13.2 The role of taxes in influencing tobacco prices

Tobacco taxation is a pillar in every major international tobacco control strategy^1-6 and is considered the ‘single most effective tobacco control intervention’.⁷ As discussed in Section 13.1, increasing prices impacts tobacco use by encouraging cessation, decreasing consumption, and reducing uptake, and is the intervention with the greatest potential to reduce socioeconomic inequalities in smoking.^5,8 Tax is the main—but not only (see Section 13.13.3)—lever through which governments can influence the price of tobacco products.

Taxation is a particularly attractive tobacco control policy because of clear evidence that taxes have  achieved public health gains, the low cost of implementation of tax increases, the widespread support and acceptance of tobacco taxation, even among people who smoke (see Section 13.12), and increases to government revenue.^5,9-12 Where increases in tobacco taxes result in higher tobacco prices across the whole population, the resulting reductions in tobacco use from even small increases in price can be very large across the whole population, and can be most beneficial to disadvantaged groups.

Despite the well-established evidence of the importance tobacco taxation, it remains an under-utilised strategy internationally. While most countries have some level of tobacco taxes, these are often inadequate or poorly structured. Reviews of tobacco tax systems internationally have noted that many countries, particularly low- and middle- income countries, performed poorly in recent years on four crucial elements of tax policy: simplicity of tax structure, increasing prices, reducing affordability, and share of tax in the final tobacco price.^13,14

The tobacco industry routinely opposes efforts to impose or strengthen tobacco tax systems, and engages in pricing strategies to undermine tobacco tax systems.¹⁵ The final price of tobacco products, the extent to which tobacco taxes are passed on to consumers, and the structure of the tobacco market are determined by the tobacco industry.

13.2.1 What makes for an effective tax system?

13.2.1.1 Types of taxes

Tobacco taxes refer to excise, customs duty, and any other sales taxes that may be applied to a tobacco product. Excise is a tax imposed on locally manufactured or produced goods, while customs duty applies to imported goods. Customs duty may be paid when a product crosses the border, or when the product is released from a warehouse. In Australia, all tobacco products are imported and are levied with an excise-equivalent customs duty (that is, duty that is equivalent to the excise rate) at the time of importation, and then a sales tax (goods and services tax, or GST) is applied at the point of sale. 

Taxes may be specific or ad valorem (value-based). Specific taxes levy a fixed dollar amount per unit. For tobacco, this may be per cigarette, or per kilogram of tobacco. Specific taxes that are based on weight may or may not include aspect of the cigarette such as filters or papers, and for loose tobacco, may be influenced by the moisture of the tobacco product. Specific taxes are generally simpler to administer and adjust.

Ad valorem taxes are a proportion of the dollar value of the wholesale or retail price of the product. Value added tax, sales tax, and goods and services tax are examples of ad valorem taxes. The value of these proportionate taxes is influenced by the final price: more expensive products attract a higher ad valorem tax than budget products do.

The structure of tobacco taxes varies considerably across countries, depending on the combination and relative rates of specific and/or ad valorem taxes in place in each jurisdiction. The structure and rates of tobacco taxes applied in Australia are set out in Section 13.6, and compared to selected countries in Section 13.9.4.

13.2.1.2 Simple structure

Tobacco tax systems may use specific, ad valorem, or a mixture of both types of taxes. Specific taxes, when uniform across all tobacco products (see below), are efficient and less complex to administer. Mixed tax systems are common, however it is recommended that in a mixed system, the specific tax should form a greater share of the total tax than the ad valorem component.¹⁴ More complicated tax structures result in greater variability in tobacco prices, and very high ad valorem taxes actually create incentives for tobacco companies to reduce the price of their products.¹⁶

It has been recommended that taxes in total should comprise at least 75% of final purchase price of tobacco products, and that excise should account for at least 70% of the final purchase price.^14,17 However, as these percentage targets are tied to the purchase price of the product, higher tax proportions do not necessarily equate to higher prices, especially in markets where tobacco products are segmented by price. A budget brand will have a higher tax proportion than a premium brand (as the manufacturers share is much larger for the premium brand), but the total price of the budget brand will be much lower. (See Section 13.6.2.2 for a demonstration of this effect in the Australian tobacco market.)

13.2.1.3 Uniformity across tobacco products

Tobacco tax policies vary widely across the world and need to be tailored to the characteristics of the tobacco market of each individual country.¹⁵ However, tax rates that are tiered according to product attributes such as value, weight, cigarette length, flavourings or other factors such as place of manufacture, are more difficult to administer and more readily manipulated by the tobacco industry.^14,18,19 Tax differentials between imported and domestically produced products, for example, where customs duty is much higher than excise, can create price tiers that favour local products but undermine the impact of tax increases.²⁰ In countries where taxes differ geographically—for example, where sales tax rates vary across states or counties—disparities exist in the prices experienced by different population groups.²¹

Systems in which cigarettes are taxed at a different rate to other tobacco products, such as loose tobacco, create a price differential favouring one type of tobacco product.^22-24 As Chaloupka and colleagues note¹⁸ ‘[t]he structuring of tobacco tax across products and brands within a country can impact the variability of prices within a country, shaping consumption and influencing tobacco users’ incentives to switch down to cheaper alternatives in response to tax and price increases.’ Uniform tax rates across all tobacco products enhance the effectiveness and simplify the administration of tobacco taxes.

13.2.1.4 Routine adjustment

Merely raising taxes on tobacco products does not guarantee effectiveness: strong tax systems must also reduce the affordability of tobacco to consumers across the market, and maintain this costliness over time.^17,25 When real income rises faster than cigarette prices, tobacco becomes more affordable, undermining the deterrent effect of taxation.²⁶ In Australia, tobacco excise has been indexed against inflation, and since 2014, against average weekly earnings in twice-yearly adjustments (see Section 13.6.3.4).

Unless taxes are adjusted sufficiently and with regularity, so that prices keep pace with income growth or inflation, the effectiveness of tobacco taxes naturally diminish over time.^{14,17,18,27-30} This is essential for specific taxes; ad valorem taxes will automatically increases as the price of the product increases.

13.2.1.5 Timing of increases

While the structure of tobacco tax systems is crucial to their effectiveness, it is increases in prices experience by consumers that impacts tobacco use.⁶ To prevent the affordability of tobacco products creeping up over time, indexation adjustments are typically scheduled at regular intervals, such as yearly or twice-yearly. Further increases to taxes may also be scheduled, such as a series of annual excise increases, or sudden, as occurred in April 2010 in Australia (see Section 13.6.3). Pre-announced tax increases allow tobacco companies to plan their pricing strategies minimisation responses,³¹ and can also allow smokers to modify their behaviour in the lead up to the increase, such as through purchasing more tobacco before the increase.³²

13.2.2 Challenges in tax system design and administration

Designing an effective tax system requires more than just establishing a tax rate. The structure, frequency and nature of adjustments, and potential loopholes must be considered, as well as how taxes will be collected and enforced. Strong tax systems should be regularly evaluated, and require operators in the tobacco market to provide data on sale volumes and comply with audits.³⁰ These practices are important to deter illicit trade.

Simple, uniform, and transparent tax structures are likely to be more effective at achieving public health goals, and are also more efficient to administer.^16,18,27,30 Complex tax systems create a much larger administrative burden, where each tobacco product must be categorised and tracked based on its attributes or the sales value of the product. These tiers also produce pricing variability³³ and more opportunities for tobacco companies to manipulate the tobacco market through pricing strategies and product design. International comparisons have shown that ad valorem tax structures are associated with up to 11% higher consumption of cigarettes compared to simple structures, and, compared to uniform tax systems, tiered systems may increase consumption by one- to two-thirds.³⁴ Research across EU countries has also shown that, controlling for other factors, high price dispersion is associated with higher rates of tobacco consumption.³⁵

While the advertising and promotion activities of the tobacco industry are heavily regulated, the major tobacco companies enjoy strong market share that affords them ‘significant pricing power’.^15,36 In Australia, as with many countries, the tobacco market is dominated by only three multinational companies. The dominance of a small number of tobacco companies allows greater industry influence over the range of prices on the market.¹⁹ Other than taxes, restrictions on the size of tobacco products, and bans on promotional giveaways, tobacco companies and retailers are able to determine the final price of tobacco products, the range of products on the market, and when and by how much their prices change. Price discounting in retailers is extensive and targeted, particularly in countries with limited advertising and promotional opportunities, with discounting forming the highest proportion of US tobacco marketing expenditure.^37,38

Even systems that follow best-practice principles usually do not require tax increases to be passed on in full to consumers, or within a prescribed time period. These decisions are at the discretion of the tobacco industry. As is evident from analysis of internal industry documents³⁹ and what is now an extensive body of international research, they may elect to apply less of the tax increase to particular types of products (usually budget cigarette brands or roll-your-own tobacco), a practice termed under-shifting, while simultaneously over-shifting (passing on more than the required increase) on premium brands to subsidise their reduced margins (or even, in some cases, losses) on the under-shifted products.^40-47 This variable, and often incremental, pass-through of tax increases will also increase the dispersion of prices across the market. These factors are explored in Section 13.4 in the context of the Australian tobacco market, and policies to counter these practices are discussed in Section 13.13.3.

The biggest challenge to tobacco taxation systems is the control of illicit trade—see InDepth13A for a full discussion of this issue.

Related reading

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References

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