Alcohol and Drug Information Centre (ADIC - Ukraine)

2.2. Types of tobacco excise tax

At the end of 2001, there was discussion in the Ukrainian media on types of tobacco excise taxes in Ukraine. Some producers (BAT and SOVAT association) proposed to change excise taxes from specific to combined specific and ad valorem tax. Other producers (mainly Philip Morris) defended the existing specific tax system.

Specific and ad valorem taxes are the two main types of excise tax.

	Specific taxes are levied on the quantity of the product produced or consumed—a fixed amount per pack, per 1,000 cigarettes, per 1,000 grams of tobacco, etc.
	Ad valorem taxes are a percentage of the value of tobacco products based on price or cost to manufacturers or importers.

Specific and ad valorem taxes have different effects on prices, profits, tax revenues, product quality, product variety, and administration. The relative merits of each tax depend in part on whose perspective is being used to evaluate their effect.

Tobacco producers care about profit and market share. Therefore, the companies that produce mainly cheap cigarettes (factories without foreign investment and BAT-Pryluki), would prefer ad valorem taxes. The companies that produce expensive cigarettes (Philip Morris Ukraine), would prefer specific taxes.

The government cares about tax revenues, ease of administration, effective tax collection, and the welfare of consumers.

When choosing between the two types of taxes, the government should keep in mind the following problems:

	If inflation is high, specific taxes should be automatically adjusted by reference to the consumer price index (CPI) to keep pace with inflation. It is critical that the adjustment be automatic—by administrative order—and not require a decision from an executive agency or approval from a legislative body.
	Specific taxation is easier to administer since it is easier to determine the physical quantity than the value of the taxed product.
	If tax rates change, producers will react differently under different tax systems. When specific tax rates rise or fall, producers tend to increase or decrease the consumer price by more or less than the amount of the tax, respectively. Thus the consumer assumes the burden of the tax change. But with ad valorem taxes, where the amount of tax paid is automatically built into the price of the product, there is less incentive for the producer to raise the consumer price. In short, increases in specific tax rates are more likely to raise consumer prices than do increases in ad valorem tax rates.
	If the ad valorem tax is a percentage of the manufacturer’s price, the manufacturer may sell cigarettes to a related marketing company at an artificially low price in order to reduce its excise liability.
	A tax based on value (ad valorem) can be difficult to administer if market prices of the excise goods are not established or are undervalued. This can cause a substantial loss of tax revenue.

It is possible to have the best of both worlds by combining a specific tax with an ad valorem tax on tobacco products. For instance, for each member country of the European Union (EU), the excise duty on cigarettes consists of two parts: one specific and one ad valorem (Table 2.1.2).

From the public health perspective, the primary purpose of the tax is to discourage consumption of cigarettes. Specific tax keeps the price of the cheapest cigarettes rather high and discourages low-income people from smoking. However, due to inflation, the tax influence on price is decreasing over time. For example, the tax on filter cigarettes in Ukraine has been stable for the last 2 years, and their inflation-adjusted price has decreased by more than 25 % over this period of time. A decrease of that sort in real prices could cause increase of cigarette consumption.

We also need to take into account which category of consumers is most sensitive to price changes, since specific tax mainly influences consumers of cheap cigarettes, while ad valorem tax has more influence on consumers of expensive cigarettes. According to the national survey results (see Chapter 3), there are no substantial differences between smokers of various cigarette price categories regarding their intention to decrease consumption or quit if the cigarette price increases. Thus, a tax increase as combination of specific and ad valorem tax (which influence all categories of smokers) could be the best option from the public health perspective.

“Hybrid” Tax

It is possible avoid tax erosion of specific tax rates and revenues due to inflation and the undervaluation of an ad valorem system. Implementing a hybrid form of excise tax enforcement and collection realizes the features of both ad valorem and specific taxation.

This hybrid tax is often referred to as the “administered-price ad valorem rate” excise tax. The excise rate is defined in ad valorem terms as a fixed percentage of the taxable price per unit. Tax authorities periodically issue a list of the official price by which the tax is assessed. The tax per unit is reached by multiplying the ad valorem rate with the official administered price.

Advantages of the Hybrid Tax

	Production and inventories are monitored and accounted for and are marked or stamped.
	The same administrative procedures and personnel are used without any further changes.
	Tax revenue loss due to the undervaluation problem of an ad valorem system is avoided, since the government determines the value of the tax base.
	Constant real revenue and rates are maintained by revising the official price list frequently. This reduces the incentive to pile or hoard taxable goods.
	Revisions of the official price list are made without involving legislative procedures, as is required with a specific rate.
	The tax administration of the hybrid system is a more effective method of excise collection than the ad valorem system. Furthermore, the erosion of tax revenues, which occurs when using specific rates, are avoided.

Disadvantages of the Hybrid Tax

	Tax administrators must be aware of the current prices of excise taxed commodities so that the official taxable price is closely related to the current market prices. Otherwise, the tax base is either over- or under-valued.
	The revision, publishing, and distributing of new data and the price list—all dependent on the rate of inflation and the frequency of revision—can be costly.
	If the revisions of the price list or the changes in the official taxable price are made discontinuously and in discreet amounts, then the incentive for stockpiling in order to reduce tax liability will remain, both for consumers and producers .
	The tobacco industry will also try to do everything they can to influence the decisions of tax administrators and keep the official taxable price lower than optimal from the perspective of government revenue and public health.

Presently in Ukraine, the combination of specific and hybrid tax could be the best option. Since the current specific tax rate is rather low from the government revenue perspective (see below), it is recommended not to decrease specific tax, but to add hybrid tax to it. Taking into account that part of the excise tax in the legal market during 2000-2001 (see Table 1.4) was about 12.5%, adding 15% hybrid tax to the wholesale price would mean approximately a 100% increase of the current specific tax rate. The details of increasing excise tax are discussed below.

2.3. Impact of excise tax increase on consumption, government revenue and smuggling