Cigarette tax myths and realities

A well-orchestrated campaign advocating for reduced cigarette taxes has recently gained momentum, primarily driven by the cigarette industry.

Their arguments crystallize into three core assertions: First, they contend that the prevailing tax structure is crippling large-scale manufacturing, including cigarette manufacturing sector, as evidenced by the 1.9% contraction in the Quantum Index of Manufacturing (QIM) reported by the Pakistan Bureau of Statistics.

Second, they allege that elevated cigarette taxes have precipitated an alarming surge in the illicit cigarette trade, severely eroding the legitimate market. The recent claim is that the illicit cigarette trade has reached 54%.

Third, they point to the half-yearly tax collection data, which reveals a concerning decline: a 2.4% drop in Federal Excise Duty (FED) and a substantial 26.1% decrease in Sales Tax, suggesting a failure of higher taxes to generate increased revenue. They posit that a proposed 25% reduction in cigarette taxes would narrow the price differential between licit and illicit products, likely encouraging illicit cigarette users to switch to licit cigarettes, thereby boosting overall tax revenue. Let us rigorously examine these claims within the economic context of half-yearly production and tax collection figures.

First, it is vital to accept that cigarettes are a demonstrably harmful product. Therefore, advocating for their production on macroeconomic grounds is not only economically misguided but directly conflicts with the public health priorities of the country and its commitment to the Framework Convention on Tobacco Control (FCTC) and the Sustainable Development Goals (SDGs).

Also, the attempt to link the cigarette industry’s performance to the overall decline in large-scale manufacturing is fundamentally flawed.

The QIM contraction is primarily driven by substantial downturns in construction and infrastructure-related sectors – specifically, non-metallic minerals, iron and steel, and fabricated metal – which have been impacted by economic policies and broader economic challenges.

Conversely, the cigarette industry has witnessed a significant 19.2% growth in production compared to the same period in the previous fiscal year. This clear divergence underscores that the QIM decline is entirely unrepresentative of the cigarette industry’s performance, further invalidating this claim.

Second, the assertion of an alarming 54% share of the illicit cigarette trade is a significant exaggeration and is made on the basis of a retailers’ survey which collected information about availability of various brands and did not consider the market shares of the brands. While the prevalence of illicit cigarettes remains a genuine concern, the claim of a 54% share lacks credible empirical support.

A recent study by the Social Policy and Development Centre (SPDC), based on a nationally representative survey of over 5,000 smokers, indicates a 33.2% share of illicit cigarettes. Though this figure is still alarming, a tax reduction is not a viable solution. Even if a reduction in cigarette taxes marginally decreases the price differential between licit and illicit products, it will not eliminate the substantial gap.

Consumers who consistently opt for cheaper illicit cigarettes are unlikely to switch to licit brands solely due to a minor price adjustment. Therefore, a reduction in cigarette taxes is not an effective strategy to curb illicit consumption.

Instead, prioritizing the strengthening of law enforcement and enhancing regulatory compliance are essential. Consequently, the focus must shift to robust governance reforms to effectively tackle the persistent illicit cigarette trade in the country, rather than a reduction in cigarette taxes.

Third, the reported 2.4% decline in FED and a substantial 26.1% decrease in Sales Tax for the July-December period of the current fiscal year, compared to the same period in the previous fiscal year, reveal significant anomalies. These anomalies are particularly striking when juxtaposed with the reported 19.2% growth in cigarette production.

While a detailed analysis of these discrepancies is beyond the scope of this discussion, it is reasonable to infer that they likely stem from adjustments in the declared market shares of premium and economy cigarette brands.

This practice, wherein cigarette companies manipulate tax revenues by altering the reported proportions of higher-taxed premium brands versus lower-taxed economy brands, can result in a decline in overall tax revenue despite an increase in production. This manipulation appears to be a calculated tactic, either to exert pressure on tax authorities or to create a pretext for pursuing tax reductions.

Historically, the cigarette industry has employed similar tactics to persuade the Federal Board of Revenue (FBR) to introduce a three-tier FED structure, which resulted in significant tax revenue losses rather than an increase. Following the realization of these revenue losses, the FBR reverted to a two-tier structure after two years.

Finally, let’s analyze the impact of a hypothetical 25% reduction in the FED rate to determine whether it would increase or decrease tax revenues. For the sake of a comprehensive analysis, we will assume a proportional reduction in the FED levied on both premium and economy brands. Initially, a 25% reduction in the FED rate directly translates to a 25% decrease in tax revenue per pack of cigarettes sold.

Critically, even if the industry were to fully pass this tax reduction on to consumers in the form of a price decrease, the resulting price reduction would be less than, or at most equal to, 25%. This is because the FED reduction does not affect the industry’s production and distribution costs or profit margins.

Now, unpack the impact of a price reduction on consumption. The extent to which a price decline encourages consumption depends on the own-price and cross-price elasticities of cigarettes and their substitutes. A recent study by the Social Policy and Development Centre (SPDC) indicates that the own-price elasticity of demand for economy and premium brands is -0.24 and -0.57, respectively.

This suggests that while economy brands hold a larger market share, their demand is relatively inelastic. Conversely, premium brands, despite having a smaller market share, exhibit moderately elastic demand.

Consequently, if a 25% reduction in the FED resulted in a corresponding 25% reduction in the prices of both economy and premium brands, we would expect a 6% increase in the consumption of economy brands and a 14.25% increase in the consumption of premium brands.

Ultimately, the impact on tax revenue hinges on the weighted average market share of economy and premium brands. Based on our estimates, derived from half-year production and FED revenues, and translated into effective tax rates and market shares, we find that economy brands constitute approximately 93% of the market, while premium brands account for roughly 7%. Assuming that the 25% FED rate reduction does not significantly alter these market shares, a corresponding 25% price decrease would result in a maximum 7% increase in weighted average consumption.

Therefore, a straightforward calculation reveals that a 25% FED reduction, coupled with a 7% increase in weighted average consumption, would lead to an approximate 18% revenue loss, contradicting the industry’s claims of revenue gains.

In conclusion, our analysis demonstrates that a 25% reduction in the FED on cigarettes would not only fail to generate increased tax revenues but would, in fact, result in a substantial 18% revenue loss. Conversely, an increase in the FED rate would logically yield greater tax revenues, aligning with sound fiscal policy.

Furthermore, reducing the FED rate poses a significant threat to public health outcomes. By making cigarettes more affordable, particularly for youth, such a policy would likely encourage increased consumption, exacerbating the already dire health consequences associated with tobacco use.

Therefore, instead of pursuing counter-productive tax reductions, policymakers should prioritize strategies that strengthen regulatory compliance, bolster enforcement against illicit trade, and implement tax measures that effectively discourage cigarette consumption and protect public health.

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