2.1. Recent tobacco excise taxes policy

The history of tobacco excise taxes in Ukraine can arguably be divided into 3 periods: 1) the lowering of excise rates in order to promote manufacturing (1993-1995); 2) an increase of rates in order to increase revenues (1996-1999); and 3) tax stabilization (end of 1999-2001).

1993-1995: What benefit does lowering rates give?

Before 1993, the tobacco industry was state-owned and there were no tobacco excise taxes. Beginning with January 1st, 1993, the excise tax in Ukraine equaled 70% of the customer’s price. At that time almost all branches of the economy, including tobacco factories, decreased their production due to a general economic crisis. The decision was made to try and improve the situation by attracting foreign investors, and at the end of 1993 a portion of Ukrainian tobacco factories became joint ventures, where the controlling interest belonged to Transnational Tobacco Companies (TTC). Investors promised a lot but also demanded corresponding work conditions. In their opinion, the excise duty rates were too high and didn’t promote production. They promised that budget losses from excise tax cuts would be compensated for by production increases. In this way, excise rate cuts began. In December 1993, the Cabinet of Ministers lowered tax rates on filtered cigarettes to 60%, and the non-filter cigarette rate to 45%. At the same time, the excise duty rates on imported cigarettes were adopted at the level of 150% of customs (purchasing) value. This outwardly appeared to defend domestic producers, but in reality this excise rate was much lower, since the majority of cigarette importers were registered «Chornobyl» funds, which were exempt from certain excise duty payments. On November 16th, 1995, the exemptions for «Chornobyl» funds and other importers were cancelled, but new excise rates for imported cigarettes - 6 ECU per 1000 cigarettes - came into effect on December 1st, 1995. This in fact worked out to be a lowering of tax rates. For example, in 1997 the level of minimal customs value was adopted, where the cheapest non-filter cigarettes cost 4.1 ECU per 1000 cigarettes. According to the excise rate of 150%, the excise tax equals 6.15 ECU per 1000 cigarettes. But in February 1996, under an anti-smuggling guise, the Verkhovna Rada lowered the excise rate for imported cigarettes to 2 ECU per 1000.

As for domestic cigarettes, the process of attracting foreign investors did not end in 1993. In February 1994, the Verkhovna Rada lowered excise rates for domestic filtered cigarettes to 50%, and for non-filter cigarettes to 35%. But even this turned out to be too little, and soon the rates were adopted at a level of 40% for filtered cigarettes and 10% for non-filter cigarettes. In this manner, the rates for filtered cigarettes were cut almost in half, and for non-filter cigarettes were made 7 times lower (see Fig. 2.1.1) in the short period of 14 months. TTC’s attention to non-filter cigarettes was not coincidental, since they produced most of these cigarettes. This tax policy caused a decrease in the production of filtered cigarettes from 22% of the general cigarette production in 1991 to 11% in 1995.

As a result of these tax rate decreases, the general production of cigarettes in Ukraine increased from 42.4 billion pieces in 1993 to 48 billion pieces in 1995 – only a 12% increase (see Table 1.1). It is clear that such a small increase could not compensate the lowering of the tax rates by 6. Taking into consideration the value-added tax, a six-fold rate cut could be compensated only by an absolutely unrealistic threefold increase in production. Compared to the level of 1992 (57.7 billion pieces), the production decreased by 20%.

Even with these excise rates, the Ukrainian market was filled with contraband. According to 1995 estimates it made up about 30-40% of the market, or 20-25 billion pieces. One of the reasons for this situation was that the tax policy resulted in a lack of effort by the TTCs to produce international cigarette brands or any filtered cigarettes in Ukraine; instead they simply sold filtered cigarettes produced in their Western factories to legal importers and even more often to contrabandists. Their main production profits in Ukraine were from non-filter cigarettes.

Thus, the policy of lowering excise taxes resulted in:

1) a significant decrease in state budget revenues, since the small increase of production did not compensate for losses caused by lowered excise rates; and

2) an increase in the shares of non-filter cigarettes in general production; and

3) an increase of contraband sales.

1996-1999: What benefit does increasing excise taxes give?

The total failure of the policy of lowering excise rates caused the government to introduce some changes. The system of taxes was changed from ad valorem tariffs (value tariffs, i.e. the percent taken from the cigarette’s value, which was often understated) to specific (i.e. a definite sum for a definite amount of any cigarettes). In February 1996, the Verkhovna Rada imposed taxes on filtered cigarettes at the level of 2 ECU per 1000 cigarettes, and for non-filter cigarettes the tax was temporarily set at 0.5 ECU in 1996 and 1 ECU in 1997. Thus, excise duty increased by approximately 1.3 times for filtered cigarettes and 2 times for non-filter cigarettes.

Tobacco producers, of course, did not like this tax policy. In July 1996, the «Ukrtyutyun» (Ukrainian Tobacco Association) claimed that «the adopted rate level destroys the domestic tobacco industry» and proposed to decrease the level of excise duty to 20% for filtered cigarettes and 10% for non-filter cigarettes, cuts of threefold and twofold, respectively. This proposal was based on the expectation that an increase in filtered cigarette production would increase aggregate budget revenues. But time proved these projections wrong. For example, it was estimated in these claims that the current rates would bring an annual production of only 39.5 billion pieces, while adoption of their proposition would bring a production of 45.7 billion pieces. The real production in 1996 equaled 44.9 billion cigarettes - 93.5% of the 1995 level. If the Kremenchuk factory is excluded from the estimates, then in 1996 production even increased by 4%. This reduction is also explained by the decrease (by 4.5 billion pieces) of exports to Russia due to measures taken by the Russian government.

Due to increases in excise rates, budget revenues from excise taxes in 1996 totaled 53 million UAH with an annual projection of 23 million UAH. Earnings from value-added taxes also rose. The growth of excise tax rates on tobacco production in Ukraine thus proved to be quite reasonable. In 1997, the tax rates on non-filter cigarettes grew 100%, as planned, and the result completely refuted the tobacco industry’s projections. Production increased by 21% from 1996 (to 54.5 billion pieces), and budget revenues from excise tax on domestic cigarettes equaled 129 million UAH (143% more then 1996 level). In 1998 the tax rates on non-filter cigarettes doubled once again. However, the excise tax on filtered cigarettes decreased from 4.8 UAH in February 1996 to 4.2 UAH because of a weakened ECU exchange rate. To keep increasing profits from cigarette excise taxes, the government increased tax rates on 3 August 1998 to 3 ECU per 1000 filtered cigarettes and 2.3 ECU for non-filter cigarettes. But in two weeks the notorious August fiscal crisis arose and tax rates in UAH almost doubled. That is why in December 1998, the Verkhovna Rada changed the rates to 2.5 ECU per 1000 cigarettes (see Fig 2.1.2). 

In 1998, excise duty rates on all kinds of cigarettes increased from 4.2 UAH in January to 10 UAH in December. In the opinion of opponents to the tax increase, this a situation would have caused a total collapse of cigarette production. The result once again proved otherwise. Production was 58.8 billion pieces (8% more than 1997 level), and the budget revenues equaled 286.7 billion UAH (122% more than 1997 level). In dollar equivalence, revenues increased from 30 million dollars in 1996 to 70 million dollars in 1997 and 117 million dollars in 1998. Hence, the state had won despite the fiscal crisis (see Fig. 2.1.3).

In 1999, the excise rate in ECU terms was stable and equaled approximately 10 UAH per 1000 cigarettes. Only in the fall of 1999 did the hryvnya’s drop in exchange rate bring the tax rate up to 12 UAH. On November 19th, the Verkhovna Rada adopted a fixed excise tax - not in ECU this time, but in UAH - 10 UAH for 1000 cigarettes (for non-filter cigarettes the rate was provisionally set to 7 UAH until 1 July 2000). By this act, the Verkhovna Rada had finished the period of annual growth of cigarettes excise rate. Nonetheless, the financial result of 1999 proved to be glorious once again – budget revenues reached 522 million UAH or 126 million dollars. These tax increases, according to all of the tobacco industry’s projections, should have sharply increased contraband, but the result again was unexpected. According to different expert opinions (e.g. the journal Tobacco Reporter), the general consumption of cigarettes in Ukraine in 1996 amounted to 60-65 billion pieces. We have verified these calculations. Production in 1996 amounted to 44.9 billion pieces, legal export amounted to 9.3 billion pieces, and legal import added up to 4.2 billion pieces. That brings the total legal consumption to 40 billion pieces. The contraband, even by tobacco industry judgments (which is always inclined to exaggerate the amount of contraband cigarettes in order to intimidate the government into lowering taxes) was at a level of 20-25 billion pieces (if we subtract from the aforementioned a total of 60-65 billion pieces). According to the laws of economics, this kind of growth in consumption in such a short period of time could only happen two ways: lowering cigarette prices and/or growth of the average income of consumers. The prices could not have decreased because taxes were growing, and the August fiscal crisis 1998 could have hardly influenced the price of cigarettes that consisted 99% of imported materials (tobacco, paper, filter). If the incomes of consumers actually did increase, they used their extra income on more expensive filtered cigarettes, because the share of non-filter cigarettes in general consumption went down. Thus, the consumption in 1998 was no more than 65 billion pieces, of which legal consumption made up 59.1(production) + 5.6(import) - 3.7(export) = 61.0 billion pieces. Therefore, the contraband amount actually didn’t exceed 4 billion pieces and was much lower than the 1996 level.

This decrease in contraband activity was stipulated first and foremost by the actions of the government. They introduced excise stamps, floor prices on imported cigarettes, strict transit control, etc. But the tax policy also played a role in the contraband decline. In 1995, contraband only sold filtered cigarettes. Increasing non-filter cigarette taxes without really changing excises on filtered cigarettes forced the tobacco industry to produce domestic brands of filtered cigarettes.

The contraband growth in 1999 was brought about by external factors, like a large difference between non-filter cigarette tax rates in Russia and Ukraine. Legal consumption that year constituted 53.7(production) + 3.4(import) - 5.7(export) = 51.4 billion pieces. The contraband thus amounted to no more than 13 billion pieces, approximately two times less than the 1996 level.

What are the results of this four-year period of tax increase?

1. The state budget income grew from 53 to 522 million UAH, or from 30 to 126 million dollars.

2. The share of non-filter cigarettes in general production decreased from 85% to 39%.

3. Contraband sales decreased.

Table 2.1.1. Economic results of two types of policy concerning tobacco taxes

2000: What benefit does stabilizing tax rates give?

In the year 2000, the excise rates on filtered cigarettes were stable - 10 UAH for 1000 pieces, while on non-filter cigarettes they temporarily (until 1 July) amounted to 7 UAH. The tobacco industry tried its best to maintain the excise rates at the previous level or even decrease them to 5 UAH, motivated by a setback in production. This setback, as they stated, was caused by non-filter cigarettes excise tax difference in Russia and Ukraine and the smuggling of cheap non-filter Russian cigarettes. In December 2000, the Verkhovna Rada decreased the non-filter cigarette excise to 5 UAH, although the profile committee, the Ministry of Finances, and the Tax Administration spoke out against it. The new tax rate took effect on January 1st ,2001.

Stabilizing the taxes on filtered cigarettes and decreasing non-filter cigarette taxes had different effects on joint ventures than on factories with 100% Ukrainian capital. During the 1999 tax growth, joint ventures’ production decreased by 10%, while the Ukrainian factories actually experienced a boost in production (Table 1.6). In 2000, production in Ukrainian factories fell 30%, but the year 2000’s tax policy affected joint ventures differently. From January through April 2000, compared to the same period of the previous year, production was practically the same. During the period of May through June it grew 27%, and in July it equaled the previous year’s production once again. This trend is very simply explained: in expectation of an increase in non-filter cigarette excise rates, production lines were run at full throttle in order to pump out as many cigarettes as possible while still paying the current low rate.

In half a year’s time, joint ventures produced an additional 2.5 billion cigarettes, and during the next half year (when excise rates increased) they produced 3.5 billion cigarettes, and so the new tax policy proved to be profitable for them.

The new tax policy was only one of the factors that caused a decrease in production at Ukrainian factories. For example, in 2000 the Donetsk factory, which produces only non-filter cigarettes and is closest to the Russian border, increased its production by 67% (Table 1.6).

In 2000, the budget got 446 million UAH from tobacco excises (195 million in the first half of the year, while the rate on non-filter cigarettes was 7 UAH, and 251 million UAH in the second half of the year when the rate was 10 UAH). This works out to be only 82 million dollars, which is 25% less than 1999’s cigarette tax revenues. And, production went up from 53.7 billion pieces to just 58.5 billion pieces, a mere 9% increase. Legal consumption (which is a basis for excise and other taxes) increased only by 4.5%. Tax rate cuts were made in order to fight against contraband, but there have been no signs of success. The year 2000 proved clearly that the claim that lowering tax rates in anticipation of increased state revenues due to a production increase is groundless.

In 2001, cigarette production increased; however, tax reduction for non-filter cigarettes had a rather moderate contribution to this growth. If compared with first half of the year 2000, the production of non-filter cigarettes decreased by 7.5 %, while the production of filter cigarettes increased by 18.5%. For the whole year, production of non-filter cigarettes was 15.2 billion pieces, which is 17 % more than in 2000, but 39% less than in 1999 (Fig. 1.1). The production of filter cigarettes increased to 54 billion pieces. It is 8 billion pieces more than in 2000. Consequently,the reduction of non-filter cigarettes tax rates with the intention of increasing their production to compete with Russian non-filter cigarette smuggling gave very moderate results.

In 2001, excise tobacco tax revenue was 583 million hryvna (US$ 108 million). In dollar value it is less than in 1998 and 1999. In 2000 the revenue from excise tax for non-filter cigarettes was the following: the first half of the year – 50.4 million UAH (7 UAH/1000 * 7.2 billion), the second half of the year – 53 million UAH (10 UAH/1000 * 5.3 billion), in total - 103.4 million UAH. In 2001 the revenue was 5 UAH/1000 * 15.2 billion = 76 million UAH. Again, the best result for governmental revenue was during the time of the highest excise rate.

When compared with European Union countries, cigarette prices and taxes in Ukraine are much lower (Table 2.1.2). If in the EU taxes are 67-79 % of the retail price, in Ukraine it is only 33 %.

Table 2.1.2. Average cigarette pack (20 pieces) prices and taxes in the EU countries and in Ukraine for July 2001

As for the difference in excise tax rates between Russia and Ukraine, even the Russian association «Tabakprom» acknowledges that Russia has one of the lowest excise rates in the world and that it must be increased gradually in accordance with the taxation level of neighboring countries. During the year 2000, Russia increased tobacco taxes twice, and taxes on some kinds of cigarettes are already higher there than in Ukraine (Table 2.1.3). In July 2001, the Russian parliament increased excise tobacco rates by 12 %.

Table 2.1.3. Excise taxes on tobacco products in the Russian Federation

In 1999, Russia collected only 2.4 billion rubles of tobacco excises while production equaled 294 billion cigarettes. Russia produced 6 times more cigarettes than Ukraine, but collected only 96 million dollars of excises, which is 30 million dollars less than Ukraine’s revenues. In the year 2000, due to an excise tax increase, Russian revenue doubled to 5.1 billion rubles (190 million dollars), while production increased by only 341 billion cigarettes (by 14%).

The problem of smuggling from Russia can be solved by intergovernmental negotiations. The mechanism for such negotiations is defined in the Framework Convention on Tobacco Control proposed by the World Health Organization.

According to the experience gained from the Ukrainian tax policy in 1993-2001, the most promising policy from the point of view of state budget revenues is to increase cigarette taxes annually to a level that at least exceeds the inflation rate. The overall positive consequences of gradual tax rate increases clearly exceed all possible negative consequences.