There is a rule of thumb that relates the rate of tax increase to the loss of sales due to reduced consumption. According to this rule, consumption decreases by 7% for every 10% increase in retail prices. It is a factor that tax authorities take into account when considering tax increases and it is also used as an argument for assisting smokers to quit. But the rule can be misleading.
One company questioning whether aggressive tax increases really cause smokers to quit or cut down is BAT, which states that ‘there is evidence to show that while some smokers are encouraged to stop or smoke less, punitive tax rises do not result in proportionate reductions in cigarette consumption’.

Vested Interest

Admittedly, it would say so. Clearly the tobacco industry has a vested interest in fighting the tax increases that make their product less attractive to their customers, but it does have a valid point. As it indicates, ‘most national governments are parties to the World Health Organisation’s Framework Convention on Tobacco Control which requires them to use tax or price policies to cut tobacco consumption. However, data shows that  rapidly-rising tobacco taxes are likely to drive many smokers to find cheaper, often illegal (untaxed counterfeit and smuggled) alternatives to their usual brands.’

In other words, the 7% decrease in consumption that is a consequence of every 10% increase in taxes refers to a decrease in legitimate consumption. The illicit trade accounts for an ever increasing proportion of the tobacco market in a growing number of countries – an estimated 50% in Hong Kong, 30% in Ireland and over a third across Canada. At the same time, there is evidence that consumption increases during periods of tax increases. The two are not unrelated!

Taking the UK as an example, cigarette retail prices rose 55% over the period 1994-2000 but, according to the ONS (Office for National Statistics), the adult smoking rate of 27% in 1994 was unchanged six years later. What had changed was the proportion of the market accounted for by cigarettes that were smuggled, counterfeit or the result of cross-border shopping. From a level of virtually zero in 1994, by 2000 illicit cigarettes accounted for 31% of the market.

From 2000 the government – which had been increasing taxes each year 3-5% above inflation – changed tack and increased taxes broadly in line with inflation instead. It also began tackling smuggling more actively and this new strategy, combined with health education campaigns and other measures, led to a drop in the adult smoking rate to 21% in 2007. In 2008, HMRC estimated that 13% of cigarettes consumed were illicit, and a further 8% came from cross-border shopping – ie. a 10% decrease over the 2000 figure.

Another example is Canada, which has gradually become one of the world’s most heavily regulated countries for tobacco products. It has also seen the exponential growth of an illicit tobacco market to the extent that, today, over one third of the tobacco market is an illegal, unregulated, unenforced and untaxed free-for-all.

Ontario, the largest province and the place where the contraband problem is most acute, is a case in point. Since 2006 the number of illegal cigarettes purchased has more than doubled, bringing it close to 50% in 2008. As illicit trade grew, government statistics showed a flat lining of the incidence of adult smoking in Canada as a whole. In Ontario, by contrast, statistics showed an increase in the incidence of adult smoking, above 2004 levels. And yet despite taxes rising and more people smoking, tobacco tax revenues actually fell between 2005 and 2009. The provincial government anticipated revenues of $1 billion in 2009. It collected $1.4 billion in 2005. The gap is, of course, explained by the rise in illegal, untaxed cigarettes.

The Bigger Picture

The USA is not immune to the same threats faced by others. In the last seven years, 46 states and DC have raised their cigarette tax rates 95 times. In a country with disparate tax rates varying from state to state, the major concern is with inter-state bootlegging or fussing over native Americans abusing the perk of low excise duty. Thus the bigger picture is lost.

This bigger picture contains the specter of fake cigarettes entering the country from abroad and abuse of pre-printed stamps that do not display the amount of tax paid nor the product to which is supposed to be attached. It also contains the challenges of purchasing illicit cigarettes via the internet, cross-border shopping and counterfeit tax stamps, all of which impact on government revenues.

The issue relates not only to tobacco, but also to alcohol – the other major source of excise revenues for governments. The drinks industry has not yet become a pariah to the extent that the tobacco industry has. But this is probably only a matter of time. Raising taxes in particular and prices in general are seen by governments as a means of curbing alcohol consumption, and in particular youth and binge drinking. But in its policy document on taxation, pricing and alcohol-related harm, the European Spirits Organisation CEPS points out that the unintended consequence of tax/price increases include theft, cross-border trade and harmful counterfeit products. Unintended they may be, but such consequences are entirely predictable.

Give Up, Pay Up or Go Elsewhere

In a nutshell, when taxes increase, some people give up, some pay up, but others go and find their supplies from illicit sources instead. So what is the answer? Assuming that taxes will continue to rise – to change behaviour and to raise revenues – this lies in stamping out, or at least bringing down the levels of, counterfeit and smuggled products.

There is so much money now at stake that those responsible for collecting taxes need to think hard about the mechanics of doing so. Closing down the illicit sources and supply chains is part of the solution. The other part is the deployment of programmes that combine authentication with tracking –  with tax stamps as the principal medium – using the sorts of technologies included in this month’s technology profile that enable genuine and taxed products to be identified and prevent illicit and counterfeit products from taking their place.

All of this, of course, takes money. But it is a worthwhile investment. So another rule of thumb should be adopted that says for every 10% increase in taxes, a given percentage of the revenues raised should be ploughed back into preventing the illicit trade. Only then is the correlation between increased taxes and decreased consumption likely to become a reality.

There is a rule of thumb that relates the rate of tax increase to the loss of sales due to reduced consumption. According to this rule, consumption decreases by 7% for every 10% increase in retail prices. It is a factor that tax authorities take into account when considering tax increases and it is also used as an argument for assisting smokers to quit. But the rule can be misleading.