Tobaccos and tax loss

A latest study estimates that FBR suffered tax loss of over Rs30 billion in 2018 on account of duty-non-paid (DNP) cigarettes. The tobacco industry observers will be quick to recall how the “DNP cigarettes” have become a bête noire for the formal tobacco players like Pakistan Tobacco and Philip Morris Pakistan. DNP is such a bogeyman that it has been used to lobby for tax changes in Pakistan recently.

But this SPDC report, ‘Quantifying the Potential Tax Base of Cigarette Industry in Pakistan, lands the blame for that huge estimated tax loss at the door of the top tobacco companies. Using econometric analyses, the report suggests that massive tax evasion has taken place in the tobacco industry through under-reporting of official production figures.

The local tobacco industry is highly concentrated, as two top firms account for over 90 percent of market share. So it should be easy for authorities to catch any tax evasion by directly assessing the tax liability inside the factory premises, no?

Not quite! The existing tax-collection regime is based on voluntary self-declaration, and the taxman can only levy GST and FED on declared production. However, without a track and trace system, the FBR has no capability to monitor actual production of tens of billions of cigarettes every year, leave along monitor sales at retail level. Theoretically, this can encourage tax evasion by under-reporting of production.

By analyzing production, financial and taxation data for the last 15 years, the study – which is funded by the University of Illinois at Chicago’s Institute for Health Research and Policy – lends credence to that theory of misdeclaration. The study estimates under-reporting at top tobacco firms to be in the range of 22 percent to 47 percent in recent years.

Those are big numbers and must cause an alarm at FBR and the Ministry of Finance. As there was 47 percent under-reporting estimated in FY17, the treasury apparently suffered a tax loss of Rs37 billion that year, per the report. Besides, cheaper cigarettes are an anathema for tobacco control programs. The formal industry has contended in the past that the DNP cigarettes are being produced by informal manufacturers, who are undercutting the genuine operations of the taxpaying formal players.

Previous studies on the subject used to dispute the market share of DNP cigarettes. The SPDC study goes further and disputes the origin or source of DNP smokes, by pointing towards possible under-reporting at the formal players’ factories. One hopes that the track-and-trace system, which FBR has recently commissioned, is properly installed and enforced so it can bring visibility to the scale and the origin of the DNP menace.

But electronic monitoring alone may not be enough. Regardless of whether the study’s estimates are on the mark, its recommendations are worth considering. For instance, it is imprudent to change FED rates abruptly, so the report calls for a medium-term tobacco tax policy to sudden and major tax changes. This can also help provide certainty to the whole value-chain, including tobacco farmers. Also, it makes sense to merge FED with GST and then collect GST in VAT mode at production, distribution, and retail stages.