Monday, February 27, 2012

Tobacco Tax 6: On Cigarette Smuggling

I posted my paper last February 23,  Tobacco Tax 5: Consumer Demand After Tax Hike and Smuggling, to some of my discussion yahoogroups, it attracted many good comments and counter-comments. I am posting them below. Get your favorite snacks, this is 11 pages long, cheers.


As usual I am amused by the graphical presentations. To begin with, it is quite amazing that anyone has been able to locate the curves at all in the x-y quadrant, when there have been no references made to previous reserach studies, that have computed for the coefficients of the cigarette demand or supply function, say in an urban setting. As you well know, slopes, inflections, and elasticities matter. Without these information, we will not know exactly where final prices and consumption will end up. Even granting the general directional shifts that you posit, without providing the precise location of the starting curves and their elasticities, one could arrive at any set of prices and consumption outcomes, and their ordinal relationships with each other, that would be different from the ones you concluded.

First off, there may be more lines in the graphical presentation than is necessary. If we limit movements to sin taxes alone on local cigarette manufactures and legit imports, there would be no reason for the demand curve to shift. One would think that final equilibrium price (and consumption) will just move along the original curve, not necessarily outside of it. Dont you agree? It will be the supply curve shifts that will determine the movement along the demand curve and the final outcomes wrt price and volume. . If this is true, then straightaways we can do away with or remove two cluttering lines from the chart.

Secondly, I agree that the supply curve will experience a shift, if the level of sin taxes change. As this will affect the marginal cost of making (legit) cigarettes available to the relevant market. But it will affect only those portions of the supply curve that represent the MC of local 'manufactures' and legit imports. I seem to recall from 101 that the supply curve is the MC envelop curve for all stocks made available to the market (i.e., in this case, local manufactures, legal imports, all the way up to contraband and smuggled). The 'stacking' or consumption order is from cheapest to most expensive. New sin taxes will certainly rearrange the original stacking order. But I doubt that the portion of the curve depicting contraband stuff will necessarily change. We are only sure of is that the final transaction or clearing prices in the relevant market will change.

Thirdly and lastly, the critical gap in the graphical presentation is the omission of the externalities ( social or health costs of smoking in a populated setting), which probably would impact the demand curve more since it is actual smoking that 'kills'. Like all pollution issues, this is the toughest nut to crack. But I think that only with these refinements, can discussions on sin taxes become more informative and productive. And that without them, we simply would remain in the dark, if not actually even be misleading.

Pardon this humble intervention but it has been a while since I last engaged. The real reason is I finally got a new internet connection with a cheaper provider. More power to you..

- Gary

Ahhh, the beauty of being criticized by Gary's wisdom. And that's the irony of it -- you won't draw him in unless you post something that is amusing to him, and I'm glad that I made one :-)

My additional points to your comments, Gary.

The graph is hypothetical, no assignment of figures and numbers. So P1 can be P5 per pack, or P22.25 or P49.50 or other random or estimated numbers that one can assign from some empirical studies out there. And yes, there can be as many supply curves and demand curves at different micro levels (demand curves by Mr. Smoker A, by Ms. Smoker B, byTherapist Smoker C, by Magician Smoker D, by Smokers ageing 15-19 yrs old, 20-24 yrs old, etc.). Likewise, Smuggler A will have his own supply curve different from the supply curves of Smuggler B, Smuggler C, and so on. But I limited the S and D curves to only 3 each for simplicity purposes. In fact I wrote that paper mainly for the various health NGOs and health professionals as my target audience, as they are the ones who are relatively active in pushing for really high tax rates for tobacco and alcohol products, mainly for public health reason, not so much for public finance. Thus, the need to simplify the graph.

It is possible that only the different supply curves will be moving and the demand curve will stay as is, and so the new equilibrium price will just lie along the original curve, I agree. But the probability of the demand curve moving rightwards or leftwards is larger than the probability of it staying in the same place. As Alex Magno wrote, if the tax is hiked from P2.70 to P30 and the retail price will go up to P100 per pack, then one option for him and other smokers is to totally quit smoking and so, DOF will collect not P30 but zero from each smoker who quit. And as I discussed in the paper, another option for smokers is to totally abandon the known brands that were hit by the tax hike and shift to lesser known cigarette brands that pay zero tax because they are entirely smuggled. The smuggler definitely paid bribes to certain government officials to make his smuggling easier, but the upward influence of bribes to the retail price is much lower than the upward tick due to the tax hike if the smuggler was a formal supplier.

The proposed larger state intervention via higher tax rate is supposed to address the social externality issue. About 7 of the 10 leading causes of death in this country are smoking related, directly or indirectly. It's good actually that we do not have elaborate and expensive welfare system that gives free hospitalization, free healthcare, etc. to people who abused their body and we ordinary mortals contribute for their healthcare so that they won't meet their creator much earlier than what they really desire.

Meanwhile, I am curious of the various simulations and elasticities. the major assumptions by the DOF in coming up with the magic number, P60 billion per year of additional revenue collections; ie, P60 B on top of existing tax collection from tobacco and alcohol products. Did they assume that tobacco smuggling is totally or partially curtailed?

- Nonoy


I dont want to belabor this issue, but the actions of Alex Magno and his tribe (reacting solely to retail price signals) can very well be accomodated by, and along, one and the same demand curve. There is no real need for that curve to shift just because his group is constricting consumption due to market price changes. .Anyway, I get the drift of your argument and would now want to beg off this interesting debate. It may be well to remember that tax people feel it their duty to continually come up with measures that will keep tax revenue levels from falling, since expenditure levels are not within their immediate sphere of control. Thats within Congress's prerogatives. They know how unpopular that task is. So we can appreciate that they start off with really atorocious tax proposals, which they can then whittle down until it finally meets with public acceptance. You are doing a yeoman's job speaking for consumers. .

- Gary

Really? You assume that smuggling will ensue when we raise taxes on cigarettes? Even with the rate of tax hikes which brought Alex Magno to such fits of hilarity, cigarette prices domestically will still be much lower than those sold in other countries. When domestic prices are lower than international prices, what is the incentive to smuggle?

- Ms. H.

the DOF did not consider tobacco smuggling as one adverse effect of the 1,000 percent tax hike. Consider petroleum products. The import tax is only about 1 to 3 percent, right? But oil smuggling is rampant, based on the estimates made by Ms. Monsod and other writers, why? I think that the 1 to 3 percent import tax is small for the importers, they can afford to pay it and avoid all the hassles of bribing BOC guys and other politicians. What really distorts their pricing i the additional 12 percent VAT on top of import tax + brokerage fees + other local taxes and fees. So to simplify things, just bribe those govt people and pay no or little VAT, etc.

Many smokers compare not so much Philippine price vs. Sing or HK or Malaysia or Japan price, etc. say for a Marlboro blue seal. Rather, they compare current price vs future price as a result of the huge tax hike. If the jump is too big, even if the new price is still lower compared to Sing or HK or Malaysia or Japan price, etc., then looking for cheaper alternatives like smuggled cigarettes is one cool alternative.

- Nonoy

I no longer smoke so this is ho-hum for me. But when I did, we chose smokes not because of price but rather taste. We bought blue seal then because they had higher quality tobaco unlike the local ones; aside from the status symbol. I agree with that quality being equal, the lower price wins.

You guys take Alex Magno too seriously. Do you still recognize him from yesterday? Besides, I don't buy his idea that smokes and sips are the most elastic. He is glossing over their addictive qualities. I remember a friend of mine when SMB firsy started touying with raising the price of beer; he said that then, he might have you reduce his food budget if that happens. Anyway, has anyone done any research on the elasticities of these products?

Lucio must be laughing all the way to the bank. PM bought FTI for market share because of the latter's preferential tax status. Now, they're going to get hit with a K percenter (yes, K stands for thousands (along with T and M), and you can tell that to PSBankers).

My problem is with alcohol. From media releases, some say Emperador will rise to P200 from P50 while Hennessy will drop to P2,000 from P2,500. It's not that I'll stock up on Emperador; rather, my friends will hold off buying Hennessy. If true, at least local brandy will become more expensive than rubbing alcohol. Brandy and wine, of course, is come hell or high water for me, as it is prescribed.

- Ed

DOF believes that demand for alcohol and cigarettes are inelastic, hence our contention that even with a tax hike resulting to decline in consumption, we would be netting additional revenues.

Estimates of elasticity for cigarettes vary from .2 to .8. We used .528. It's a bit challenging explaining what this means to some who I think just simply refuse to understand.

Those opposing tax hikes argue that it is discriminatory and anti-poor to subject a low-priced cigarette or drink to the same tax rate as the more expensive brands. We argue that cigarettes and alcohol products are not necessary nor basic goods which are essential to the survival of people. Every stick of cigarette, Hope or Pall Mall or Astro, carries the same mix of toxic chemicals which is hazardous to health.

So far, only the tax on tobacco has been subject of discussions during the hearing. We have to wait for the discussion on alcohol products.

- Ms. H.

I came across some figures: it seems that cigarettes and beer are similarly or more inelastic than rice. Wine and spirits are more elastic (probably since they are more expensive?). Also, taxation is not only to raise revenue but manage consumption too.

- Ed

The alcohol people, specially the distillers, are lowkey in these discussions because of the recent WTO decision ruling with finality against the Philippines. The government needs to amend the tax structure to make the tax provisions compliant withe WTO provisions. But the other day, the first salvo was actually hurled by Asia Brewery against the DOF bill, claiming it is anti-poor. Our rebuttal - the proposal only wants to promote moderate drinking and healthier lifestyles, which certainly cannot be anti-poor.
- Ms. H.
If cigarettes from neighboring countries are smuggled illegally say into the philippines, wont they be able to escape paying domestic taxes to their mother or source country? if they are able to , then would not that make it possible for smuggled cigarettes to be sold here cheaper than local manufactures?
- Gary
based on WHO data on a survey of the most sold brand, PH prices are still lower. In any case, smuggled cigarettes into the Philippines can be legitimate exports from some other countries, and normally there are no taxes levied on exports anyway.

- Ms. H.

Re smuggling, Good luck!

The last time Ontario, Canada increased the tax rates (in the 1990s) on tobacco products, smuggling went out of control. Even the big tobacco companies were found to gave encouraged smuggling, and were fined millions of dollars.

They would export Canadian cigarettes to the US, then bring them back through the Indian reserves on the Canada-US border. Not only did it result in new reduction of tax revenues, it also bred new groups of criminals - including native Indians and their friends among the Hell's Angels.

The governments have to pull back the tax hike to original levels within two years, but some damage has been done.

So, let the kumpits thrive the Philippine seas again.

- Amiel

Good points, Amiel, thanks.

It seems that the DOF does not believe the "tobacco industry's bogeyman smuggling".
If so, why did they stop at 1,000 percent increase? Why not 3,000 or 6,000 percent increase? After all, DOF and BOC can control smuggling and Philippine cigarettes will still be "cheaper" compared to cigarettes from Sing, HK, Japan, etc.

I mentioned it earlier, oil smuggling is rampant as narrated by Ms Monsod and others, mainly because the combined costs of import tax (1-5 percent), VAT (12 percent), customs brokerage, LGU taxes, excise tax, etc. are way high, it's cheaper to pay huge bribes to BOC people, the police and LGU officials than pay all those taxes and fees.

The higher the taxes, the higher the temptation to cheat and bribe government people. So more taxes, more regulations, more corruption. Taxation and other forms of government coercion are like anti-gravity measures, they oppose the natural movement of people and nature. People want things to be as cheap as possible, whether these are nutritious food or laptops and books or harmful tobacco and alcohol products, they want things to be cheap, at free trade prices.

By slapping as much taxes and indirect extortion as high as possible, government is inviting more corruption and the corrupt are more than happy to work in government, like the BOC, BIR and Congress, di ba.

- nonoy

Just a couple of things:

1. Smuggling is a non-issue. Why? It's rampant everywhere in the region. Since it can't be eradicated but not everything can be smuggled, we might as well make the most of what we could withn the rest. PH excise taxes on tobacco are behind those of its neighbors so it's just leveling the field. The case mentioned was in 1990. The environment and logistics today in PH are much different. Can't imagine Philip Morris exporting to ASEAN to be smuggled back here, or smuggle from their ASEAN plants. Tobacco is facing not only higher taxation but production and consumption controls everywhere. I don't think they'd like to antagonize authorities here or anywhere else in Asia where it is still relatively easy for them. What will probably happen, if at all, is illicit local trading in cigarettes. Oh, how fortunes come and go!

2. Do we want all things to be cheap. If you cannot ban bad products, might as well bill them to ameliorate their effects. Of course we want free choice, but if there is cost to society then that has to be tempered in my view.

- Ed

Thanks Ed for the additional points.

1. Smuggling is AN issue. The more restrictive the government trade and investment policies, the more lucrative and tempting smuggling becomes. HK is a free trade economy, unilateral free trade (ie, no trade negotiations, no need for FTA, no need for WTO in most cases), so no one is smuggling there, except those for goods which are expressly prohibited and regulated (bombs, guns, poisonous substances, pets and animals perhaps, etc.).

2. All things that are clearly not harmful (cellphones, shoes, bags, clothes, appliances, cars, etc.) should be left to their free trade prices (ie, zero tax and tariff). Only local taxes like VAT, which apply also to local goods and services, should be applied to imported goods and services.

- Nonoy

Big Tobacco will not engage in smuggling? Oh... They were fined $550 Million in 2010 (see article below) or this link:

Canadian firms exported to the US, so there was no local tax on the cigarettes. Then, these were smuggled back to Canada. That was the time the the government raised taxes from $5 to $10 per box of 10.

ASEAN manufacturers could "export" to the Philippines and not pay local taxes.

While the big tobacco companies were not charged directly for smuggling, they were fined for conspiracy to commit smuggling - as they cannot explain where the truckloads of cigarettes are going (not usual channels). Does the ASEAN governments have that resolve to track and penalize? As far as I remember, nobody in Malaysia was charged with smuggling cigarettes to PH in the 1960s-1970s.

Tobacco firms to pay $550M over smuggling

Last Updated: Wednesday, April 14, 2010 | 12:44 AM ET CBC News

A decade-long legal battle pitting Big Tobacco against the federal and provincial governments drew to a close Tuesday, with two cigarette makers agreeing to pay more than half a billion dollars in connection with a massive smuggling operation set up in the 1990s to dodge taxes.

North-Carolina-based R.J. Reynolds Tobacco Co. will pay the two levels of government a total of $325 million to settle claims related to the smuggling.

A Reynolds subsidiary, Northern Brands International Inc., has been fined $75 million after pleading guilty under the Criminal Code to one count of conspiracy for helping others sell contraband cigarettes.

Canadian tobacco manufacturer JTI-Macdonald Corp. has been fined $150 million after pleading guilty under the Excise Act to helping people sell and possess contraband tobacco.

The governments had previously reached deals with two other tobacco manufacturers, Imperial Tobacco Canada Ltd. and Rothmans Benson & Hedges.

Taking into account those deals and the ones announced Tuesday, cigarette makers have been hit with a total of $1.7 billion in fines and settlements.

"It was litigation that had been going on for more than 10 years now, and simply, that's really what led to the settlement at this time," said R.J. Reynolds spokesman David Howard. "Essentially, it was a business decision that it was time to move on."

Under the terms of the settlement, R.J. Reynolds did not admit any guilt.

Though named in the suit, the company was not directly involved in the alleged smuggling, Howard said. However, its subsidiaries and operating companies "had individuals that were involved in alleged activities during those years," he said.

RCMP called it a massive fraud

The case stems from a contraband operation the RCMP once called the biggest corporate fraud in Canadian history.

From late 1980s to the mid-90s, with tobacco taxes at what were then all-time highs, several cigarette manufacturers shipped cartons of their product to the U.S. labelled "for export," thereby avoiding Canadian excise levies, which apply to domestic product only.

The cigarettes were then smuggled back into the country, many through Akwesasne, an aboriginal reserve that straddles the U.S.-Canadian border near Cornwall, Ont.

Back in Canada, contraband packs sold for as little as half the price of legal ones.

By 1992, an estimated 20 per cent of cigarettes sold across Canada and 50 per cent of those sold in Quebec were smuggled. That figure rose to 60 per cent by 1994. The brands involved included Export A, Player's and du Maurier.

While the smuggling operation was in full swing, tobacco companies were lobbying governments to lower cigarette taxes, pointing to the prevalence of contraband product as all the more reason to grant them tax relief.

Faced with a massive illegal industry and lost tax revenue, Ottawa and various provincial governments relented in 1994 and lowered levies on tobacco. They began raising them again after allegations surfaced in 1999 that the tobacco companies had quarterbacked the entire smuggling operation.

Northern Brands, the R.J. Reynolds subsidiary, was fined $15 million US in 1998 on a tax evasion rap south of the border, but the Canadian government aimed higher, hoping to recoup billions of dollars in lost tax revenue.

The federal government sued major tobacco companies in 1999 in a U.S. court for several billion dollars in damages, but that case was dismissed. In 2003, Ottawa tried again, this time in Canadian courts, suing the tobacco companies for $1.5 billion.

The government also pursued criminal penalties against tobacco companies and their managers, laying charges for fraud and conspiracy in 2003 against Toronto-based JTI-Macdonald, formerly known as RJR-Macdonald, and eight of its former senior executives.

The following year, police raided the Montreal headquarters of Imperial Tobacco, hunting for documents in relation to the smuggling.

'Sweetheart deal'
Anti-smoking advocates say Tuesday's $550-million settlement is "a sweetheart deal" for tobacco-makers.

"The tobacco smuggling in the early 1990s was, at the time, the largest and most destructive fraud in the history of Canadian business and public health," said Garfield Mahood, executive director of the Non-Smokers' Rights Association.

The association said the drop in cigarette prices in the early 1990s made tobacco products more accessible to young people and led to a resurgence of teen puffers after a generation of falling rates of smoking.

It noted that the federal and provincial governments filed claims for nearly $10 billion over contraband smokes. Mahood said that makes the $550-million settlement "a complete sellout."

"Canadian governments led by the feds had an opportunity to play hard ball, to build trust among Canadians in the rule of law related to white-collar crime. Instead, they blew away the opportunity to recoup billions of desperately needed lost tax revenues," Mahood said.

In another email loop, I got this comment from Dr. R.

Dear Nonoy
Thanks for your analysis of the effects of increasing tobacco tax increases. I would like to point out that demand for cigarettes has been found to respond to price. This is the public health intention - I.e., to reduce smoking prevalence. There is a point however when the demand becomes inenlastic ( studies show that 15% of smokers will continue to smoke at whatever price) - the idea is to reach this point in order to reduce the health problems that are smoking related.

Thanks Doc.
I fully understand the public health concerns in raising the tax on tobacco, and I am 100 percent supportive of raising the tax on tobacco and alcohol products. Last night, I heard a cardiologist from Capitol Medical Center, Dr. Atubag, speak in a rotary meeting, and he outlined how smoking really increases the risks of CVDs.

My concern only is on the rate of increasing the tax. Is 1,000 percent increase optimal? Or 5,000 percent, or only 200 percent, or other numbers? There are at least 3 simultaneous goals that must be attained together:

1. reduce smoking by people through higher price,
2. reduce smuggling which produce cheaper cigarettes that encourage more people to smoke, and
3. raise revenues for the government but smuggling will produce little or zero for the government.

I believe that a 1,000 percent tax hike will increase smuggling and thus, cheaper cigarettes can still get in. Smuggling need not come from abroad, they can come from ordinary bodegas within the country protected by the local police and LGUs. If smugglers will pay the equivalent tax of 200 percent as bribes to the police and LGUs, it's still cheaper than paying 1,000 percent in actual tax.

If jueteng, prostitution, shabu and many other services that are explicitly declared as banned and prohibited, not just allowed but heavily taxed, can exist until now, cigarette smuggling is a possibility that can actually happen. And all the 3 goals above will be defeated.

- Nonoy

Hi Nonoy
The 1000 percent figure is tobacco lobby propaganda - only the lowest priced brands will be so affected which is good because the lowest socioeconomic groups are the most price sensitive and will immediately respond by reducing consumption. My recommendation is to commit the government to annual incremental increases while monitoring consumption until the asymptote is reached.

- Dr. R.

I like your proposal Doc.

An annual hike in tax can be done in one law, saying something like "10 percent increase in tax rate each year until 2025..."

Another scenario that can crop up aside from cigarette smuggling, would be the rise of micro-cigarette producers, like the micro-brewery, micro-winery. I know for instance of duhat wine being produced by a farmers' cooperative in one barangay in pangasinan with the brand "le dilla". Such wine producers and their wine are not taxed.

So some tobacco farmers' cooperative would be producing their own brand of cigarettes and since the public, the media, even NGOs are tame to criticize POs like a farmers' coop, such possibility can crop up. Soon they may become front manufacturing of the big tobacco guys. But this is still speculation on my part.

- Nonoy

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