Turning on tobacco

Are Pakistanis smoking less of tobacco these days? The country’s leading tobacco player, Pakistan Tobacco Company Limited (PSX: PAKT) recently reported that it sold 36.1 billion sticks in CY16, which is 16 percent lower than the previous year. Cigarette volumes are apparently also down at the second-ranked firm, Phillip Morris Pakistan Limited (PSX: PMPKL). (There are more players in the formal sector, but their volumes are not significant.)

But still, there is no way to verify that folks are indeed smoking less. Volumes of these two players, which are the two heavyweights in the formal, legitimate market, do not reflect the entirety of the tobacco market. It is the illicit cigarette trade – taking place through either non-duty-paid locally-produced cigarettes and through smuggling and counterfeit smokes – that is masking the real picture.

The organised industry has been urging the government to rein in the threat posed to them by the duty-evasive illicit cigarettes. Now, in its latest annual report, PAKT management claims that illicit cigarette trade had reached an “unprecedented”, “highest ever share of 40.6 percent as at December 2016”. It also noted that the legitimate tobacco industry declined by 10 percent in CY16 on account of duty-evasion in the illicit segment.

The duopoly maintains that tobacco volumes are taking a hit because of illicit tobacco trade. PAKT suffered a second consecutive year of lower cigarette sales. PMPKL, in its latest annual report, also suggested, “Volumes remained under pressure due to the exceptional growth in the low price non-tax paid tobacco products triggering an accelerated consumer down trading… The future operations of the company will continue to be adversely impacted by the rapidly increasing market share of illicit trade.”

The PAKT management lays the blame majorly at those local producers who operate under the radar and don’t pay their fair share of taxes and duties. “The bulk of the illegal cigarettes are local Duty-Non-Paid (DNP) which represents more than 85 percent of the illicit market. DNP cigarettes are produced in Pakistan on which duties and taxes have not been paid to the government,” the report noted.

A large price differential exists between duty-paid (legitimate) smokes and duty-non-paid (illicit) smokes. The latter is available between Rs20 and Rs35 per pack, whereas the former is available at Rs72 a pack in the value-for-money segment, the report said. One cannot possibly sell a cigarette pack in Pakistan at Rs35 legally, because the minimum payable tax on a 20-cigarette pack is Rs43. So, legitimate players cannot compete at that level, and thus get undercut.

Sure, lax enforcement is to blame for cheap, duty-evasive cigarettes running amok. But the origin is the ever-increasing incidence of FED on the organised sector’s sales. Every year, there is a budgetary increase of FED on tobacco products. Already this year, the federal government has raised the FED on locally-produced cigarettes twice. The first FED hike on both the upper and lower tier cigarettes came with the June budget announcement and the second one came in early December.

Declining volumes are already beginning to threaten growth of government revenues from tobacco majors, who contribute big league in the form of federal excise duties, custom duties, sales tax, and income tax. In CY16, PAKT paid a total of Rs90 billion under those levies, a relatively retarded year-on-year growth of 4 percent. PMPKL paid a sum of Rs25.3 billion, which is 2.3 percent lower than CY15.

On the surface, not much seems wrong with the duopoly. After all, last year, PAKT produced record profits. And PMPKL also returned to modest profitability. But declining volumes mean that sustaining that profitability, which is driven mostly by internal efficiencies, won’t be sustainable. A cloud hangs over future topline growth. For PAKT, the topline (net turnover) began to flat-line in CY16. It started dropping for PMPKL (see the illustration).

The government is within its right to raise levies, for want of public health or budgetary revenues. But it must also provide the formal sector with a level-playing field to compete. Otherwise, both public health and tax revenues may suffer in long run due to illicit cigarette sales. Smoking is injurious to health. But it would be more injurious if dubious-quality brands become the masses’ dominant source of tobacco intake.