Title of the Government to Revise Indonesia’s Tobacco Excise Tax Policy

article
URL of the https://www.indonesia-investments.com/finance/financial-
article columns/government-to-revise-indonesia-s-tobacco-excise-tax-
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No of words 746
Date of 22 August 2017
publication
Date of 29 January 2018
Commentary
Written
Section of Market Failure
Syllabus

Government to Revise
Indonesia's Tobacco Excise
Tax Policy
Every year Indonesia's Tax Office adjusts the excise tax on tobacco products.
The adjustment is always made in consideration of the central government's
tax revenue targets as well as the input of specific stakeholders (including
pro-health lobby groups, or groups that defend the interests of tobacco
manufacturers or farmers).
22 August 2017 |

Coming September the tobacco excise will be revised again (while the actual implementation follows
in January 2018). Heru Pambudi, Director General of the Finance Ministry's Directorate General of
Customs and Excise, said tariffs of three segments will be revised: (1) machine-rolled white
cigarettes, (2) machine-rolled kretek cigarettes, and (3) hand-rolled kretek cigarettes.

Pambudi added the hand-rolled kretek cigarettes segment will see the smallest increase in excise tax
because hikes tend to have a bigger impact on this labor-intensive sector (cigarette manufacturers
could decide to layoff workers).

Besides collecting additional tax revenue, tobacco excise taxes also aim at discouraging smoking,
hence improving people's health.

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Per July 2017 Indonesia's Tax Office collected IDR 78.7 trillion (approx. USD $5.9 billion),
consisting of IDR 58.2 trillion of excise taxes, IDR 18.5 trillion of import duties, and IDR 1.9 trillion
of export duties. Pambudi added that this performance is better compared to the performance in the
same period one year earlier.

However, Muhaimin Moefti, Chairman of the White Cigarette Manufacturers Association

(Gaprindo), urges the government not to raise tobacco taxes as it will impact negatively on the
domestic tobacco industry.

Considering production volumes in Indonesia's tobacco industry have not been able to rise over the
past three years, another excise tax hike would put too much additional burden on the industry,
Moefti said. In fact, cigarette production volumes have contracted by around 2 percent after the
government introduced an average 15 percent excise tax hike in 2016. The impact of that shock is
still felt in the industry today. Moreover, it is also reason why the government's tax revenue target
from the tobacco industry has not been achieved (part of the smoker community could not afford to
buy as many packages as they did before).

Indonesia remains an attractive market for cigarette producers. The World Health Organization
(WHO) claims that there were 95 million Indonesian smokers in 2015, and - even more alarmingly -
20 percent of the Indonesian youth were categorized as smokers. This also explains why cigarette
producers Gudang Garam and HM Sampoerna are among the top ten biggest companies in terms of
market capitalization on the Indonesia Stock Exchange.

However, recent government actions - for example drastically hiking tobacco excise taxes and
curbing tobacco advertisement - have had a big impact on the industry and therefore many analysts
say Indonesia's tobacco industry is now heading for its "sunset".

So far this year shares of HM Sampoerna have fallen 7.05 percent to IDR 3,560 a piece. Meanwhile,
shares of Gudang Garam still managed to climb 11.27 percent over the same period.

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 IA Commentary
This article is about the upcoming annual revision in tax policy on tobacco products in Indonesia.
Tobacco is a demerit goodi as it not only cause various adverse health effects to the smoker, it
causes negative externalities to third parties. The health of nearby non-smokers who inhales the
smoke produced will be harmed (also known as second-hand smoking).

Overconsumption of tobacco, a demerit good, is an example of market failureii. Tobacco is

produced at a higher quantity than what is socially preferred. In a free market, incentives for
personal gain and profit can lead to a socially undesirable consequence. For that reason, the
government of Indonesia could intervene to attempt to correct the negative externality through
taxation.

Negative externality

Price of
Tobacco S=MSC=MPC

(IDR)
𝑃1
P Welfare loss
A

D=MPB
MSB
0 Q 𝑄1
Quantity (packs) of Tobacco
Fig.1.1 MPB and MSB of Tobacco

As seen in the Fig.1.1, the MPB (marginal private benefit) curve, which is also the demand in the
free market system, is more than the MSB (marginal social benefit) curve. In this graph, MPC
and MSC are assumed to be equal. The difference of MPB and MSB is the negative externality
from consumption of tobacco. This causes the quantity produced to be at 𝑄1 which is higher than
the socially efficient allocation, Q. The negative externality causes a welfare loss (such as the
loss in productivity of labour and hospital cost incurred by third parties), presented as triangle A.

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 E
Price of
Tobacco
F 𝑆2 =𝑆1-tax
(IDR)
𝑆1=MSC
𝑃2 .𝑒 2
A
G. tax
𝑃1 B 𝑒 1
P D C

D=MPB

MSB

0 Q 𝑄2 𝑄1 Quantity (packs) of Tobacco

Fig 1.2 Tax on tobacco
When tax is levied by the Indonesian government, the supply curve shifts from 𝑆1 to 𝑆2 , causing
the equilibrium to move along the demand curve from 𝑒1 to 𝑒2 . This increases the price from 𝑃1
to 𝑃2 and quantity to fall from 𝑄1 to 𝑄2 , closer to Q, the socially optimal output. The welfare loss
also decreases from C+D to only D.

Taxation generates government revenue, shown as rectangle A+B. Rectangle A and B is the tax
burden for the consumers and producers respectively. Rectangle A is much larger than B. This is
because demand curve for tobacco is often said to be inelastic; meaning the percentage change in
quantity demanded is smaller than the percentage change in price. The addictive nature of the
nicotine causes smokers to feel that other goods is not substitute for smoking. The rise in price
also cuts the consumer surplus from A+F+E+G to only F+E, meaning that consumers are now
worse off as some consumers can’t afford the higher price while those who still buys needs to
spend more money.

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Although producers have lesser tax burden compared to consumers, they are still heavily affected
by the previous 15% excise tax hike. As indicated by the 7.05% fall in price for the shares of
Gudang Garam, one of the largest cigarette company in Indonesia.

On the downside, many would argue on the effectiveness of taxing cigarettes because a high tax
can only do so much to discourage people from consuming it, as seen by the relatively smaller
reduction of output due to the elasticity. However, since government generates high tax revenue
from this, it may also be effective to reinvest the tax collected on promoting the dangers of
smoking through advertisements or education for the youth. Perhaps the taxing cigaretters would
be more effective for younger smokers as the demand is more elastic. Younger smokers tend to
have lower income, so buying cigarettes takes up a higher proportion of inome. Taxing cigarettes
may successfully shift their preference as compared to older smoker who may have acquired the
habit through many years of smoking.

In addition to that, the tax may hurt economic growth and employment. Since hand-rolled kretek
cigarettes, which have a labour intensive production, employs many workers, unskilled workers
are much worse off as they are first to be dismissed when lower quantity of output is produced.
This is highly concerning for a developing country like Indonesia that has large numbers of
unskilled workers.

Taxing tobacco will indeed reduce consumption of cigarettes to some extent, but in the short run,
the government may be unpopular amongst consumers, workers and producers. Fortunately, it is
outweighed by the benefits in the long run as it will increase the health of people and reduce
negative externality such as hospital bills. The tax may even effectively reduce young consumers
who are less addicted to cigarette, making a healthier new generation. The government must set a
tax rate which will neither put heavy burden on disadvantaged stakeholders yet still reduce
smoking as much as possible.

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Bibliography
i
Tragakes, Ellie. Economics for the IB Diploma. Cambridge University Press, 2012.
ii
Blink, Jocelyn, and Ian Dorton. Economics: Course Companion. Oxford University Press, 2012.