Other important aspects of Article 6 recommendations approved at COP5

25 Jun 2013

Photo courtesy www.worldlungfoundation.org

 

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The draft guidelines sent to COP5 for discussion pointed out that,7 if tobacco product prices remain the same while incomes rise and when there is inflation, tobacco products become more affordable and consumption increases. This is shown visually in Appendix 1.

COP5 adopted a recommendation that:

Parties make tobacco products less affordable over time “by taking into account both price elasticity and income elasticity of demand, as well as inflation and changes in household income”.8

[To reduce consumption and therefore benefit public health, tobacco taxes and prices need to increase by substantially more than inflation and increases in average income.

These concepts — the impact of inflation and income on demand for tobacco products — are discussed in more detail in the WHO Technical Manual on Tobacco Tax Administration (pp. 87-88 in the English version).]9

Note also that substitution has an impact on affordability and can undermine the impact of a tax target. That is, if taxes on some but not all tobacco products increase, smokers are more likely to use the more affordable types of products rather than quitting or cutting down. This is discussed in more detail below.

Advocates should use the affordability recommendation to push for annual tax increases over and above inflation and income growth.

 

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Tobacco taxes can be either specific or ad valorem — or a combination thereof. Specific taxes are a fixed amount per quantity of tobacco products (e.g. $1 per pack of 20). Ad valorem taxes are a percentage mark-up on price (e.g. 30 percent, added to the retail price, or 40 percent added to the manufacturers’ price).

COP5 adopted a recommendation that:

Parties should implement the simplest and most efficient system that meets their health and fiscal needs, and taking into account their national circumstances. Parties should implement specific or mixed excise systems with a minimum specific tax floor, as these systems have considerable advantages over purely ad valorem systems.10

The draft guidelines submitted to COP5 described the advantages and disadvantages of using ad valorem taxes alone, specific taxes alone, and a combination of the two systems, in Section 3.1.

The main advantage of ad valorem taxes is that they automatically increase when prices increase, either as a result of inflation or as a result of price hikes by manufacturers/retailers etc.

But there are significant disadvantages. Relying on ad valorem taxes alone can mean that tobacco products remain extremely cheap. For example, an ad valorem tax of 100 percent of the manufacturer’s price on a pack sounds like a lot. But if the manufacturer’s price is only $0.50, the retail price of the pack will be $1.00, an amount that would be very affordable in many countries.

Ad valorem taxes also ensure greater price differences between basic and “premium” products, meaning that, when taxes go up, more smokers will switch to the lower-priced brand rather than reduce their consumption. This will partially undermine the public health impact of any tax increase.

Also, ad valorem taxes give the tobacco industry considerable influence over the amount of tobacco tax revenue the government collects. In some situations, increases in ad valorem taxes can be met by cuts in manufacturers’ price, leading to no increase in revenue.

Specific taxes, on the other hand, establish a minimum tax amount for a product, and a de facto minimum price. For example, a specific tax of $0.20 per stick ensures that smokers will pay at least $4.00 for a pack of 20 cigarettes, whether it is a low-price or premium brand. Overall, affordability is more easily controlled with specific taxes.

Specific taxes are also easier to administer than ad valorem taxes, because manufacturer, distributor and retailer pricing decisions have no impact on the amount of tax owed. In an ad valorem system, governments need to decide what price the tax applies to — the price manufacturers charge wholesalers? — the price wholesalers charge retailers? — the final retail price recommended by manufacturers, before taxes? — the price of a particularly popular ‘reference’ brand? Some options create opportunities for tax fraud. For example, a manufacturer can declare that their “recommended retail price” or list price is $0.80 per pack, but actually price the product at a higher pre-tax level of $1.20, thus reducing their tax charge.

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An issue in many countries is the difference in tax treatment and affordability between various tobacco products. This is important for public health because if some types of products are taxed more heavily than others, or if tax increases apply only to some products, smokers can continue to smoke or use other forms of tobacco that are more affordable. This is known as “substitution”, and it reduces the impact of tax increases on consumption.

COP5 adopted a recommendation that:

All tobacco products should be taxed in a comparable way as appropriate, in particular where the risk of substitution exists.

Parties should ensure that tax systems are designed in a way that minimises the incentive for users to shift to cheaper product in the same product category or to cheaper tobacco product categories as a response to tax or retail price increases or other related market effects.

In particular, the tax burden on all tobacco products should be regularly reviewed and, if necessary, increased and, where appropriate, be similar.11

In some countries, the biggest problem is with cheap direct cigarette substitutes, such as roll-your-own tobacco, or loose tobacco labelled as “pipe tobacco”, that is used primarily to roll homemade cigarettes. Sales of these substitutes may be significant, and cheaper taxes on these products will significantly undermine the impact of higher taxes on cigarettes.

For example, in Uruguay, the tax and price differential between roll-your-own tobacco and manufactured cigarettes has been partially responsible for less-than-expected decreases in total tobacco consumption in that country, despite other strong tobacco control policies.12

In other countries, the tobacco product alternatives may not be direct cigarette substitutes, but are widely used tobacco products nonetheless, such as gutka or waterpipe. So if taxes are raised only on cigarettes but not on waterpipe tobacco, many tobacco users will be unaffected by the tax increase.

For example, in India manufactured cigarettes comprise a minority of the tobacco market. There is a very large disparity in the tax treatment of cigarettes as compared to bidis (tobacco rolled in tendu leaf, for smoking) and various forms of oral (non-smoked) tobacco. The latter two categories of products — which comprise most of the market — are taxed at very low rates.13

Differences in tax rates on manufactured cigarettes and other tobacco products not only undermine public health, they also hurt the public treasury. A recent US government report estimated that the tax-rate gap between roll-your-own tobacco and pipe tobacco, as well as between small cigars and large cigars, had cost the government $615 million to $1.1 billion in lost tax revenue by 2011, following the large federal tobacco tax increase in 2009.14

There are several reasons for differing tax treatment of different products:

  • Roll-your-own tobacco is usually taxed by weight while cigarettes are often taxed by stick (or by pack, which has the same effect). Taxes by weight are open to manipulation by manufacturers, who have developed various techniques to puff up tobacco and lower product density, meaning that less loose tobacco is needed to roll a cigarette. By doing so, they reduce the tax payable per hand-rolled cigarette, making roll-your-own much cheaper than manufactured cigarettes.
  • Some finance ministries consciously choose to set lower tax rates on roll-your-own tobacco on the (misguided) theory that these products are used mostly by low-income smokers who can’t afford to pay as much tax as smokers of manufactured cigarettes.
  • Some countries explicitly try to protect some industries over others. For example, in Bangladesh’s 2011-2012 budget speech, the Minister of Finance announced tax increases for manufactured cigarettes and for chewing tobacco, but spared bidis from the increase, stating, “However, this will not jeopardize the Bidi industry in any way as no new tax burden are imposed rather other comparative advantages have been increased.” [sic]15

Make sure you understand the reasons for different tax rates on different products in your country, in order to help you determine the best strategies to align tax rates to reduce or avoid substitution to lower-priced products, and to push for these strategies based on the Article 6 recommendations.

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COP5 adopted a recommendation on requiring fiscal markings.

In many countries, manufacturers are obliged to buy tax stamps, often paying the full amount of taxes due on one pack of cigarettes for each stamp. Stamps are designed to be as difficult as possible to counterfeit (covert markings can be used to make them harder to copy), and are often numbered, as with bank notes. This allows enforcement officials to do spot checks at the wholesale and retail level, with a good chance of detecting tobacco products on which no tax has been paid.

Markings systems can be extended to include key information on a particular pack of cigarettes, such as where it was manufactured, for which market it was destined, and who the first purchaser was. This is the first step in a tracing system, which allows authorities to re-create the trajectory of product found on the black market. In a tracking system, governments attempt to monitor flows of tobacco products, with a view to detecting “anomalies” as they occur. For example, a large shipment of Colombian-made cigarettes that is declared as being for sale in Cambodia should raise suspicions, as it is unlikely there is a significant legitimate market in Cambodia for Colombian cigarettes.

Advocates should highlight this recommendation to tax authorities, along with other successful anti-smuggling strategies, when the argument that “higher taxes increase smuggling” is raised.

Impact of different tax scenarios on price, market shifts, and taking inflation into account

The three scenarios in the following section illustrate possible outcomes from increases in different types of taxes.

Imagine a country is introducing tobacco taxes for the first time. In this country, there are only two brands: A local brand selling at $0.80 per pack, and an international brand selling at $1.20 per pack. Each brand has a market share of 50 percent.

There are two proposals on the table, one to impose an ad valorem tax of 50 percent of the pre-tax retail price, the other to impose a specific tax of $0.50 per pack. These increases, on the face of it, seem to be quite similar: Initially, they would both seem to raise the average tax per pack by $0.50.

But this is not what actually happens, if you take into account industry price cuts — more likely to happen with ad valorem than with specific taxes — and the market shift that results. As you will see in detail in the following section, the three scenarios have different outcomes for the price difference between brands and thus their relative market share, for real price, for per capita consumption as a result of these two factors, and for government revenue.

In short, specific taxes are generally superior to ad valorem taxes for both revenue and health outcomes, so long as they are adjusted for inflation from time to time.

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Sketching out scenarios like this can help you analyse the likely impact of different levels and types of taxes in your country.

Scenario 1: Ad valorem tax of 50 percent of retail price; equal market share between brands

  Local Brand International Brand
Price before tax increase $0.80 per pack $1.20 per pack
Price difference between local and international brand, in percent The international brand is 50% more expensive than the local brand.
New ad valorem tax rate 50% of pre-tax retail price
Amount of tax payable $0.80 x 50% = $0.40 $1.20 x 50% = $0.60
New price $1.20 (0.80 + $0.40) $1.80 ($1.20 + $0.60)
New price difference between local and international brand, in percent The international brand is still 50% more expensive than the local brand.
Price five years later, after 50% cumulative inflation (but no industry price increases above inflation) $1.80 $2.70

Outcomes of Scenario 1:

  1. The price difference between the local and international brands remains at 50 percent, but the overall increase is prices is likely to result in some down-trading — that is, moving from the international brand to the cheaper, local brand. Hence, tax revenue per pack will likely be less than $0.50.
  2. The price continues to increase with inflation, because inflation increases the retail price, and the ad valorem tax is a percentage of the retail price. The 50 percent price difference between brands is also preserved. However, the real price has stayed the same, because the price has kept up with, but has not exceeded, inflation.

Scenario 2: The same ad valorem tax of 50 percent, countered by industry price cutting

  Local Brand International Brand
Price before tax increase $0.80 per pack $1.20 per pack
Price difference between local and international brand, in percent The international brand is 50% more expensive than the local brand.
New ad valorem tax rate 50% of pre-tax retail price
Industry’s adjusted price $0.60 $1.00
Amount of tax payable $0.60 x 50% = $0.30 $1.00 x 50% = $0.50
New price $0.90 ($0.60 + $0.30) $1.50 ($1.00 + $0.50)
New price difference between local and international brand, in percent The international brand is now 67% more expensive than the local brand.
Price five years later, after 50% cumulative inflation (no industry price increases above inflation) $1.35 $2.25

Outcomes of Scenario 2:

  1. The industry price cut has resulted in a lower-than-anticipated per-pack tax revenue of $0.40 per pack at the time of the tax increase.
  2. The industry price cut gave a greater price advantage to the local brand, therefore increasing the price difference between the two brands. This is turn will likely shift the market more strongly in favour of the local brand and result in an even lower average tax revenue per pack over time, owing to this market shift. Let’s assume a shift to 70/30 percent in favour of the local brand. The average increased tax revenue per pack would be $0.36.
  3. As with Scenario #1, the price continues to increase with inflation, keeping the real price stable (although at a lower level because of the original price cut).

Scenario 3: Specific tax

  Local Brand International Brand
Price before tax increase $0.80 per pack $1.20 per pack
Price difference between local and international brand, in percent The international brand is 50% more expensive than the local brand.
New specific tax rate $0.50 $0.50
Amount of tax payable $0.50 $0.50
New price $1.30 $1.70
New price difference between local and international brand, in percent The international brand is now only 31% more expensive than the local brand.
Price five years later, after 50% cumulative inflation (no industry price increases above inflation) $1.70 (original price of $0.80 x 1.5, plus $0.50 tax) $2.30

Outcomes of Scenario 3:

  1. The price difference between the local and international brands is decreased from 50 percent to 31 percent, meaning that the market may shift from the current equal market share between the two brands in favour of the international brand. This will increase the percentage of smokers paying a higher price for cigarettes, thus amplifying the impact of the tax in decreasing consumption.
  2. The tax revenue per pack is predictable at $0.50, regardless of market shifts, because the amount is fixed for all brands.
  3. The price increases with inflation, but the tax portion of the price does not. Therefore, the overall real price will decrease, unless further tax increases are made to keep up with or exceed inflation. Furthermore, real tax revenue for government will decline.

Solution: increase the specific tax to reflect inflation – i.e. to $0.75 per pack by the end of the five-year period.

 

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Proceed to Appendix 1

7 Document FCTC/COP/5/8, Draft guidelines for the implementation of Article 6 of the WHO Framework Convention on Tobacco Control: Report of the working group, Available on-line.

8 Decision FCTC/COP5(7). Set of guiding principles and recommendations for implementation of Article 6 of the WHO Framework Convention on Tobacco Control.

9 WHO Technical Manual, op. cit.

10 FCTC/COP5(7), 3.1. Available on-line.

11 FCTC/COP5(7), 3.3. Available on-line.

12 Another factor in Uruguay was rising household income which far outpaced increases in tobacco prices. See Ramos-Carbajales A, Curti D. Política fiscal, asequibilidad y efectos cruzados de precios en la demanda de productos de tabaco: el caso de Uruguay.[Fiscal policy, affordability and cross effects in the demand for tobacco products: the case of Uruguay]. Salud Publica de México 2010ñ 52 suppl 2:S186-S196. Available on-line.

13 John R et al, The economics of tobacco and tobacco taxation in India. IUATLD.

14 US Government Accountability Office. Report to Congressional Committees. Tobacco Taxes: Large Disparities in Rates for Smoking Products Trigger Significant Market Shifts to Avoid Higher Taxes. April 2012.

15 Towards building a happy, prosperous and caring Bangladesh. Budget speech 2011-12. Abul Maal Abdul Muhith, Minister, Ministry of Finance Government of the People’s Republic of Bangladesh, Dhaka, 26 Jaisthya 1418, 9 June 2011. Available on-line, p. 177.

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