Cigarette Taxation Policies and Illicit Trade in the European Union
By Piyali Kundu
In this paper, I will argue that the sometime contradictory nature of taxation on tobacco products between fiscal goals and public health goals under EU tax harmonization efforts creates a taxation regime that is less than optimal in terms of meeting public health goals and ensuring uniformity among all member states. I will show how this tax regime, with its incongruous state-by-state policies, is threatened by illicit trade, both large and small, despite efforts for harmonization.
Tobacco control advocates generally agree that taxes on tobacco products are the single most cost-effective policy tool to induce current smokers to quit, reduce consumption of heavy smokers and prevent uptake by non-smokers, especially youth. 31 Given the known adverse health effects of cigarette consumption, taxes are also the best way to increase government revenue to offset healthcare costs incurred by smokers. The goals of public health and those of fiscal authorities to increase government revenue are seemingly in congress regarding the benefits of taxation on cigarettes. However, tobacco taxation is not just about healthcare goals and the fiscal imperatives. Thus, the optimal level of taxation from the point of view of tax authorities does not reach the public health goals in all cases. For public health advocates, tobacco taxes are about reducing the “pleasurability” or smoking, thereby decreasing demand and access to cigarettes by toughening the business environment for companies. 25 For tax authorities, tobacco taxation is first and foremost an opportunity to “cheaply” increase revenue by taxing a price-inelastic good. 30
Despite the inherent conflict between these two parties, the two outcomes of levying taxes on tobacco products – increase in revenue and increase in health – make taxes an important public health measure. The Framework Convention on Tobacco Control (FCTC), the first public health treaty negotiated by member countries of the World Health Organization (WHO), recognizes the importance of tax measures and makes it a priority of the treaty. Article 6 highlights the need for tax and price measures as “an effective and important means of reducing consumption by various segments of the population, particularly young persons.” 6
However, the issue of how much and what kind of tax to levy depends on economic and political considerations and thus varies across countries and regions. This variance has economic and health implications for populations because it produces incentives for illegal cross-border trade and shopping that undermine the purposes behind the tax increases. For Europe, European Union (EU) tobacco tax harmonization – a process whereby all member states of the EU have brokered uniform tax rules for tobacco products that must then be applied in all member states – has produced a concerted regional effort to reduce the health effects of tobacco, increase revenue for governments and mitigate the criminal activities associated with tobacco trade for member states. However, comparisons among states and non-EU members highlight the complications produced by national tobacco tax policies that remain inconsistent with neighboring states despite harmonization efforts.
In this paper, I will argue that the sometime contradictory nature of taxation on tobacco products between fiscal goals and public health goals under EU tax harmonization efforts creates a taxation regime that is less than optimal in terms of meeting public health goals and ensuring uniformity among all member states. Next I will show how this tax regime, with its incongruous state-by-state policies, is threatened by illicit trade, both large and small, despite efforts for harmonization. Large scale, “container” level smuggling is the main issue for the EU since non-member states, especially those in Eastern Europe, take advantage of loopholes in the EU tax structure to smuggle popular brands from high-tax jurisdictions to countries all over Europe. Ukraine, Serbia and Andorra are three major hubs of this criminal activity and highlight the unique situation faced by the EU. Ultimately, in order for the purposes of the tax harmonization in tobacco products to achieve its twin goals of meeting public health imperatives and protecting an important source of revenue for national governments, better adherence to the FCTC provisions and the forthcoming Protocol on Illicit Trade will be necessary. Specifically, concerted criminal and border capabilities are needed, along with a “track and trace” regime parallel to the uniform tax regime, which can be funded by the additional revenue incurred from the tobacco taxes.
In part II, I will review the tax structure applied to tobacco products, focusing on cigarettes. The dichotomy between public health and fiscal imperatives presents a complicated and contradictory relationship between the optimal level of taxation for public health goals and the optimal level of taxation for revenue and political goals. Part III will cover the EU efforts at harmonization of the taxation regime in order to reduce disparities between states. Part IV will survey the extent of the smuggling within the EU, highlighting the difference between large-scale smuggling and small scale cross-border shopping and the implications of these issues. Part V will focus on three case studies of non-member states that represent the biggest hurdles in curbing smuggling, emphasizing the inability of the current harmonization regime to deal with these threats. Part VI presents several solutions to the cross-border trading and the large scale smuggling that plagues EU tobacco control advocates, focusing on the FCTC provisions, the upcoming Protocol on Illicit Trade in Tobacco Products.
II. Taxes as a Public Health Measure
For public health advocates, “tobacco control” means reducing the consumption among smokers, inducing current smokers quit, and preventing smoking uptake by those currently not smoking, especially young people. 25 On the other hand, policy makers and tax administrations have other interests with regards to regulating tobacco products and the tobacco industry. The revenues are often a vital part of the national budgets and are used for funding social programs and other expenditures. However, according to the numbers principle of economic policy, the objectives of an economic policy must be equal in number to the number of economic instruments designed to achieve the objectives. 25 For instance, if the target is public health improvement (as measured by decreased prevalence and incidence) and the instrument is taxation on tobacco products, the tax cannot be used to simultaneously meet other social policy goals – such as reducing poverty – at the same time.
For public health advocates, there are many tools available to public health advocates and policy makers to achieve these goals, including: public awareness campaigns on the adverse effects of smoking, advertisement and sponsorship bans to reduce marketability of industry, and quit lines and other cessation methods to help current smokers quit. 28 Taxes are embraced by the public health community as an effect way to prevent uptake and provide a disincentive for current smokers to continue smoking in the amounts that they do. The caveat is that the tax level must be high enough to force smokers to either cut down or quit. There is no specific price amount at which point a smoker will quit, as demand for tobacco is tied to income levels, types of taxes applied to products and the elasticity of the demand – meaning the willingness of consumers to incur costs to continue consumption levels. 10
For fiscal authorities, tobacco taxes remains one of the few tools that produces revenue for the government in an easy and effect way. It is easy because placing taxes on goods that are price inelastic produces revenues regardless of the rate of consumption. 31 When demand is inelastic it means that a change in the price will not decrease consumption by the same percentage amount, meaning people will continue to consume regardless of the price. Also, imposing taxes can be done effectively because cigarettes are a good that can be supervised by the government from the manufacturing level to the retail level. The revenue generated from increasing taxes by 10%, producing a price change of 10% would increase revenues by 7%. 24 As an example, the United States took in $15.3 billion in revenue from tobacco taxes in 2007 with a federal tax increase of $1.00. Thus, an increase of 10% would produce a revenue increase of an additional $1.1 billion. From the point of view of policy makers and fiscal administrators the significant revenues generated is a boon for government budgets that use the funds for everything from financing healthcare to offsetting deficits in non-health related departments. 18 The destination of the funds is a concern for public health advocates who believe revenue from tobacco taxation should be used for tobacco control goals, such as funding advocacy and healthcare work, meeting Mpower goals, setting up “track and trace” regimes and smuggling border control. Thailand is the only country in the world where all of the excise tax revenues from tobacco fund major healthcare programs regarding tobacco-related morbidity and mortality. 21
There is thus disengagement between public health advocates on the one hand and fiscal policymakers on the other regarding the aims and levels of tobacco taxation. Fiscal policymakers, who are ultimately in charge of levying the taxes, see the situation as a win-win because unlike other public health measures to increase health, increasing taxes is the most cost-effective means to increase revenue and achieve public health goals without placing further fiscal demand on the government to increase healthcare expenditures related to smoking, such as government sponsored programs to reduce smoking through education, legislative bans on advertising and sponsorship, smoking bans. For public health advocates, the lack of connection between the billions raised in revenue from taxes and the destination of the funds is an area of contention and one of major concern. However, due to the revenue-generating facet of taxation, increasing tobacco taxes provides one of the few solutions to tobacco control advocates to achieve health goals without creating conflicts with other public policy groups and interests. 21
This win-win scenario for both policy makers and public health advocates allows for tobacco control to expand beyond the realm of health ministries and health advocacy groups since taxes on tobacco products is a lucrative endeavor for governments’ fiscal arms as well. However, given the fiscally-driven and economic efficiency bottom line of tax administrators and fiscal policy makers, public health advocates need to remain privy to the specific issues of tobacco taxation such as the level and amount the policy makers can impose on the tobacco industry and on tobacco products. 30 The case of the European Union and specific European countries highlights the incongruity between the optimal level of taxation touted by tax administrators as the most revenue-generating and the level needed to drastically reduce consumption and prevent uptake. While the situation of taxes is certainly not one of either increasing revenues for budgetary purposes or putting health first, tobacco taxes do remain at a level that meets modest public health benchmarks, even as it meets the optimal level for revenue purposes.
Types of Taxes
There are several types of taxes applicable to cigarettes and other tobacco products. Like all commercial goods, cigarettes are subject to excise taxes. Excise taxes can come in the form of specific or ad volarum taxes. Specific taxes are taxes that are levied on the producer and can account for as much as the retail price of the goods. A specific tax places a standard, fixed currency amount to the product no matter what the production cost, diminishing the differences between cheaper and more expensive brands. It is imposed at a fixed amount of tax per unit, not as a percentage. In the case of cigarettes, it is the tax imposed on 1,000 units – cigarettes – or 1,000 grams. Ad volarum is a percentage of the value of the product, such as 45% of the manufacturers price. Value-added tax is levied on businesses at all levels of manufacture and product of a good based on the increase in price at each level. It is like a hidden sales tax because the retail price of a good reflects the amount of VAT applied at each level of production until it reaches the stores and other points of purchase. For instance, a VAT of 10% raises the retail price by 10%, making it essentially consumption tax that purchaser of the good incurs. Cigarette taxes in the EU are subject to 13% VAT tax, meaning 13% of the total price that the purchaser of one pack of cigarettes pays is a VAT tax. Ad volarum and VAT taxes have a multiplier effect, meaning that price differences at production level are multiplied with the addition of the tax. This leads to price difference between cheaper and more expensive brands, and allows producers to lower their prices at production to incur a low tax percentage of ad volarum and VAT taxes. 31
Tobacco companies use several methods by which to navigate through various types of taxes for their advantage. For countries where production costs are cheap, companies prefer ad volarum taxes since these are applied at the manufacturing level and are a percentage of the manufacturing price. In other instances, companies circumvent tax increases through various pricing strategies. For instance, making lower priced brands that use less refined tobacco provides alternatives to increased prices of most popular brands. Price-related marketing efforts such as multi-pack discounts and providing coupons to consumers offsets the effects of increased excise taxes. 4
III. European Union Tobacco Tax Harmonization
The European Commission has evolved its tax policy for tobacco over the past 20 years as new considerations on the tobacco trade have taken shape. More comprehensive approaches have become necessary to harmonize health policy on the issue of tobacco related morbidity and mortality. Additionally, due to the increasing number of countries entering the EU, harmonization has increasingly been seen as a way to mitigate the risk between price differentials among the, which has become a major issue as it has caused illicit trade to flourish.
Tobacco taxation within the EU is complex and consists of several types of taxes. All cigarette products are subject to minimal levels of specific, ad volarum and Value Added Tax (VAT). This structure of the EC tobacco tax is a unique blend of different types of excise taxes to produce what is called the hybrid tax. It is a hybrid structure because it combines an ad volarum amount and a specific amount to the overall excise tax, which is a percent of the total price of the pack of cigarettes. There are advantages and shortcomings of both ad volarum taxes and specific taxes, as mentioned in Part II, and combining these types to form a hybrid has served to gain consensus among member states that have different economic considerations vis-à-vis tobacco. During the 1970s, growers in the South favoured ad volarum taxes as it kept their prices low, while Northern countries favoured specific taxes since they imported the raw lead to manufacture the cigarettes and ad volarum rates apply directly to manufacturers. In the 1980s, the European Commission (EC) pushed for common indirect tax rates to discourage smoking behaviour. 29 This essentially meant a preference for uniform VAT tax as this is the consumption tax. 29 However, the differences in prices between states did not allow for this approach to come to fruition and instead necessitated the current harmonization approach that includes a hybrid tax at minimum levels high enough to ensure revenues for governments and meet public health demands.
Since 1988, the EU Commission in charge of EU-wide policy has stated that fiscal harmonization had to include an anti-tobacco component with uniform taxation rates that were “set at a level compatible with essential public health requirements”. 29 The gap between public health goals and fiscal imperatives highlighted in the Part II are evident in the evolving EU taxation debate. Sticking true to the fiscal imperative argument, tobacco taxation policymakers of the EU Commission had initially had the objective of raising revenue and protecting national manufacturers and growers. In 1992, there were several directives made to harmonize tobacco tax levels across all the member states. The rationale for this consisted of several administrative and fiscal reasons. Firstly, the EU Commission found it easier to administer blanket policies that can be imposed on all member states and successor member-states. Secondly, due to the well-known fact that cigarettes and tobacco products have low price elasticity in that people addicted to nicotine will smoke regardless of taxes, there was potential to raise revenue for the member states and the EU. And lastly, the existence of negative outcomes, or externalities, due to increases in tobacco related morbidity and mortality meant that the revenue for taxes could offset the increase in healthcare expenditures. These include negative health-related outcomes, such as increasing chronic disease burden and acute health outcomes such as cancer, stroke, and heart attacks, all of which place further pressure on healthcare costs in European states and increased government expenditure. 27 Related to diminishing health outcomes are externalities such as quality life years lost and disability that take people out of the workforce and strain government welfare systems as they become dependent on the state, not just for healthcare needs, but for social and financial needs as well. 30
The initial proposal in 1992 was to remove the ad volarum tax disparities across member states and increase the specific tax level in all states. 29 The initial policy proposed a 45% ad volarum tax on all cigarette packs of 20 cigarettes and a 0.30 euro-cent specific tax minimum for all states. For some countries, these changes would result in large increases in the price per pack, while for others it would have resulted in small increases. For instance, in Spain, there would have been an increase of 85%, while for the Netherlands and the UK there would have been increases of 2% and 3%, respectively. 29 The price elasticity of demand was determined as -0.55, meaning that cigarettes are a relatively inelastic good whereby price increases would deter some but not most smokers from consuming cigarettes. Overall, members of the EU Commission negotiating the harmonization policies thought there would have been a reduction of 9% – 16% in cigarette consumption if these above taxes changes were made. The wide range in decreasing consumption is due to the disparities in price increases among states in the North and the South of Europe.
The longer-term goal would be to impose a 57% ad volarum tax and a 0.43 euro-cent specific tax. However, these policies would result in a North-South divide whereby high increases in price would result in decrease of consumption in the Southern countries, but would not have the same effect in Northern countries. This is due to income growth overall in Europe due to normal patterns of harmonization in other economic areas such as trade and production, which would increase GDP and GNP overtime. Simulations and projections by EU Commission health economists stated that if income continues to grow in all EU states, there would be a 20% increase in expenditure on cigarettes across the EU because income elasticity for cigarettes are non-negative. 29 This means that even as income rises, the demand for cigarettes remains “normal” (does not change), leading to the conclusion that as income rises and price of cigarettes rises, people continue to consume at their normal rate, leading to increasing expenditure on cigarettes (which means more profit for companies). Given the differential growth rates between Northern countries and Southern countries, Northern countries would have more expenditure on cigarettes that would diminish the impact of increased prices at the levels proposed. 29 In the best-case scenario, policymakers posited a moderate decrease in consumption of 7% in all countries, but rising incomes would offset any decreases in expenditure on cigarettes. With these policies, policymakers concluded that tax harmonization at this level may not achieve the most robust health goals, despite stated health aims. 29
Given the modest results projected from these earlier proposals, the EU developed more robust levels of taxation to maximize the political leverage provided by the Framework Convention on Tobacco Control, which was signed by the EU in 2003. Under the auspices of the World Health Organization, the FCTC calls for strong tobacco control measures from signatory states, especially high tax measures. 2 Following the ratification of the treaty in 2003 there was more support for the measures laid out in the EU Council directive 2002/10/CE. Taxes under this policy would follow the hybrid model. Ad volarum taxes must be between 5% and 55% of the total tax on cigarette packs, reflecting the compromise with southern member states that prefer the ad volarum taxes. Minimum excise tax – specific and ad volarum – must be 1.28 Euros per pack and the total level of excise tax must be 57% of retail price. This last measure was established to offset the aforementioned pricing decrease measures employed by tobacco producers to offset losses due to taxes. When countries have only ad volarum taxes, producers can lower their prices because ad volarum shifts according to the price of the product, whereas specific tax remains static. Placing the total level of excise tax as 57% of retail price means that producers cannot lower prices (i.e. switching to cheaper leaves, etc) to an extent that will nullify the effect of the cigarette text. 2
With these measures taken together, the level of taxation for cigarettes in the EU must be at a minimum of 70% per pack. Countries, however, are free to choose the proportion of specific versus ad volarum. This directive has been seen as a compromise to fit the needs and realities of member states. Since Northern countries prefer specific taxes, and Southern countries prefer ad volarum taxes, a mixed tax with a flexible ad volarum rate and a standard excise rate means countries can decide their specific ad volarum and specific tax amounts. Furthermore, compromise was made to only include these taxes on the most popular brand category, which includes the prices for the most popular brands only (see Table 1). This represents a part of each country’s tobacco market, since some countries have domestic brands that are not exported, and thus would not be considered “most popular brands”. The decision to apply harmonized levels on most popular brands was because states do not have a harmonized, standard level of taxation for non- popular brands or local brands, and because within the EU, the large multinationals such as BAT, PMI, Imperial, Gallaher and JTI share the European market amongst themselves, making the popular brands those that can be found anywhere in the EU.
Ultimately, the harmonization process has set a standard for all member states. Secondly, it has increased prices in several states by a substantial amount. However, price differentials between states have not been significantly reduced, since member states can choose the proportion of specific and ad volarum to get to the 70% standard. This has led to intra-EU cross border shopping from high-price jurisdiction to low-price jurisdictions and to illicit trade between non-EU Border States and the EU.
IV. Smuggling in the EU
The issue of smuggling and tax evasion in Europe is segmented into several viewpoints, ranging from industry lobbyists; individual states’ standpoints and the EU level office for anti-fraud, OLAF. The industry has predicted that increases in tobacco taxes will result in the divergence of cigarette trade from legal to illegal channels as consumers refuse to pay higher costs. Their predication is that this divergence would either channel through smuggling or cross border shopping from low price to high price countries and would result in governments losing out as a result of the lost revenue from taxes. The viewpoint of OLAF and WHO experts and health economists make quite a different projection in the European context. 15
According to members of OLAF charged with spearheading the EU-wide response to tobacco-related illicit trade and tax evasion, domestic brand differences between members states do not matter. Instead, it is the international brands that are the ones that can be smuggled and sold anywhere due to popularity and which the EU policy makers should focus on when considering pricing disparities between states that could give rise to cross border trade. However, even with this consideration, the prices differences among the popular brands do not make it profitable to move cheaper cigarettes from the southern and eastern countries to the northern countries because differences in price are not so disparate. Despite the macroeconomic differences and levels of development between European states (whether part of the EU or not), there is no gaping difference in the standard of living – across most European states, the tax incidence is over 60% in all countries, even if prices are varied. 15 This leads to the conclusion among OLAF policy makers that the case for the EU ought to be focused on the large scale tax-evasion and illicit trade of cigarettes, not the local level cross border shopping that the industry and media focus attention on.
A major shortcoming of the harmonization policies is the focus on destination-based product taxes, which means that taxes are applied for a good at the destination countries – not at the country of origin or the port country. 22 The implication of this is a loophole that allows entrepreneurs, tobacco companies and organized criminal groups to circumvent the newly established taxation regimes. 15 Additionally, as mentioned in the previous section, tax differentials among states within the EU and with non-EU border states leads to the adverse effects of cross-border shopping and illegal smuggling. This issue of cigarettes travelling through clandestine chains that undermine the tax systems follows two different paths, cross border shopping and massive container-level tax evasion.
These shortcomings of the tax regime are particularly troublesome considerations for the EU since it is under the Schengen Agreement – the single market act. Under the single market act, which came into being in 1993, goods and products within the EU can move freely across pact members, which includes all member states of the EU and several other states, such as Switzerland, Norway, and Andorra. Cigarettes are a “good” that can flow freely from one country to another; however, countries can determine how much tobacco can cross borders for personal use only and can cap the amount an individual can bring in. Most countries set maximum weight limits on tobacco product – for instance, in France it is 1 kilogram of tobacco, which is equivalent to 1000 cigarettes or 50 packs. 18
Cross border shopping is legal within the single market of the EU and accounts of 3% of all cigarette consumptions. The tobacco industry argues that tax differentials between neighbouring states leads to such high rates in smuggling via this method, emphasizing cross border smuggling as the crux of the issue of illicit trade. Taking France as a typical, western European case study, it is of note that cross border shopping constitutes 14% of all sales in tobacco as of 2006. 18 The flow of cigarettes is from Luxembourg, Spain and Belgium into France, which has a tax incidence of 80.4%, one of the highest in the entire European region (WHO internal data, 2008 most popular brands tax rates ). With tax increases in 2003 and 2004, the actual price of cigarettes went up 44.5%, which was an important fiscal step given that 32.2% of tax revenue from cigarettes goes to finance the healthcare system. Given this, the issue of cross border shopping and smuggling is a real threat to the healthcare budget of France. However, due to the open market of the EU, it is impossible to distinguish between legal cross-border shopping, smuggled tobacco products and illegal cross border shopping. The same trend can be found in Germany, which sees an influx of Luxenbourgish, Polish and Czech cigarettes on its market from either cross border shopping and small-scale smuggling. 9 The efforts of the tobacco control movement, especially in the realm of cessation and reduction of consumption are undermined by the presence of easy access routes to cheaper tobacco.
“Container-fraud” or Large-scale smuggling
Despite the reality of cross border shopping as a potential method of undermining strict tax codes, EU tax harmonization mitigates this risk since prices among member states are not that different. Likewise, it constitutes 3% of all cigarettes consumed and the inability of states under the current rules of trade to precisely quantify the issue of cross border shopping makes it a difficult and ineffective focal point to focus all anti-smuggling efforts. Thus, the focus has instead fallen on large-scale smuggling, sometimes called “container fraud”.15 This kind of smuggling is the main area of focus of the forthcoming, WHO-sponsored Protocol on Illicit Trade in Tobacco Products and the main area of work for the EU Commission on Transnational Crime (OLAF). Large scale smuggling consists of 7% of all consumption in Europe, with Eastern Europe leading the way with 13% of consumption. 20
In general, container fraud smuggling can be quantified by the difference in exports versus the volume of imports. The world production of cigarettes is known fairly accurately since cigarettes do not keep for long (unlike other products) and thus, it can be assumed that the production is equal of world consumption. 12 While the gap between imports and exports are somewhat accounted for by the legal duty free sales of cigarettes, it is estimated that about 45 million cigarettes are sold duty free, only a fraction of the gap between imports and exports when considering that about 910 million cigarettes are exported each year while only 586 million are imported. 12
With focused attention on massive tax evasion as the crux of the smuggling problem, OLAF has indicated that the direction of contraband cigarettes is from Western and Northern wholesale markets to non-EU states in the East, such as Ukraine and countries in the former Yugoslavia. From these countries, the cigarettes are either sold on the streets for cheap or imported clandestinely back to markets of the EU states (both North and South) where they do not pay any taxes. 13 The direction of the trade is paradoxical and against the economic assumption that smuggled goods flow from low-tax jurisdiction to high tax jurisdictions – meaning from Eastern Europe to Northern/EU regions. This does not happen because buying cigarettes even from these regions would mean paying some kind of tax, which would not yield high profits. Thus, it is cheaper for smugglers to pay 0.30 euro cents wholesale price for imports in the Northern European ports – Rotterdam, Antwerpen, Rostock and Hamburg – pick up the goods in low-tax Eastern European ports and sell them for market value after smuggling back to the EU, duty not paid. 13 The Schengen Agreement and the trade law that says that cigarettes destined for a European country do not pay any duties at the port of entry allow for this route to be exploited. Smugglers can easily re-route transport or forge documents to states that the end destination has been reached. In other cases, these cigarettes may actually be exported to Eastern Europe with large portions smuggled back via speedboat from Andorra, Cyprus, the former Yugoslavian countries, Albania and others. 12 The solution to such circumvention would be s “track and trace: regime that puts a chain of custody mark on packets to show that cigs reach intended market legally.
V. Tobacco Policies of EU Border States
Given the method of obtaining contraband cigarettes, the border EU states, which are also the low-tax jurisdictions when compared with Northern and Western countries within the EU, have remarkably high percentages of total consumption coming from smuggled chains as well. In Lithuania a packet of Marlboros costs $2.00, making it the lowest priced jurisdiction in the EU. However, as of 2008, 36% of all cigarettes consumed came from illicit trade. 17 Conversely, in places like the Netherlands, Belgium and Denmark that have much higher prices for packs and over 70% tax incidence on the most popular brands, smuggling constituted 5% of the total consumption. 12 The difference can be attributed, partly, to borders with non-EU states that have environments conducive for producing and importing cheap cigarettes, duty unpaid; links to organized crime that can enable smuggling; and smoke-friendly legislative environments that allow tobacco companies to profit from smuggling. Ultimately, policy differentials between EU and non-EU states maintain smuggling levels, keeping illicit trade between non-EU and EU countries a major problem for health and crime.
From the findings of crime investigators, tobacco control experts and health economists, container fraud is supply-driven, related to organized crime, the culture of street selling and the complicity of the industry. 13 The issue of smuggling, however, is played out differently based on region. In countries such as Spain, which had one of the highest percentages of cigarettes coming from the black market, tax measures have led to more concerted border control efforts with neighboring countries to police smuggling routes. In other places, such as Sweden, a tax increase did lead to more instances of smuggling, but once taxes were reduced to the pre-increase levels, smuggling still continued because the networks had already been established.15 Still others, such as Romania and the Baltic countries face cigarette markets with high rates of smuggling, despite having low prices in cigarettes. Ultimately, smuggling is more than a price and tax issue and involves business environmental factors.
The inability of harmonization thus far to produce blanket results is even more apparent when comparing the non-EU states that border the EU and the taxation policies therein. These are porous borders since bordering states such as countries in the former Yugoslavia , Ukraine and the principalities of Western Europe have visa agreements with the EU. However, in the realm of trade and the movement of goods, the major ports of Europe are located in the EU – Rotterdam, Antwerpen, Rostock and Hamburg – and move goods across via train to non-EU border countries daily. 22 From the beginning, during negotiations in the 1990s following the introduction of the newly independent former Soviet states, member states and the newly independent countries emphasized that what has worked in the developed countries of western Europe will not work in newly developing states. For example, the reliance on a strong civil society and a base for non-governmental organizations to educate the public, lobby for change, and help socialize the public to the harmful effects of tobacco and the need for taxation do not exist in these former Soviet states. 3 Likewise, with governments reforming after almost a century of de facto foreign rule, the bureaucratic structure to implement taxation and ensure the transparent and effective transfer of revenues to different departments were underdeveloped compared to the evolved governments of the Western and Central European states in the EU.
Nearly half of the 6% of cigarettes sold with duty not paid (contraband) come from Eastern Europe, according to BAT, at $85 billion in sales. Sales of contraband cigarettes are at 13% in Eastern Europe, compared with 7% in Western Europe (despite it being the highest priced region). 13 The following cases represent the various complex issues the EU faces with regards to smuggling. The first two case studies are Serbia and Ukraine. These two Eastern European states border the EU and have open access into the EU due to visa and trade agreements. While these countries are considered “low-tax”, they each have high domestic consumption of smuggled cigarettes in addition to representing major origin points for smuggled cigarettes. Environmental factors, such as lax legal environment (for businesses and organized criminal networks), need for foreign investment to boost their new market economies, and easy access to lucrative markets in the West typify the circumstances under which illicit trade occurs. In the last case, Andorra, the complicity of the industry is highlighted, demonstrating that taxes are subject to circumvention not just by criminal networks and entrepreneurs but by the industry itself.
Serbia Case Study
Serbia has always had its own thriving tobacco industry. Following the end of the communist regime by the 1990s, the state owned tobacco companies were broken up as bid for investment from foreign multinationals came flooding in. 23 The fledgling nation under socialist leader Slobodan Milosevic, and prime ministers thereafter have opted for any and all foreign investment to Serbian economy, which gave tobacco multinationals a unique opportunity to set up cheap manufacturing facilities within Serbia and tap into a previously closed market. Since the tobacco industry has a strong political hold due to its ability to attract foreign investment, policymakers and legislators are risk averse and do not want to alienate the smoking public with stricter rules and higher taxes. 23 What the companies found was an eager cigarette market: 59% of adult men and 44% of adult women smoke, with youth smoking prevalence among the highest in Europe. 23
In addition to a vast domestic market for foreign multinationals to market their products, Serbia has a lax legislative environment that represents a boon for multinationals. All the tobacco control laws in place are focused on non-tax issues, such as regulating the nicotine content, establishing cigarette bans in public places, and set up frameworks for advertising bans for the future. The results of these laws have been unclear and tobacco industry sees the Serbian market as still susceptible to smoking consumption in large volumes. 23 Ironically, the focus on cigarette ingredient content may mean a shift from high-tar, low-quality cigarettes that typified the Serbian industry products to low-tar and higher-quality alternatives, which is an advantage for the transnational companies from other European countries (BAT, Gallaher, Imperial) to get bigger share into the market.
However, foreign investment and the influx of multinational tobacco companies on the Serbian market, coupled with lax laws introduced a widespread network of smuggling out of Serbia to the region and into the EU. 26^ Like Andorra, foreign companies can dump their excess cigarettes into the Serbian market, knowing well that there are many smokers in the region. However, with the domestic brands still competing, and cigarette prices reaching levels as low as 0.72 euros, these excess cigarettes are absorbed into smuggling networks and funneled to the rest of Europe using the trade routes described in Part IV. Indeed, under Milosevic, 90% of all cigarettes produced within Serbia – whether under the auspices of domestic or foreign companies – were smuggled out of the country. 26
Ukraine Case Study
Touted as one of the biggest origin countries for cheap cigarettes (second only to Russia) Ukrainian made popular brands such as Marlboros and Viceroys flood EU markets by the millions. At first blush it seems that Ukraine presents the classic case study to support the claims by industry officials that cheaper, low-tax jurisdictions bordering high-tax jurisdictions are the reasons for illicit trade. However, it is evident after examining the details of the nature of the illicit trade in Ukraine that other factors are at play that debunk this theory. Similar to Andorra, the way smuggling works here is the classic model of producing or importing cheap cigarettes into a low tax jurisdiction and shipping it untaxed to the markets of the EU, where they enter the black market.
Led by Phillip Morris International, all four major companies – PMI, Japan Tobacco International (JTI), Imperial Tobacco and British American Tobacco (BAT) – produced or imported an excess of 130 billion cigarettes in 2008, which is 30% more than the market demand according to Ukrainian statistics. These 30 billion “lost cigarettes” are funneled to Western, EU countries where they enter the black market, losing revenue for the government and undermining the tax structure.
In contrast to industry’s simplistic argument that tax levels are all that matter in smuggling, European and WHO experts argue that that the key factors in smuggling is the conduciveness of legal and economic environment in the operating countries. If costs are low, organized crime a norm in business, there is a low chance of prosecution and it is easy to set up a business to coordinate illegal trade, then smuggling can take root in the economy. 17 This non-tax related environment is typified in Ukraine, where consumption of illegal, duty not paid cigarettes is as high as 18%, despite having prices as low as $1.05 per pack. 19
Ukraine’s low-income status among European countries, its history of state-run enterprise and lack of bureaucratic infrastructure to implement laws make it an attractive destination for companies to carry out operations that lead to illicit trade. For manufacturers, producing in this legally lax jurisdiction means that the excise taxes are very low compared to production costs in EU states. Likewise, due to trade laws in Europe, when goods enter a port but have another port of destination – in this case, Ukraine – the goods do not need to be paid duty on until it reaches the destination. 12
Additionally, high smoking rates with the annual consumption around 2,565 cigarettes per person and state-run factories that broke up after the end of the Soviet Union prompted companies to rush to invest in Ukraine. The result is the easy manufacture of millions more cigarettes than is demanded by the local population, prompting smuggling to flourish across borders into Romania, Poland and Hungary – all EU states. 13 These features of Ukraine are similar to many of the Eastern European countries that came out of communist government rule in the 1990s, posing a huge threat to the rest of Europe. It is exactly this ability of companies to produce cheaply that makes the border countries a focal point for illicit trade. That these countries are also potential ascension countries to the EU prompts a response from the EU to tackle the issue of organized crime and smuggling at this root.
Andorra Case study
While non-EU border states such as Ukraine and Serbia produce a unique problem to EU legal cigarettes markets, another facet of illicit trade is large scale container smuggling that occurs within the regional area of the EU itself, with Andorra a well-known case example.
Andorra, a principality sandwiched between France and Spain, highlights the complicity of the tobacco industry and the manipulation of trade laws to circumvent taxes. BAT and Imperial Tobacco shipped upwards of 1520 million cigarettes to the small principality by 1997, increasing from previous shipments of 13 million. Unless Andorrans were smoking 60 British-brand cigarettes a day each, these excess cigarettes were smuggled back either to the United Kingdom, where they would have entered the black market or gone onto other destinations, duty not paid since packets would have “Andorra” as the destination. 14 It was possible to conduct such operations in Andorra because of the lax rules regarding imports and exports and a strong organized crime base that would act as legal distributors of BAT and Imperial Tobacco products. Most importantly, Andorra is a tax-free zone, making it a tax haven for banks, customers and companies alike. Thus, the profit margin of conducting business through Andorra illustrates why this is such a lucrative business: a container of cigarettes, which has 5-10 million cigarettes, originating in the UK can be bought for $200,000 and resold for $2 million. Lost revenue for the UK government reached 2.5 billion pounds by 1997, even as industry officials collected their profits since their money comes from the initial sale of the product. 14 Spain was one of the biggest destinations for Andorran smuggled cigarettes.
This feature of the European market is also highlighted by the Luxembourg trade, whereby only 15% of the cigarettes bought there are actually consumed there, often ending up in France, Germany and Belgium as their final destinations. 14 Manufacturers are technically within the law in such countries’ jurisdictions, because what dealers and retailers do is not their business. Manufacturers of British cigarettes could sell these exorbitant amounts of tobacco to Andorra and not be required to follow up on where the end-market lay. 14
VI. Potential Solutions
Smuggling and cross border shopping represents a major threat to the tax harmonization regime. Solutions to the issues of smuggling and cross-border trading between member states and non-member states remains mired in the divergent ways experts and policymakers view the causes of smuggling and cross border shopping. The view of prominent tobacco specialists in the EU and OLAF is that smuggling in Europe has been a paradox and contrary to logic. As noted, smuggling has gone from wealthier, high-tax countries to less developed, low-tax countries rather than the other way around where cheap cigarettes from “cheap” countries go to more expensive countries. As explained above the main reasons for this have been: 1) EU trade laws that allow goods to be taxed at destination – rather than origin- points, allowing companies to ship to Eastern European countries where taxes are low; 2) smoke-friendly legal and business environments in non-EU countries such as Ukraine, Serbia and Andorra allows companies to produce cheaply and in excess, fueling the illicit trade; and 3) prevalence of criminal organizations that have networks reaching throughout Europe.
Given these different factors that contribute to illicit trade within the EU, several different policy recommendations emerge to find solutions. One main solution is to “turn off the tap” of supply driven tax circumvention by criminal organizations and the tobacco industry that are at the heart of the smuggling problem. 13 To do so, concerted regional efforts are needed to reduce incentives to produce excess cigarettes and to smuggle while protecting the integrity of the tax increases and other tobacco control policies. Often, member states, given their focus of domestic circumstances overlook the regional considerations necessary in staving off illicit trade. 11 Giving into the fear mongering by industry officials, Sweden reduced taxes due to concern over smuggling after having two substantial tax increases in December 1996 and August 1997. Analysis of the decision to do so reveals misinformation on part of the policy makers regarding the relationship between taxes and smuggling, especially with regards to overblown misconception that cross border shopping between states and bootlegging would flood the Swedish market. 14 Also, there was a lack of public support for the taxes since the incidence of taxes in Sweden was already at 73% for a pack of cigarettes.
As an example of the “turning off the tap” solution, Spain has been one of the most successful in reducing smuggling despite having one of the cheapest cigarettes markets in the EU. As explained in the previous section, contraband from Andorra flooded the Spanish market to an extent that 15% of all cigarettes sold within Spain were duty not paid. Efforts between French, UK and Spanish governments and OLAF sealed off the Andorran border and civil guards were mandated to patrol hills and valleys to control smuggling at the “container” level (5-10 million cigarettes). These coordinated policing efforts decreased contraband market from 15% of all cig sales to 5% by 1999 without any change to the tax incidence of 76.1% on the most popular brand cigarettes. An unintended consequence to health, however, was the increase in legal sales by 10 billion, though this came hand in hand with revenue increase of 25%. 14
Secondly, in order to mitigate the unintended consequences of the European trade law saying taxes are applied at the destination point, a “track and trace” regime needs to be set up in parallel to tax harmonization. An effective track and trace regime is a major issue of negotiation during the intergovernmental session of the Protocol on Illicit Trade in Tobacco Products. The proposal is a system whereby all tobacco products are labeled with the port of destination so that products cannot be diverted to illegal channels. 7 Article 15.2 of the FCTC also highlights the need for the Parities to the treaty to set up effective measures to trace at which point products are directed to identify where the criminal activity originates. 6 Both the FCTC and the forthcoming protocol acknowledge that other sectors, such as food, pharmaceuticals and postal shipment employ such tracking measures through barcodes and stickers on products that indicate the destination, the intended price and other information that would be helpful in monitoring the transport of products. 6
Smuggling aside, the harmonization policies also have issues of contention between public health and fiscal goals. Thus, in order to ensure that tobacco taxes meet the health objectives of decreasing prevalence and preventing uptake, taxes must be earmarked for tobacco control programs. Earmarking has been proven to multiply the beneficial health effects of increasing taxes, with examples from the United States showing that when even a portion of the tax revenues goes to anti-smoking activities, decreases in consumption levels and prevalence are larger than expected. 8 Earmarking taxes would go a long way to reconcile the gap between public health advocates and fiscal authorities that administer taxes. The tobacco tax harmonization process in the EU originated with a professed commitment to public health goals since tax differentials and the varied rates of prevalence among EU countries posed a health challenge to Europe as a whole. Additionally, the issue of smuggling is recognized as an important public health issue as it introduces cigarettes at low prices all over the EU, threatening efforts to decrease prevalence and preventing uptake, especially by youth. 13 One way to earmark taxes is to set up health promotion foundations that provide sponsorship to sports, arts and other organizations to replace tobacco sponsorship. 5
Cigarette taxation is an important public health and fiscal measure for the European Union. The need for concerted efforts in improving the health for all Europeans became an imperative during the 1980s; much at the same time as tax harmonization was seen as an imperative to unify the single market that is the EU. Tobacco taxation is thus an important measure to improve both health and economic relations between countries. However, there is contention between the two sectors over the optimal level of taxation that would meet health goals and fiscal goals. Both cannot be maximally improved at the same time due to principles of economic policy.
Through decades of negotiations at the EU level, a uniform tax regime emerged to include a hybrid tax that includes minimum amounts of specific and ad volarum taxes and uniform VAT taxes for all states. As a compromise, states can decide whether to increase taxes beyond the minimum. While most EU states have an incidence of over 65% of retail price as taxes, the type of taxes – whether specific or ad volarum – still make price differences among states. EU border states not subject to the uniform tax have even further variance in their tax levels, which creates a problem in a continent where transport and trade are intertwined and interconnected. What has emerged is a lucrative, billion-dollar illicit trade in tobacco products that poses a threat to the harmonized tax regime as well as to health.
In order to come up with effective models to protect the integrity of the single market tax harmonization it is clear that combating smuggling and illegal cross border trade is a major public health and financial security issue for the EU. Smuggling is a health problem because it introduces low-cost cigarettes into domestic markets, undermining the efforts of tobacco control to reduce consumption, induce quitting and prevent uptake by youth. Smuggling is a fiscal problem that is a major threat to government budgets as it circumvents taxation, depriving the government of millions in revenue. Several factors enable smuggling to occur, the major causes including trade laws and business environments.
With trade laws that place taxation at the destination point, companies can ship consignments to cheap economic environments where taxes are lower and refuel the goods back into the EU. This is common practice as noted by the Serbian, Ukrainian and Andorran case studies. In addition to this method, smoke-friendly business environments allow companies to manufacture cheaply, even in EU states, circumventing taxes and worsening health as domestic consumers have easy access. This was highlighted in the case of Ukraine and Serbia, which have high smuggling rates as well as high consumption rates. The direction of trade is thus not the simple South/East to North/West that the tobacco industry has pitched – often successfully as highlighted by the the case of Sweden in the 1990s – for decades. It is instead a circle that originates first and foremost from the wealthier countries of Northern Europe where wholesale cigarettes are shipped and imported.
For the EU, tax harmonization that applies to all members states must also consider smuggling an issue that effects all member states since undermining the system in one region – such as EU border states that have an influx of smuggled cigarettes – essentially undermines the system in all areas due to the single market act, the legislatively-protected free movement of people and borders, and the trade laws that do not insulate one state from another. Just as harmonization has been a concerted effort since the 1970s, so too must combating smuggling. Several solutions outlined in the FCTC and the forthcoming Protocol on Illicit Trade highlights track and trace regime to ensure that transport of cigarettes are monitored, with destination, origin and price labeled on each pack. This would ensure that diversions from Northern entry ports do not occur and inflated shipping to tax havens such as Andorra are monitored. Concerted efforts to reduce smuggling for vulnerable countries – those bordering non-EU states that are known origin points – can also be coordinated at the EU level. Spain’s success story in reducing smuggling market while increasing taxes is testament to such an approach that included tax authorities, several member states, and border patrol and crime investigators from OLAF. The tax harmonization regime can also ensure that it meets the demands of EU member states by channeling revenue to health programs related to tobacco control objectives. In addition to making good on the health promises of the harmonization regime, funds for track and trace monitors and methods to stave off smuggling in tobacco products could also come from tax revenue.
Overall, the harmonization of tobacco taxes in Europe is a unique regional experiment in curbing the tobacco-related health outcomes by tackling the economics of tobacco. Additionally, harmonization in tobacco has been an experiment in setting regulations under the single market system where transport and trade are nearly borderless among countries within the EU and for most border states not in the EU.
1. 2009 State Tobacco Tax Increase Legislation. National Conference of State Legislation. Available at: http://www.ncsl.org/default.aspx?TabId=13862
Subject: Public Health, Healthcare Policy
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