Costs and Benefits of Tobacco Tax Harmonization in EU. The case of Bulgaria(1)

After the release of the final report of the European Commission on Bulgaria on 26th September there is no doubt that Bulgaria will become an EU member on January 1st 2007. One of the various aspects of joining the EU is the need for harmonization of the excise duties in Bulgaria with the tax regime set in the European Union. That means that Bulgaria will have to introduce the minimum excise duties on certain goods until 2013 – on tobacco products, alcoholic beverages, energy and petrol. In this article we will review the impacts on the Bulgarian economy of the introduction of only one type of the duties – the excise duties on tobacco. The experience of the ten new EU member states serves as an example because many of the difficulties that these countries face coincide with the problems that Bulgaria meets and will have to solve in the process of integration.

Taxes on Tobacco in EU – requirements and purposes

The Derivatives of the Council of the European Union amended last in 2002 prescribe the following parameters of tobacco tax structure:

• Member States impose a cigarette excise duty consisting of a specific and an ad valorem component. The minimum total excise duty must be 64 Euro per thousand cigarettes (1.28 Euro per pack of twenty).

• The minimum total level of excise taxation on the Most Popular Price Category (MPPC) of cigarettes in each Member State should be 57% of the retail sale price (including VAT).

• States are exempt from this requirement if the total excise duty on MPPC cigarettes is 101 Euro or more per thousand cigarettes (2.02 Euro per pack).

• The specific element of the tax should be no less than 5% and no more than 55% of the total tax on the MPPC, including the VAT.

There are four general aims of the EU policy in the sphere of tobacco taxation. Here are the stated purposes and the facts related to them:

1)To achieve tax harmonization and uniformity – the EU requirement has not achieved harmonization of tax burdens so far, neither any significant convergence of retail selling prices in EU.

2) To discourage consumption of tobacco products – there is considerable substitution away from high-taxed cigarettes towards low-taxed tobacco or non-duty paid cigarettes. Also, high taxes lessen disposable income of people and discourage consumption of other goods and services.

3) To raise revenues for the government – higher taxes lead to an increase in smuggling and shadow economy, which reduce the government excise and VAT revenues.

4) To correct for negative externalities from smoking. Smokers impose costs on society such as the higher expenses of treating smoking-related illness, lost of well-being and market earnings as a result of illness or death – however, smokers tend to live shorter lives than non-smokers which saves on pension system and healthcare costs of age-related diseases. Also, the principle of personal sovereignty and the idea the of rational consumer are broken by the introduction of consumption-suppressing taxes on cigarettes.

Current situation in the EU

The graph below presents the prices per pack of cigarettes in counties of EU as well as in the two accession states – Bulgarian and Romania. The retail price is divided into pre-tax level and overall tax burden that includes specific, ad valorem taxes and VAT.

Graph 1: Cigarette retail price breakdown
(EUR per pack of 20 cigarettes)

Source: European Commission, July 2006

At present all old EU members (EU-15) meet the minimum requirement of 64 EUR tax per 1000 cigarettes. Relative total tax burdens, which are on average 75% of retail price, do not vary greatly between most old member states. However, there are substantial differences in the absolute amounts of total tax burdens and retail prices of MPPC cigarettes. The most striking and self-evident example is the gap between UK and Spain – the price per pack in UK is 7.69 Euro with an overall tax of 3.05 Euro while the price per pack of cigarettes in Spain is 2.25 euro with a tax of “only” 1.76 Euro.

Currently, only Cyprus and Malta comply with EU cigarette tax regime from all new member states (EU-10). The countries have to increase current excise duty levels on cigarettes by between 18% (Slovenia) and 310% (Latvia). The negotiated transition periods of most of them are relatively short. The periods are as follow:

– Dec. 2007 – for Czech Republic and Slovenia
– Dec. 2008 – for Hungary, Poland and Slovakia
– Dec. 2009 – for Estonia, Latvia and Lithuania

Once a transit state, Lithuania has become a heavy recipient of smuggled tobacco products since the process of harmonization to the EU tax regime began. Until 2003 large quantities of cigarettes were destined for EU-15, and there were only small portions for the local market. From 2003 affordability decreased and the economic incentives for buying smuggled cigarettes increased substantially among Lithuanians. The result was a boost in smuggling for the local market.

In Hungary, despite a 37% tax increase, in 2004 the state revenue development dropped below the 2001 level and in 2005, the legal market keeps shrinking.

Bulgaria – the new member state from 1st January 2007

Bulgaria has already begun harmonizing its excise duty regime on cigarettes since 2002. In 2006 it increased the excise taxes from 6.1 Euro for 1000 cigarettes plus 31.8% on sale price to 7.7 Euro for 1000 cigarettes plus 48% on sale price. As a result, the hike in retail prices of cigarettes in 2006 was 62%. The next (and last) tobacco price adjustment is scheduled for 2010 when specific and ad valorem taxes will increase by more than 40%. These are preliminary projections set in the negotiation program between Bulgaria and EU that says that Bulgaria has to adopt the acquis communautaire for cigarettes till 2010.

Excise duties on cigarettes were increased earlier than required by the European Union because the Bulgarian Government aims to have higher inflation in 2006 and thus, to avoid it in 2007-2009 when the macroeconomic indicators of the Bulgarian economy will, most likely, be scrutinised against the Maastricht criteria for the introduction of the euro in Bulgaria in 2009 or 2010.

The analysis of the components of tax incidence (as of September 2006) shows that the relative share of specific taxes to the overall tax burden in Bulgaria is lower than the EU averages, while the share of the ad valorem exceeds the EU averages. Although Bulgaria meets the requirements of the EU Directive concerning the relative sizes of the tax components, economic theory suggests that there are differences in the economic impact that different types of taxes have on the industry and the market as a whole. According to Professor Cnossen from Maastricht University ad valorem taxes increase absolute price differences, discourage investments in quality, promote cheap tobaccos and favor cheap homegrown tobaccos.

In order to assess the impact of the harmonization process in Bulgaria concerning tobacco taxation and make a cost-benefit analysis of the EU requirements, we need to look more closely at the peculiarities in the country related to tobacco industry and as such, to take into consideration the policy of cigarette production in the country. The production of cigarettes in Bulgaria is still under the monopoly of the state-owned Bulgartabac Holding with a market share of more than 90% of the cigarettes sold legally on the market. The domestically produced cigarettes have been protected by high import duties and all cigarettes have been subject to price regulations imposed by the Government. Tobacco producers have been heavily subsidized in comparison with other entrepreneurs and as a result, the tobacco production in the country is not efficient and a lot of farmers will not receive direct payments under CAP as they fail to meet the requirement of minimum 1 hectare per farm. Control on customs has proven weak and corruption practices are still common.

However, the future of the tobacco business in Bulgaria is not that dismal. Bulgartabac Holding has already begun restructuring its subsidiaries and will privatize several of its plants in the coming months. Abolishment of fixed prices on cigarettes is due in October 2006 and thus the market will be liberalized. Import duties on cigarettes imported from EU will be abolished due to EU accession of the country. New market players have recently entered the market such as Philip Morris and British American Tobacco, which is a clear sign that competition on the market has begun its first steps towards intensifying.

The smoking prevalence in Bulgaria is very high, around 50% in 2005 of the population between 18 and 69. Still, there is a trend towards decreasing of smoking in the country, as in 2002 the prevalence was 59.5%. This tendency, however, is not induced by tax changes. Also, Bulgarians are among the heaviest smokers in Europe according to recent research. Smokers in Bulgaria tend to smoke, on average, more than 20 cigarettes per day. Only Greeks, Cypriots and Romanians can compete with Bulgarians by this indicator.

Also, Bulgaria ranks first in the EU by the percentage of total agricultural land devoted to growing tobacco. In absolute figures, the country is passed only by Greece by the indicator “hectares of land devoted to growing tobacco”.

Findings for Bulgaria

The impact of applying EU cigarette tax regime in Bulgaria is as follows:

1. Affordability of cigarettes decreases substantially in Bulgaria.

The retail cigarette prices in Bulgaria are lower than in most of the EU members, but in real terms (cigarette prices relative to personal disposable income) they are much higher compared to the EU benchmark.

The increase of cigarette prices will be considerably greater than the expected growth in disposable income per capita in Bulgaria. Given the great percentage of smokers in the country, the high tax rates will have a negative impact on overall consumption and savings of people, which means less economic growth for the economy.

2. Increased smuggling, cross-border shopping and bootlegging.

Due to the hike in excise duties at the beginning of the year, Bulgaria now experiences an influx of smuggled cigarettes, which the industry suggests account for more than 15% of the market. The retail prices of cigarettes are already higher than in its neighbors Romania, Serbia, Macedonia and Turkey. Also, legal purchases of cigarettes in duty-free shops have risen by 24% for the first 6 months of 2006.

3. Reduction of purchases of domestic brands, which harms domestic tobacco producers and manufacturing workers.

Bulgartabac’s sales fell by 24% on an annual basis in the first half of 2006, while revenues from core operations fell by 48%. We observe substitution from Bulgarian brands to imported brands – Serbian and Turkish brands are the main substitutes in the “cheap” category, and many also prefer to buy duty-free “expensive” brands.

4. Fiscal losses due to fewer revenues from direct and indirect taxes.

The increase of smuggling and sales in duty-free shops means less VAT and excise taxes paid to the government. In the first half of the year, revenues from excise duties account for 45% of the expected annual excise revenues for 2006. In comparison, all other tax revenues account for more than 50% of their annual expected levels. That means that revenues from excise duties are lagging behind all other taxes. In addition, less consumption of legal cigarettes means a forgone amount of VAT payments, while losses in tobacco industry means less corporate tax payments.

5. Undermining of public confidence in the fairness of the tax system.

6. Taxes hurt the poor much harder than the rich – cigarette excise duties are discriminatory and highly regressive.

7. Privatization of the state-owned cigarette companies will be even harder in such an environment – tax harmonization impedes competition in the sector and set rules that are not in the interest of all market players.

8. Higher taxes increase incentives for fraud, bribery and corruption practices.

Conclusion

Our general recommendations are for tax cuts and abolishment of the requirement for minimum tax burdens on tobacco products within the EU. The tobacco excise duty harmonization in EU fails to meet the stated purposes, and at the same time the costs that are imposed on the economy are not taken into full account by policy-makers. Tax competition, not tax harmonization is the right step for fighting with the black market and encouragement of investments in research and development of healthier products. We believe that the European Commission should review its tax policy and launch an EU-wide debate on the abolishment of the minimum level of excise duties in the member states.

—————————————————————-

(1) The article is based on a speech delivered at an international conference on “Economic, social and security impacts of tobacco excise duty harmonization in the EU”, held on 20th Sept 2006 in Prague, organized by the Liberální institut. For more texts and presentations of the participants please go to: http://libinst.cz/data/Tabak_Aj_final.doc