Prices of tax-paid brands: increase results in rise in sales, growing use of illicit cigarettes: analysis

A global research firm has analysed that the steep increase in prices of the tax-paid cigarette brands in Pakistan have resulted in a huge increase in the sales and consumption of illicit cigarettes in Pakistan. As a result, revenue from the duty paid cigarettes has declined while the smoking incidence remains the same.
According to a new report of KPMG on "A review of cigarette taxation in Pakistan" it was revealed that the large increase in cigarette taxes and prices have resulted in a decline in duty paid sales but only a marginal decline in the proportion of the population who smoke. This is mainly because at least some consumers have switched to illicit cigarettes which are freely available at a much cheaper price than their legitimate counterparts. The large increase in illicit cigarette consumption has increased the potential revenue foregone had tax been collected on all illicit cigarettes. As taxes increase, duty paid sales fall as consumers switch to illicit trade threatening tax revenues.
Although it is commonly perceived that an increase in cigarette tax rates could result in an increase in tax revenues, all other factors remain constant, in reality any changes in tax rates must be considered along with a range of other variables such as inflation, growth in incomes and the potential impacts on the market for illicit cigarettes, report suggested.
It said that the larger price increases result in larger growth in illicit cigarette consumption and the introduction of lower, frequent price increases to some extent help in checking growth of illicit cigarette consumption when compared to large, annual price increases. With respect to the current situation in Pakistan, changes in consumer incomes and cigarette pre-tax prices are two potential factors which one might expect to affect the relationship between tax rates and tax revenues, it maintained.
The particular strategy chosen by the Pakistan Government will depend on a number of factors such as; the magnitude of tax revenues collected, minimising the potential impact any price increase could have on illicit cigarette consumption, the accessibility to lower priced cigarettes, the risk of industry price wars, and other policy objectives.
The report highlighted that the presence and growth of illicit cigarettes in Pakistan not only undermines the government's multiple policy objectives but also adversely affects their tax revenue raising ability, a particularly important point at a time when the country has become more dependent on foreign aid and loans. If taxes had been collected on every illicit cigarette, an additional Rs 11.3 billion in tax revenues, would have been collected in the 2010/2011 financial year, approximately 19.2% of the tobacco tax revenue collected in that year. In 2014/2015 the revenue loss from sale of illicit cigarettes rose to Rs 29.8 billion which is approximately 29.2% of the tobacco tax revenue collected in that year.
The report stated that duty paid cigarettes became less affordable for consumers in 2015 compared to 2011. Total taxes on the weighted average price cigarette increased between 2011 and December 2015 by Rs 15 in real terms (ie inflation adjusted) per pack of 20 cigarettes. Over the same period, the pre-tax price of cigarettes (ie the price excluding all duties and sales tax) increased by a smaller amount, by Rs 10 per pack of 20 cigarettes in real terms. As a result, the average pack price increased from Rs 43 to Rs 68, in real terms, with taxes responsible for 62% of the retail price increase. Over the same period, the average household's income fell by 1%, in real terms. The combination of a decline in household income and rising duty paid cigarette prices made cigarettes 59% more expensive, relative to incomes, for consumers in December 2015 compared to 2011. The increase in the price of duty paid cigarettes contributed to a widening price differential between VFM segment duty paid and illicit cigarettes.
In addition to analysing the impact of potential changes in cigarette tax rates and prices on duty paid cigarette sales and tax revenues, KPMG has also undertaken a separate, high level analysis of the impact of these changes on illicit cigarette consumption.
The report said that a 1% increase in the price of duty paid cigarettes, in real terms, could be expected to result in a 1.3% decline in the sale of duty paid cigarettes. It does not, however, mean that there would necessarily be a 1.3% decline in total tobacco consumption if the result of the increase in the price of duty paid cigarettes was some consumers switching to illicit cigarettes. As new data becomes available and historical data for macroeconomics factors are revised, any estimates of the PED for duty paid cigarettes may change in a relatively short space of time. Some caution will therefore need to be exercised when making tax or other policy decisions using historical market performance as a guide to the future. A cautious, incremental approach to future tax rate increases, as opposed to large one-off changes, could be appropriate.
The consumption of illicit cigarettes is driven by a number of factors. These may include the macroeconomic environment, the regulatory burden on duty paid manufacturers and levels of enforcement. A key determinant of illicit cigarette consumption is the price differential between duty paid cigarettes and illicit cigarettes. As illicit cigarettes avoid taxation they can be priced substantially below the price of even the cheapest duty paid cigarettes. For a given level of income this makes illicit cigarettes more affordable for consumers than duty paid cigarettes. As cigarette taxes are increased over time, this tends to increase the price differential between duty paid and illicit cigarettes further.
In order to ascertain optimum future tax increases, historical data of the price differential between duty paid and illicit cigarettes and the consumption of illicit cigarettes in Pakistan was studied. Studying data between 2009/10 and 2015/16 it was estimated that an elasticity of 0.27 for illicit cigarette consumption relative to the price differential between the price of a pack of value for money (VFM) segment cigarettes and the price of a pack of illicit cigarettes. This indicates that for a 1% increase in the price differential, illicit cigarette consumption would increase by 0.27%.
The research reveals that larger price increases result in larger growth in illicit cigarette consumption and the introduction of lower, frequent price increases result in lower estimates of illicit cigarette consumption when compared to large, annual price increases. The lower levels of illicit cigarette consumption seen in scenarios with smaller, frequent increases may be as a result of a lower propensity to switch to illicit cigarettes by consumers. However, even if this is not the case there is no indication that moving to a frequent approach will have a negative impact on illicit cigarette consumption, or on tax revenues, research concluded.