Over 300 billion cigarettes are sold each year in Indonesia, making it the world’s second largest cigarette market after China. As such, it is important to know how Indonesia taxes tobacco products. Last year, I wrote about the counterproductive complexity of the country’s tobacco tax system, but in December Indonesia announced some positive design changes. As of January 1, 2022, the number of tax brackets has been reduced.

The reduction in brackets is an important and welcome first step in simplifying the tax treatment of cigarettes. Following the changes, the number of taxation levels was reduced to eight by combining four existing levels into two. At the same time, taxes were increased by an average of 12%.

The following table contains the new rates and levels.

Although the new design represents an improvement, the government is expected to continue to reduce the number of tiers in future years. There is still too much unnecessary complexity in the design. For example, the majority (73%) of cigarettes sold in Indonesia are machine-made kretek cigarettes (tobacco is mixed with cloves). This type of cigarette is taxed at one of two rates depending on the quantity manufactured and the price. If a manufacturer manufactures more than three billion cigarettes, the tax is IDR 985 per stick ($1.38 per pack). If a manufacturer manufactures less than three billion cigarettes, the tax is IDR 600 per stick ($0.84 per pack). The difference between the high rate and the low rate is 39%, but the products are responsible for similar negative externalities and societal costs. On a positive note, until this year there were three tiers for machine-made products kretek cigarettes, and less is better.

Although the tiered system may offer some tax relief to “small” manufacturers, it also introduces the risk of tax arbitrage. It is important to note that the rate change does not affect the marginal cigarette – each cigarette is taxed at the highest rate if a manufacturer manufactures more than three billion sticks. A tax rate difference of nearly 40% and a steep cliff encourage manufacturers to stay below the limit through tax arbitrage. Quantity thresholds, however, are not the only perverse incentive in the design: the current tax design also provides a lower tax for certain products sold at lower prices, which means that low-priced products are essentially subsidized. This incentive could encourage companies to reduce the quality of their products to keep costs as low as possible. If more products are sold at lower prices, both the consumer and the tax collector lose out, as this impairs consumer choice, increases the costs of collecting taxes and reduces revenue generated from the levy.

Excise taxes on tobacco products should be levied to internalize externalities (offsetting societal costs) associated with consumption, and well-designed taxes have the added benefit of raising revenue and improving public health . Tobacco taxes already have relatively narrow tax bases, and further narrowing only serves to introduce instability into the design of the tax. Taxes should avoid favoring certain manufacturers by picking winners and losers. In Indonesia, the tiered system still fails to offset societal costs, as similar products are subject to different tax rates even though there is no difference in harm between a cigarette made by a “ small” manufacturer and a large manufacturer. Moreover, arbitration eliminated any advantage for small domestic manufacturers.

Further simplifying the design to ultimately collect only one flat rate would make the tax more efficient in terms of offsetting the societal costs associated with consumption, but it would also reduce the costs of collecting the tax as the scope for arbitrage would be limited .

Indonesian lawmakers should continue down the path of reform to eliminate perverse incentives in their tobacco excise tax and continue to simplify the design. This would represent sound excise duty policy, but would also improve revenue generation and have a positive impact on public health.