On taxing tobacco

It’s the budget season. And tobacco industry, which is a major tax revenue source, is under focus again. As per current tax regime, cigarette packs having a retail price below Rs88 carry FED of Rs33 per pack, whereas cigarettes packs with retail price above Rs88 are charged FED of Rs74 per pack.

It is unclear whether and by how much cigarettes will again be subject to a FED hike. Federal health minister has reportedly asked finance ministry to raise FED on the lower slab to Rs44 per pack, besides earmark 2 percent of tobacco tax revenues for tobacco control and fighting non-communicable diseases. There is also some chatter suggesting expanding the two-slab tobacco tax regime to three tiers.

In the absence of definitive studies, the impact of high tobacco taxation on smoking incidence is a matter of debate in Pakistan. Looking at the formal industry provides a partial clue. During the first quarter ended March 31, 2017, the top two tobacco players – Pakistan Tobacco Company (PSX: PAKT) and Philip Morris Pakistan (PSX: PMPKL) – have undergone a sharp turn in fortune (see illustration).

One might be tempted to cheer the fact that cigarette volumes have begun to fall lately (see illustration). Are Pakistanis really smoking less? Maybe yes, maybe not! The duo – which control bulk of the formal market – suggests they have been hurt by rising incidence of illicit cigarettes trading in the lower segment of the market.

PAKT, the market leader, claimed in its latest directors’ review that “the illicit sector grew to an unprecedented market share of 41% as at March 31st 2017 (33.2% as at March 31st 2016).” Latest review by PMPKL management echoed the same, attributing the firm’s rather massive 1QCY17 top line slump to “the decline in sales volumes as a result of exponential increase of the non-tax paid cigarettes segment”.

Previously, the PAKT management has pointed the finger at some local producers instead of smuggled products. “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 2016 annual report stated. DNP cigarettes are selling in the range of Rs20-Rs35 per pack, as per PAKT, significantly below the minimum tax payable on a pack of smokes.

The formal players are not hurting alone – government revenues from the industry are also plunging. The 1QCY17 downturn in PAKT and PMPKL top line meant that the federal government hauled Rs13 billion+ less from the two companies (combined) under the heads of excise duties, sales tax, and corporate tax. This comes to a potential tax loss in excess of Rs50 billion for CY17.

The issue at hand is not the survival of tobacco MNCs or protecting tax revenues. The core of the issue is improving public health through tobacco control. Taxing tobacco heavily has led a decline in tobacco smoking in some countries. And indeed, taxing tobacco at punitive levels should work in a country where bulk of the population belongs to the low-income segment.

But simply taxing formal tobacco sales in a regulatory-porous country like Pakistan may do the opposite. A two-pronged strategy needs to be put in place: in addition to taxing tobacco, also crack down on the mushrooming informal, duty-evasive sector, which seems to have taken over a big chunk of low-end cigarette market by dint of their extremely low price points that undercut formal sector players.

It doesn’t look like the government will reduce existing FED rates – besides fiscal uncertainty of such a move, being a signatory to the WHO’s ‘Framework Convention on Tobacco Control’ may also come in the way. But the government must understand that there is no way around cracking down on illicit tobacco trade. One hopes the budget will announce concrete measures in that regard.