The central banks annual report has sounded an alarm over exponential growth of duty-evading cigarettes. The SBP has warned that a large, informal sector undermines the viability of the legitimate players thus discouraging both domestic and foreign investment in the sector. Conclusive evidence is not presented, but intuitively, a high federal excise duty (FED) on formal-sector cigarette sales should make them price-uncompetitive and grow illicit tobacco traffic, in the absence of sustained crackdown.

Illicit cigarette trade is happening under numerous banners, but three of them stand out. Biggest segment is where informal local manufacturers operate under the radar or when licensed, local manufacturers under-report their production to flood the market with non-duty paid, hence cheaper brands. Second is the contraband stuff, where imported commercial brands defeat or circumvent the applicable duty regime. And third are the counterfeit brands, the knockoffs, which mimic the famous global and local brands.

For a background, this fiscal, the federal government has reportedly hiked the FED on locally-produced cigarettes twice. First time it came with the June 2016 budget announcement. FED on cigarettes whose retail price exceeded Rs4,000 for a thousand sticks (upper tier) was increased by 9 percent to Rs3,436 per thousand sticks. Similarly, there was an 8 percent increase in FED to Rs1,534 per thousand sticks on cigarettes whose retail price did not exceed Rs4,000 per thousand sticks (lower tier). From December 1, the FED has been further jacked up by 7 percent on the upper tier and by 8 percent on the lower tier.

Some hint is now there that the FED regime is becoming counterproductive. The illicit cigarette trade may be booming as even higher duties further undercut genuine players. SBPs warning is one. Pakistans largest tobacco firm, the Pakistan Tobacco Company (PSX: PAKT), also stated in its recent quarterly report that illicit market of cigarettes in Pakistan had grown, to 39.5 percent as at September 30, 2016.

Back in September 2014, a report by International Tax and Investment Center and Oxford Economics prepared on behalf of Philip Morris International (PMI) to study illicit tobacco trade in Asia estimated Pakistans illicit cigarette traffic at around 22 percent. Now, this nearly 40 percent illicit cigarette volume, if it is indeed that much, makes one wonder how bad the situation has really become in recent years.

The assertion that illicit trade is booming can find haven in the fact that recent FED collections from formal sector have visibly declined. Pakistans tobacco duopoly collected 20 percent less or Rs4 billion lower money under the head of excise duties and sales tax on their gross turnover in Jul-Sep 2014. (This is not to suggest that illicit trade is the only reason even a major reason behind slowing demand of formal sector and hence low collection of excise duties and sales taxes. Factors like health awareness campaigns might also be play).

PAKTs excise duties on its gross turnover showed a year-on-year drop of nearly 23 percent, reaching Rs9.96 billion in 3QCY16. The sales tax collection also slid by 22 percent, receding to Rs2.94 billion in the quarter. This decline is not a seasonal trend, for PAKT has, in previous years, shown year-on-year growth in excise duties and sales tax for the same Jul-Sep quarter.

Philip Morris (Pakistan) Limited (PSX: PMPKL) also mentioned in its latest quarterly report (Jul-Sep) that it suffered a volumetric decline in that period. The PMI affiliate reported 6 percent lower excise duty collection (Rs2.04 bn) and 7 percent lower sales tax collection (Rs0.63 bn) during 3QCY16 on a year-on-year basis. (Unlike PAKT, yearly change in PMPKLs Jul-Sep duty/tax collections has been erratic in recent years, one year going up and the other coming down).

The same PMI study had also argued that due to tripling of excise duties between 2008 and 2014, Pakistan lost less tax dollars to the tune of $275 million in FY14. The government, unless it has been relaxing under a rock, perhaps recognizes the negative impact the high FED has had on potential tax revenues and the competitiveness of the organised sector. As always, numbers are open to interpretation. But it appears that the singular government tactic of taxing tobacco heavily, without a sustained crackdown on illicit tobacco trade, is not going to work anymore, not even for the government.