiliated company rule dummy is used to identify the spillover effect on the prices of firms’ cigarettes which do not have an affiliated company. We argue that an independent firm may expect that cigarette prices produced by companies with affiliated firms will have a greater price increase because of the affiliated company regulation. Consequently, the pressure for an independent firm to limit the cigarette price increase is lesser. All specifications are regressed using two methods; namely the random effect and the fixed effect. We use the Hausman test to identify the preferred result for analysis.
Taking the first derivative of the unrestricted specification with respect to cigarette tax, will give us the following result:
Parameter 
, 
, 
reflects the effect of a percentage increase in cigarette tax on the percentage increase of cigarette price in the ad valorem, mixed and specific tax regimen for SKT, respectively. With the introduction of the affiliated company rule in 2013, the effect of a percentage increase in cigarette tax on the percentage increase of cigarette prices for SKT becomes 
. The different effect of tax increase on cigarette price between SKM and SPM from the base group (SKT) are captured by parameters 
and 
, respectively.
Descriptive statistics
The descriptive statistics are presented in table 2 (see online supplementary appendix III and IV for the number of brands and observations by year). We have 11 523 brands which consists of 8502 SKTs, 2685 SKMs and 336 SKTs. Due to exit and entry, the number of observations at the brand level varies from 1 to 13, resulting in an unbalanced panel data of 32 711 observations. SKT contributes the largest number of observation across all the years. There were significant increases from 2005 to 2006 regarding the number of brands sold for all cigarette types in 2006, perhaps due to unchanged tax rates. The number of brands decreases when the specific component was included in the mixed regimen in 2007. In 2008, the specific tax component increased significantly which might have had a negative effect on the smaller firms’ competitiveness. Because small firms were losing their competitiveness, and many small firms produced SKT, combined with a government decision to close small cigarette firms with less than a 200 m2 factory (Ministry of Finance Decree No. 200/2008), the number of SKT brands fell from 2347 to 1841. The number of SPM brands only slightly decreased from 36 to 33. On the other hand, the number of SKM brands increased from 420 to 573. We argue that this increase is because of the firms’ decision to produce SKM in the lowest tier to capture the remaining market due to a significant reduction in the number of SKT brands in the lowest tier. The number of SKM brands in the lowest tier in 2007 and 2008 were 379 and 508, respectively, while the number of SKT brands in the lowest tier in 2007 and 2008 were 2288 and 1792, respectively.
Supplemental material
Supplemental material
Descriptive statistics
Results and analysis
The regression results presented in table 3 show that the parameters of tax are positive and significant in all specifications, indicating a higher percentage tax increase leads to a larger percentage price increase in the ad valorem regimen. However, the parameter is less than one, implying the evidence of tax is partially passed on to consumers. Other parameters are sensitive to variable inclusions, suggesting the presence of omitted variable bias in restricted specifications. Thus, we use the unrestricted specification as the preferred specification. The Hausman test result for the unrestricted specifications between random effect and fixed effect suggests fixed effect regression to be used for our analysis.
Regression results
Based on equation (2), we tabulate the degree of tax pass-through for all cigarette types (table 4). We can see that the change from the ad valorem regimen to the mixed system resulted in increased tax pass-through for all types of cigarettes. This is consistent with2 15–18 the use of a specific tax resulting in higher tax pass-through. However, the change from the mixed tax to the specific tax causes a reduction in the tax pass-through, although the degree of tax pass-through is still higher than under the ad valorem regimen. We argue that despite Indonesia fully implementing a specific tax system, the number of tax tiers in the specific regimen is more than the mixed regimen, causing a reduction in the tax pass-through. As that tax rate is progressive and based on (among others) the production volume, an existing firm can avoid a higher tax rate to increase its profit by maintaining the production volume of the existing brand to stay in the same tax tier, and at the same time creating a new brand with a similar taste that will apply a lower tax rate due to a smaller production volume. With a lower applicable tax rate, a firm is able to sell cigarettes at a lower price. The results in table 4 suggest that the number of tax tiers is indeed negatively correlated with cigarette prices.
Summary of tax pass-through
The implementation of affiliated company regulations reduces the chance of avoiding a higher tax rate because the applicable tax is based on the combined production volume, and thus, increases the tax pass-through for directly affected firms. We can observe that the tax pass-through in table 4 is higher in the last row compared with the previous row for all cigarette types. The implementation of the affiliated company rule also increases cigarette prices for firms with no affiliation, indicated by the positive and significant parameter for 
.
From table 4, the tax pass-through of SPMs is always higher than SKTs and SKMs. One possible explanation for this is that SPM is the only cigarette type that does not have a flavour which reduces the consumers’ probability of switching to SKM or SKT. Consequently, producers are more willing to pass a large portion of cigarette tax increases onto the cigarette price. On the other hand, smokers who prefer flavoured cigarette have two options, namely SKM and SKT. As SKM and SKT contain cloves, both can be considered substitutes. A large increase in the cigarette price in SKT would cause consumers to switch to SKM (and vice versa). Thus, producers of SKT and SKM have a greater incentive to limit the price increase which results in lower tax pass-through compared with SPM.
Conclusion
This evaluation can inform policy-makers in Indonesia regarding the effectiveness of several policies in reducing the tobacco consumption in Indonesia. Despite the Indonesian government continuously increasing cigarette tax rates, the complicated tax structure reduces the effectiveness of the cigarette tax increases in making cigarettes less affordable. A multi-tier tax structure provides an incentive for tobacco firms to produce cigarettes that will have a lower tax rate applied. The absence of a minimum cigarette price (for all cigarette types) and the maximum excise tax rate of 57% also provides an additional incentive for tobacco companies to limit the price increase. This is because changing the maximum excise rate would require an amendment to the Indonesian Excise Law which is usually a lengthy process, so therefore reducing the number of tiers seems to be a possible solution to reduce cigarette consumption in the short term.
The Indonesian Ministry of Finance has issued a roadmap policy on cigarette tax simplification in 2017 through the issuance of Ministry of Finance Regulation No. 146. The roadmap rules that the number of tiers will be gradually reduced until five tiers remain in 2021. However, on November 2, 2018, the Ministry of Finance decided to neither raise the cigarette tax nor reduce the number of tiers in 2019. As the result of this decision, the government has missed the chance of reducing cigarette consumption through tier reduction. Our results suggest reducing one tier will increase cigarette prices by 2.9% (on average). Assuming that the price elasticity of demand in Indonesia is still −0.6 as found by Adioetomo Djutaharta,19 there will be a 1.74% reduction in cigarette consumption. As the total cigarette production in 2017 was around 330 billion sticks, this 1.74% reduction is equivalent to a reduction of 5.7 billion sticks.
Another possible government policy to reduce cigarette consumption is the implementation of a minimum cigarette price (for all cigarette types). However, learning from the implementation of the minimum cigarette price law in Malaysia,20 it is important to set a sufficiently high minimum cigarette price to reduce cigarette consumption significantly.
What this paper adds
A complex cigarette tax system implemented in Indonesia reduces the effectiveness of cigarette tax in increasing cigarette prices, because it lowers the degree of tax pass-through. Tier reduction and the implementation of the affiliated company rule since 2013 are expected to increase the degree of tax pass-through.
No prior study has examined the effectiveness of tier reduction and the affiliated company rule in increasing cigarette prices in Indonesia.
We found that both the tier reduction and the affiliated company rule increases the degree of tax pass-through, Non-affiliated firms are also found to have a greater level of tax pass-through after the implementation of the affiliated company rule.
References
Footnotes
Contributors BWP collected the data and other relevant information for the study, conducted the analysis and prepared the manuscript as a master thesis at the University of Indonesia. VA designed the study, conducted statistical analysis, wrote and revised the manuscript.
Funding This study was funded by Universitas Indonesia (http://dx.doi.org/10.13039/501100006378) and grant number: HIBAH PITTA 2018.
Competing interests None declared.
Patient consent for publication Not required.
Provenance and peer review Not commissioned; externally peer reviewed.
Data availability statement Data are available upon reasonable request.