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Q&A: why governments tax harmful behavior

The professor says excise taxes involve more than discouraging potentially harmful behavior: “It’s not that government should do it; it’s that the market requires it.”

We recently discussed excise tax policy with Professor Sijbren Cnossen of Erasmus University in Rotterdam. Cnossen has deep experience with tax issues and has advised several countries on their tax systems. Here’s what he had to say about the purpose of, and approach to, excise taxes.

Ros Barr (EY Global Indirect Tax): Could you briefly define what we mean by excise taxes?

Sijbren Cnossen: When I talk about excise taxes, I’m thinking about taxes applied on selective products that typically carry some negative impact — such as alcohol, tobacco, gambling, polluting and fossil fuel use, and, more recently, sugar consumption. The taxes improve social and market outcomes by internalizing the external cost that the use or consumption of these goods or services imposes on society.

If these external costs are internalized — by which I mean if they are included in the price — producers and consumers make better choices in using or consuming potentially harmful products. Because not only do these prices then include private costs, the purchase cost and so on, they also include the cost imposed on other people of consuming or producing these goods.

These costs can be financial, physical or psychological. For example, cars can crash because the driver is drunk and hits a passerby, or a nonsmoker may get smoke in his eyes, which irritates him. Taking another example, a low-lying delta like the Netherlands may be flooded on account of global warming due to fossil fuel burning.

Would you say that the main purpose of excise taxes is to allow governments to cover the costs of some of the harms caused by certain activities and perhaps to influence the behavior of consumers to consume less of the harmful goods or change their use to something that is less harmful?

The market requires that these costs be included in the price because they are real costs imposed on other people in society, and they should be included in the price to enable producers and consumers to make the right decisions. It’s not that government should do it; it’s that the market requires it.

Doing so improves the efficient allocation of resources because the price is a better reflection of all the costs that go into the product and that the product generates in consumption or production.

Do these types of taxes only apply to goods?

No. They can also apply to services. Think of gambling or road use, where drivers cause wear and tear to roads or — and I think this is a more pertinent example — cause congestion, which is a tax on labor because people sit idle in their cars.

Three-fourths of all the cost of road usage is congestion costs. And they are an external cost because you prevent another driver from getting where he wants to get to on time.

Do you think excise taxes should aim to raise revenue for governments?

Well, of course, traditionally, excise taxes are lucrative sources of revenue because they can be administered more easily than many other taxes. Duties on alcohol, tobacco, motor fuel oil and motor vehicles can be readily collected because the products are easy to identify.

The volume of sales tends to be high, so the revenue from them is high, too. And the fact that there are generally few producers for, say, cigarettes, alcohol and petroleum products simplifies revenue collection. Importantly, there are few substitutes for these products.

People cannot turn to other products to satisfy their wants. So consumption remains high despite the excise, which increases price. And that’s why excise taxes in most OECD [Organisation for Economic Co-operation and Development] countries still contribute about 10% of total tax revenues.

Do we have evidence that these taxes can actually influence consumer behavior?

Oh, yes, there is plenty of evidence that these levies have an impact on consumer behavior and on producer behavior.

Should they be used in this way?

Certainly! We want to change consumer and producer behavior by internalizing these external costs. Think of fossil fuel use. You really want to reduce that in order to limit the increase of the world’s temperature to 2 degrees. And taxes on these fuels are effective.

But there is also a potential problem. A good tax affects consumption best where the damage increases in proportion to consumption.

Now, that’s true of tobacco use, and that is true of fossil fuel use, but it’s not quite true of alcohol consumption or entertainment gambling, for instance.

If the excise on alcohol is increased to cover the external costs caused by heavy drinkers — and about 90% of all external costs are caused by 10% of alcohol abusers — then, of course, moderate consumers will also suffer, although there is no reason to penalize them.

And that’s also true of entertainment such as gambling. If we are rational adults and we are not addicted, why should we be taxed on what we are doing?

Does that mean that for some behaviors, excise taxes can have a more paternalistic role than is necessary?

Well, it could be. What we might say is that if the reduction in harmful consumption as a result of the imposition of the excise on heavy drinkers is greater than the welfare loss of the additional alcohol tax on moderate consumers, then probably we should proceed. But otherwise, we should not increase the tax.

Is there a way to determine what the optimum level for an excise tax should be?

Definitely! We have really good studies, particularly on alcohol and tobacco consumption and now also on fossil fuel use and on road usage, which clearly show how high the external cost is — that is, the costs imposed on other people.

And we can divide that cost by the number of liters of alcohol or the number of cigarettes, liters of gasoline or time and place where we drive, and determine the optimal excise per liter or per kilo or per number or per whatever the basis is.

What trends are we seeing in excise taxes around the world?

I think excise taxation used to be the stepchild of tax policy; it got very little attention. But I think this has changed as governments and people have become more aware of the harmful effect of the consumption and use of products such as tobacco and alcohol because the studies show that the external costs of over- or abusive consumption of these products are clearly very substantial.

But excises have really come to the fore through the increased awareness of the environmental damage that the overuse of fossil fuels can bring about. Global warming is a good example.

And that has led to interesting choices for governments in the tax policy arena, between, for example, taxes, cap-and-trade schemes like the European Union approach to CO2 emissions and command-and-control methods to combat global warming.

Do you see regional differences in the approach to excise tax policy?

I do, but I also see a converging awareness of attitudes to excisable products. For instance, the Paris agreement on global warming really brought everyone in the world together to do something about the human disaster that we may face if we don’t reduce the consumption and use of fossil fuels and look for alternative, clean forms of energy generation, such as solar panels and wind turbines.

That global awareness is also more pronounced with respect to smoking, drinking, gambling and driving. The World Health Organization has come out with a very strong stand against smoking quite successfully and is now taking on alcohol consumption, and that has influenced tax policies.

Of course, there are still differences between policy, practice and administration, and the external cost issue is not understood equally well everywhere. Sometimes governments raise more revenue than is commensurate with the level of the external costs, and that, of course, is where paternalism comes in.

If you confine the tax to the external costs, then you’re fine because you are improving the efficient allocation of resources. But if you go over that level, then there is paternalism unless the marginal cost of raising an extra euro in excise tax revenue is lower than the marginal cost of raising an extra euro from other taxes.

Do you see any differences between developed and emerging economies in this area?

I think that the ability to impose certain excise taxes is greater in developed than in emerging economies. It’s important, too, to have effective alternative revenue instruments, for example, if you need to compensate for the loss of revenue as a result of the lower use of taxed fuel or you need to cover the cost of investing in harnessing energy from the sun or the wind.

And the administrative capacity to do that may be lower in emerging economies than in developed ones.

The UK has seen some new taxes aimed at improving health or the environment, such as the recent plastic bag charge and a forthcoming tax on sugary drinks. Are these common developments worldwide?

Many African countries also impose a tax on plastic bags. And in the Netherlands, we have to pay something extra in order to get a plastic bag from the shop owner. So yes. That’s a growing trend.

And taxes on sugary drinks are now coming to the fore. Sugar causes obesity. We know that. And obesity is a big problem in many countries. The issue we face here from a tax policy perspective is that the excise is imposed on sugary drinks but not on candy or other forms of sugar.

So we see a real shift in consumption from what I call fluid candy to solid candy. And that’s not going to help the obesity problem. If we want to tax sugar, we should tax all sugary products, including candies, sweet cookies, sugar coatings and so on.

What would you say is the main difficulty for governments in applying and collecting excise taxes?

Well, specific or production-based excise taxes are a lot easier to apply and collect than ad valorem sales-based taxes. It’s much easier to count goods, weigh them and determine their strength and so on than to inspect books of account for compliance purposes. I want to emphasize that.

Excise tax rates should be specific — that is, expressed as a fixed amount per kilogram, per liter, motor vehicle or whatever measure is most appropriate. External costs can be translated into a specific rate but not into an ad valorem rate.

In addition — and I emphasize this in respect of developing countries — specific rates are much easier to administer because they do not involve the sort of margin-shifting avoidance techniques we have seen for taxes based on value.

The only problem is that the real value of revenue raised through specific rates can be eroded over time. So if you adopt specific rates, you have to give the minister of finance discretionary power to increase them if inflation exceeds, say, 2% or 3%.

Because you can pinpoint the place of production, import or storage of excisable goods, these taxes might be easier to collect and administer than some other taxes. Is that right? What about for taxpayers?

Well, governments can still have a problem with imposing taxes on homegrown products such as wine and tobacco, especially in developing economies. You see this with tobacco and beer all over Africa.

So that can still make it difficult for governments to apply and collect the excise. But that’s not true for petroleum products, of course, and not necessarily true of cars or motor vehicles.

The main difficulty is that some excise taxpayers object to the large sums of money they have to pay to the government. And they will often come up with the argument that the consumer has not yet paid the excise at the time it is levied, so there is a cash flow cost.

And what you see in many countries is that the excise tax rate tends to be horrendously complicated, depending on the length of cigarettes, whether there is a mouthpiece or what the retail price is. You have the same with alcohol.

People think that imported whiskey, for example, should bear a higher tax than locally manufactured products even though the external cost of abusive consumption is the same. So that tends to complicate excise tax administration and compliance.

A comment that I have heard from multinational companies in this respect is that one of the difficulties they face in the excise tax compliance burden is the lack of harmonization of these types of taxes between countries.

That’s particularly true for multinational companies because they do not want their products to be discriminated against. But it’s also a problem for tax administrators.

If rates were closer for cross-border sales, we would have much less wasteful cross-border shopping between, for instance, the UK and Belgium. The European Union could do more in this respect. Common specific alcohol duties have not been raised since 1992.

Let me go back to the importance of specific rates. In many countries, excises are calculated on the import value of products and, of course, then you get into the discussion about what the value of the excisable product is. If you had specific rates, you would not encounter that issue.

What can we expect to see in the future in the development of excise taxes?

I think we will see greater attempts to improve the proper administration of excise taxes and particularly those imposed for an environmental purpose or in connection with transportation. I think there is still a lot of tax policy work to do in the field of transportation.

I foresee that we probably will get agreement on imposing excises on the fossil fuel use of planes and ships plying international skies and waters, and we may see greater use of excises on “bad” foodstuffs, such as sugar. In many instances, however, it would be better to raise the reduced VAT rate on foodstuffs to the level of the standard rate before embarking on excise taxation of selected foods.

Further, we will see more attention being paid to the regulatory approach. Regulations are really a supplement to excise.

There are many instances where the excise does not achieve what we want it to achieve but where regulations can. For instance, imposing server liability for alcohol sold to minors, not having cigarette vending machines in hotels or in schools, or prescribing engine emission levels for new cars. That type of regulation is equivalent to excise taxation and helps a lot in reducing or regulating consumption.

If someone came to you tomorrow and said it’s your opportunity to impose a good excise tax, what features would it have?

I would internalize the external costs of all the activities which I have mentioned — smoking, drinking, gambling, polluting, fossil fuel consumption and use, also maybe sugar consumption and driving — and I would make sure that the excise equals the marginal external cost of production or consumption.

And I would make the rate specific. I would impose it on all — well, on nearly all — products whose use or consumption entails external costs. But I realize that some external costs are so small that we shouldn’t bother.

I would not want to “reform” society through excise taxation. I would not impose excises in excess of external costs because I think that is paternalism, which I do not favor. But I would impose it up to external costs because that’s what the market tells me that I should be doing.

Read more: Indirect Tax in 2017

The views of third parties set out in this publication are not necessarily the views of the global EY organization or its member firms. Moreover, they should be seen in the context of the time they were made.

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