Uneconomical

It seems difficult for some to understand that high rates of taxation do not necessarily mean large revenues to the Government, and that more revenue may be obtained by lower rates. — Andrew Mellon 

After the close of the First World War, the US found itself encumbered by high indebtedness. The war waged in another continent seriously strained Washington’s finances. The bonds floated to finance the war effort needed to be repaid.

Freshly-elected US President Warren Harding decided to take the fiscal bull by the horns in order to avert economic decline. He ordered a comprehensive review of fiscal policies. To oversee the process, he convinced a brilliant banker Andrew Mellon to serve government as Treasury Secretary.

Mellon was, at that time, a legend in his own time. If the financial world was like the Catholic Church, Mellon would be a saint.

A lesser mind, responding to the huge public debt, might have impulsively moved to raise tax rates. Mellon did not — which is why he has become such an icon in fiscal management.

Mellon understood that if tax rates are too high, people will tend to buy less products. The economy will slow down and the net effect will be that government will collect less revenues in the end.

Mellon saw that sharply raising tax rates will be uneconomical in the end. Consumers, the domestic economy and government will all suffer in the end.

Instead of escalating tax rates, Mellon took the counter-intuitive strategy. He maintained existing rates and tried to grow the economy instead. That strategy, supplemented by disciplined public spending, produced better results. Manufacturing grew, more people were employed and, ultimately, government collected more revenues.

Often, people in power, anxious for quick solutions to tight fiscal fixes, go for the simplest strategy that leaves the economy in ruins down the road.

It will do well for the economic managers of this administration to carefully study Andrew Mellon and that particular episode in US fiscal history before they push for a 1,000% increase in excise tax rates on manufactures described as “sin products.” The blowback on the domestic economy of such a steep tax increase might be unmanageable.

It will also do well for our taxmen, Finance Secretary Cesar Purisima in particular, to carefully study the complex experiences of our neighbors with regards punitive taxation on “sin products.” These are more recent and also more comparable experiences.

Singaporean Prime Minister Lee Hsien Loong, for instance, announced in 2006 plans to substantially raise tobacco duties. He eventually, and reluctantly, backed off from doing so after realizing that government revenues were falling drastically not so much because people were smoking less but because tobacco smuggling had spiked.

Across the straits, meanwhile, Malaysia went ahead increasing tax rates on tobacco products by an average of 22% from 2004 to 2010. They now probably regret doing so.

Over that period, sales of legitimate cigarettes dropped by 25% as illicit and smuggled products rose sharply. In the face of a dramatic shift in consumption patterns from legitimate to smuggled tobacco products, Kuala Lumpur implemented expensive security measures such as the use of high tech tax stamps procured from Sicpa Products Technology. The same technology is being offered to the Philippine government.

As it turns out, the cost of enforcement is eating up whatever revenue gains there might be. Only the supplier of the expensive tax stamp seems to be making money out of this situation.

Meanwhile, there is large-scale economic dislocation in the farming communities as purchases of tobacco leaf plummet. Malaysian agriculture authorities released data describing the extent of economic dislocation.

Sales of Malaysian tobacco leaf reached a high of 12.9 kilos in 2004. After the new tax schedule was imposed, sales dropped to 9.4 million kilos. By 2007, tobacco leaf sales plunged to only 6.4 million kilos or only half of what it used to be. The trend continues.

By no means does this indicate that cigarette use declined by the same proportion, resulting in public health gains. A study done by Goldman Sachs identifies Malaysia as having among the world’s highest levels of cigarette contraband. Contraband cigarettes increased from 14% to a whopping 39.7% by 2010.

What this tells us is that Malaysian smokers are shifting from regulated to unregulated tobacco products. The cost of enforcing the new taxes must have risen to impossible highs that Kuala Lumpur could not reverse the trend towards contraband. Production of contraband cigarettes must be a growth industry elsewhere, outside the Malaysian government’s tax net.

It is imaginable that, given the drop in tobacco leaf sales, Kuala Lumpur must now be spending more to provide a social safety net for the badly-hit farmers. They must be spending quite a lot of money to help farmers transition to another crop or to simply subsidize their losses from dropping sales. If they do not do that, social and political tensions are bound to rise.

This can only contribute to eradicating whatever revenue gains Kuala Lumpur’s taxmen might have hoped to gain from over-taxing tobacco products. They did not look as the economic consequences closely enough.

Neither, it seems, have our own taxmen studied the economic complexities that might arise from this even more drastic proposal to raise excise taxes by 1,000%. Typical of the way things are done under this administration, proponents of the sharp increase in excise taxes could not satisfactorily answer questions during the House hearing. Consequently, a decision on this administration priority measure was postponed.

Meanwhile, farmers in the north have taken to intentionally misspelling the Finance Secretary’s name as “Poor-isima.”