4.1. The level of cigarette smuggling into country and its impact on government revenues

Since smuggling is an illegal activity, it is very difficult to get an accurate estimate of its level and its impact on revenues. Estimates of the amount of annual budget loss caused by smuggling vary from 100 million UAH (data of the State Tax administration) to up to 200 million US dollars (1 billion UAH) (according to Ukrainian MP Tatiana Zadorozhnaya, Business newspaper, N 27, 2000). The estimates usually do not provide the source of data and method of calculations with two exceptions: the SOVAT Association (Association of Support of Alcohol and Tobacco Production and Sale) and the International Centre For Policy Studies.

4.1.1. The existing estimations of smuggling volume and losses of the budget

The SOVAT association presented the following calculation (see Table 4.1):

Table 4.1. Calculation of Ukrainian budget losses from illicit trade of tobacco products in 2000 by the SOVAT Association

Note: the monthly average rate Euro is taken at the rate of 1 Euro = 5,4 UAH. The ratio of illicit filter and non-filter cigarettes is assumed at 10 % to 90 %.

We consider the given calculation to be flawed for several reasons:

1) The volume of consumption of cigarettes in Ukraine is overestimated, and accordingly, the volume of smuggling is overestimated. We shall consider this problem below, but for now we shall consider the calculation involving the smuggling volume offered by the authors.

2) The calculation is based on the assumption that all smuggled cigarettes could be imported into Ukraine legally, with payment of all taxes and duties. The price of a pack of non-filter cigarettes, for which VAT is calculated, is (10+3) Euro х 5,4 (exchange rate) + 8,5 UAH (excise tax per 1000 sticks)/ 50 (number of packs of 20 for 1000 sticks) = 1.57 UAH, and with VAT the price of a pack is 1.89 UAH. At such a price, the legal import of Russian cigarettes (even filtered ones) becomes absolutely senseless, as their market prices are 0.50 UAH for non-filter and 1.00 UAH for filter cigarettes. The losses for the budget thus arise from the assumption that the volume of smuggled cigarettes could be replaced with cigarettes made in Ukraine with all taxes paid. But in such a case, it is necessary to exclude the sum of the import duty from accounted losses. As forthe VAT, according to the State Statistic Committee data in 2000 the average price of non-filter cigarettes was 0.92 UAH for a pack, and for filter ones – 1.42 UAH. The price of 1 cigarette was respectively 0.046 and 0.071 UAH. Thus, the losses from non-paid VAT would be from non-filter cigarettes: 0.046 x 20%/120% x 20,3 billions = 156 millions UAH, and from filter cigarettes 0.071x 20%/120% x 2,3 billion = 27 million UAH. Thus, the following calculation of losses is more realistic: 195 (excises) + 183 (VAT) = 378 million. In UAH, that is 2,5 times less than presented by the SOVAT.

The International Centre For Policy Studies has estimated total amount of smuggling in 1999 to be 18,6 billion. They presented two estimates of the budget revenue losses: 660 million UAH and 400 million UAH. The first one proceeds from a technique similar to the SOVAT, but uses a more realistic customs price for non-filter cigarettes (see Table 4.2).

Table 4.2. Losses of the consolidated budget and the Pension Fund as a consequence of illegal tobacco imports in 1999

* the following average customs values were used: 0.45 UAH for non-filter cigarettes and 2.5 UAH for filter cigarettes.Source: ICPS estimates

Thus, the authors of the calculation specify that “if all taxes were paid, the price of a non-filter pack of “Prima” cigarettes produced in Russia would exceed 1 UAH, making the cigarettes non-competitive compared to domestically produced analogues. Hence, the above-given estimate is likely to be a theoretical one. More accurately, budget revenue losses may be estimated under the assumptions of zero illegal imports and legal domestic production of the same quantity of cigarettes.

Therefore, they offer a different circuit of calculation: Based on data from 1999 on the production and total contributions of tobacco companies to the state budgets at all levels, we calculated that the average tax content in each cigarette produced in Ukraine was approximately 2.2 kopeks. Hence, according to our calculations, if illegally imported cigarettes had been legally produced in Ukraine, the budget would have received an additional 400 million UAH in the form of taxes and duties.

The authors do not take into account that the taxes were paid from all legally produced cigarettes (60% of them were filter ones), and the smuggling, according to their data, consists of 94% of non-filter cigarettes, and therefore the average tax content in each cigarette should be much lower.

The same authors estimate total amount of the illicit cigarette market to be 700 million UAH. If so, the tax share of this amount is not less than 57%. It is equal to the minimum tax level of the EU countries, while in Ukraine the tax share in legal retail price is 32%. Proceeding from this assumption, a more realistic rating of losses of the budget could be 224 million UAH.

4.1.2. Estimation of smuggling volume and losses of the budget by the ADIC-Ukraine

Thevolume of the legal market of tobacco products (manufacture - export + import) is well known from the statistics data. In 2000, it was 53,6 billion cigarettes. All of the calculations involving thesmuggling volume are based upon estimates of the total volume of the tobacco products market (with the assumption that there is no smuggling of legally sold cigarettes to other countries).

Certainly, it is impossible to measure the volume of the market precisely. In June 2001, the Institute of social research conducted a national representative survey in Ukraine. The survey included questions on the quantity of the smoked cigarettes. A careful analysis of the survey data and the age-gender structure of the population has made it possible calculate the amount of smoked cigarettes (including the smuggled ones), which is 67 billion pieces (see Table 3.17). However, the survey method has some shortcomings, and it is impossible to rely only on it.

There is a more simple and reliable method. The tobacco industry experts have incentive to exaggerate the volume of the market to exaggerate the volume of smuggling (in order to lobby for reduced taxation of their products). Therefore, from all of the tobacco industry estimates, we can work with the lowest figures. For Ukraine, this figure is quite stable (65 billion pieces). This estimate was given by a Tobacco Reporter journal in 1996, by the JTI in 1999 (Companion Magazine N 9, 2000), and was confirmed by Philip Morris in 2000 (Business newspaper, N 9, 2001). The association «Ukrainian Tobacco», which usually circulates the figure of 75 billion in its media messages, notes in a letter to the World Health Organization for the FCTC public hearings: “According to professional estimates, the overall market has declined from 80 billion cigarettes in 1990 to 65-70 billion cigarettes in 1999”.

Thus, it is quite realistic to assume that in 2000, the total market volume in Ukraine was 67 billion cigarettes. Hence, the volume of smuggling was equal to 13 billion cigarettes. To simplify the calculations, we assume that this volume consists of 10 billion non-filter cigarettes and 3 billion filter cigarettes. If all of these cigarettes were made in Ukraine, the budget would receive the following incomes (Table 4.3):

Table 4.3. Losses of revenue as a consequence of smuggling in 2000

This amount is 6 times less than total tax (including local taxes) revenues from tobacco production in 2000 (1,5 billion UAH).

In reality, the loss would be even less, since the illicit non-filter cigarettes are sold at a price of about 0,50 UAH a pack and it is hard to expect that the entire volume will be replaced by packs costing 0,92 UAH. Besides, smuggling partly consists of filter cigarettes (mainly international brands) that are sold in Ukraine without any tax stamps. To eliminate this flow, it is not enough to harmonize the tax rate with neighboring countries. Thus, the real losses from smuggling in 2000 did not exceed 200 million UAH.

In 2001, the volume of the legal market is much higher (56 billions for 10 months), and according to general opinion, the quantity of cigarettes smuggling declined at least twice (although the expected growth in the manufacturing of non-filter cigarettes did not take place). Therefore, in 2001, the budget loss resulting from of tobacco smuggling will not exceed 100 million UAH, which corresponds to the calculation of the State Tax Administration.

The government proposes to increase the cigarette excise tax rate to 13,5 UAH for 1000 pieces. However, budget revenues can only grow from excise taxes of 30% (approximately 160 million UAH). Even if the volume of smuggling returns to a peak level in 1999-2000 (although it is very unlikely), the additional losses in the budget will not exceed 100 million UAH.

4.1.3. The estimation of budget incomes from Ukrainian cigarette smuggling

According to expert estimates, low excise taxes for filter cigarettes in Ukraine provide incentives for illegal import of cigarettes that are legally sold in Ukraine, with Ukrainian tax stamps, to other countries (see below). In this case, all taxes to the state budget are paid. If 1000 filter cigarettes with price of 1.50 UAH for a pack are illegally sold, the budget revenue would be: 10 UAH (excise tax) + 2.5 UAH (Pension Fund tax) + 1.5 * 20/120 (VAT) * 50 (number of packs of 20) = 25 UAH. According to the SOVAT association experts estimates (Tobacco Review, N 3, 2001) in 2000 showed that about 5 billion cigarettes were illegally imported from Ukraine. Accordingly, in 2000 the budget income from the smuggling of Ukrainian cigarettes was 125 million UAH. In 2001, the production of filter cigarettes in Ukraine sharply increased and the illegal import of Ukrainian cigarettes possibly increased. However, even if it had stayed at the 2000 level, in 2001 the balance of incomes and losses of the state budget as a consequence of smuggling in Ukraine was positive.

4.1.4. International experience

It has been argued, often by the tobacco industry, that higher cigarette taxes will not have the intended effect of raising revenues and discouraging cigarette consumption. This is largely based upon the argument that higher taxes will lead to an increase of all forms of smuggling, thereby significantly reducing sales of higher taxed cigarettes, but not reducing overall consumption since legal and illegal substitutes can be found.

Some countries, most notably Canada and Sweden, have accepted these arguments, rolling back prior tax increase.

Beginning in the early 1980s, Canada steadily increased its cigarette taxes so that by 1991, there was a large price differential between US and Canadian cigarettes. Estimates suggest that the market share of smuggled cigarettes, which was low till 1990, was nearly 30% at its peak in 1993. Much of the Canadian black market in cigarettes consisted of domestically produced cigarettes that had been exported to the USA and then illegally smuggled back into Canada. However, even between 1990 and 1993, while estimated contraband cigarette consumption rose from 1.3 billion cigarettes to 14.5 billion cigarettes, the overall per capita cigarette consumption declined by 14%. While total cigarette tax revenue fell somewhat from 1991 to 1993 as a result of the sharp upturn of cigarette smuggling, they were still well above tax revenues prior to the tax hikes. In response to an aggressive tobacco industry-sponsored campaign, the Canadian federal tax was greatly reduced. Smoking prevalence has risen sharply since the tax roll back, reversing the earlier downward trend associated with tax increase. While the purpose of the tax cuts was to combat the smuggling problem and raise cigarette tax revenue, they had the opposite impact. Federal tax revenues fell sharply after the tax cut, from CA$2,98 billion in 1992-1993, the last full fiscal year prior to the tax cut, to CA$1.91 in 1994-1995 the first full fiscal year after the tax cuts. This drop in revenues occurred despite the surge in tax paid cigarette sales, which rose from 30.2 billion cigarettes in 1993, to 45,6 billion cigarettes in 1994.

After a careful analysis of the previous failure, Canada has returned to its policy of tobacco tax increases. In November 2001, Canada’s federal government and the country’s provinces raised tobacco taxes by up to CA$4.50 ($2.83) per carton of 200 cigarettes in a drive to reduce smoking. The rise in taxes, the second such hike this year, will bring CA$240 million a year into federal coffers. The largest increases are in five eastern provinces, where taxes had been slashed in 1994 in an effort to reduce smuggling across the U.S. border. However, the higher taxes did not fuel a new rash in smuggling, because changes introduced at the time of the last tax hike, in April, meant tobacco export taxes also go up. Special export tax was introduced in Canada to reduce the incentive to smuggle exported Canadian cigarettes back into Canada. There was no adverse impact on smuggling from the tax hikes in April.

Sweden had much the same experience as Canada. Despite the fact that cigarette prices were higher than those in most EU countries, smuggling was estimated, at most, to be 2% of Swedish cigarette market in 1996. Two significant tax increases in December 1996 and August 1997 raised average cigarette prices by 43%. The tax increases were effective in both increasing tax revenues and in reducing smoking in Sweden. Tobacco tax revenue rose by 9% in 1997, and smoking prevalence rates, based on annual survey data, fell sharply from 1996 to 1997. At the same time, anecdotal reports and some very limited empirical evidence suggested that cigarette smuggling rose after the tax increases. In response to the perception that smuggling was becoming a problem, the August 1997 tax hike was repealed in August 1998. As a result, Swedish tax revenues from cigarettes decreased from SKE 6313 to SKE 5770 in 1998, while tax paid sales per capita rose from 34 packs in 1997 to 51 packs in 1998.

The experiences of many other countries mirror those of Canada and Sweden. That is, in country after country, with very rare exception, increases in tobacco excise taxes have led to increase in tax revenues and reductions in tobacco use. In South Africa, for example, cigarette excise taxes were increased by 351% over the period from 1990 to 1997, increasing revenues by 177% and reducing tax paid sales by 22%. Smuggling increased from imperceptible levels to about 6% of the market. Similarly, estimates from the United Kingdom based on data from 1971 through 1993 imply a revenue elasticity for cigarette taxes of 0.6-0.9, indicating that an increase in cigarette taxes raises cigarette tax revenues by 6%-9%. Likewise, France increased taxes and prices several times in 1991-1996, nearly doubling the nominal retail price of cigarettes. This led to a reduction of more than 14% in overall cigarette sales and reduced smoking prevalence by 15%. At the same time, tobacco tax revenues rose by nearly 80%, while smuggling remained relatively unimportant.

4.1.5. Ukrainian experience

Tobacco excise taxes were decreased several times in 1993-1995. The data on budget revenues for these years are not available, but data on the legal consumption reveal that smuggling was very high those years (20-25 billion pieces annually or 30-40% of total market). In 1996-1998, excise taxes were increased annually. Governmental revenue from excise tobacco taxation increased from 54 million UAH (USD30 million) in 1996 to 129 million UAH (about USD 70 million) in 1997, and to 286,7 million UAH (USD 117 million) in 1998. In 1998, the level of smuggling was estimated as 4-10 billion cigarettes, or 6-15% of total market. The contraband growth in 1999 was brought about by external factors, such as the large difference between unfiltered cigarette tax rates in Russia and Ukraine. This difference was mainly caused by the famous financial crisis of August 1998 when the exchange rate of both the Russian ruble and the Ukrainian hryvna to the US dollar and other hard currencies dropped, while excise taxes were established in rubles in Russia, but in Euro in Ukraine. The contraband in 1999 was estimated at no more than 13 billion cigarettes (20% of the total market), approximately two times less than the 1995 level. However, in 1999, the revenue from excise tobacco taxation increased to 522 million UAH (about USD 126 million), despite the decrease of legal tobacco consumption from 61 to 51 billion cigarettes.

In November 1999, tax rates were decreased, and in 2000, the budget got 446 million UAH from tobacco excises (195 million in the first half of the year, while the rate on unfiltered cigarettes was 7 UAH, and 251 million UAH in the second half of the year when the rate was 10 UAH per 1000 pieces). It amounted toonly 82 million dollars, which is 25% less than 1999’s cigarette tax revenues. Legal consumption went up to just 53.6 billion pieces, a mere 5% increase.

The Ukrainian experience clearly shows that an increase of excise tobacco taxes did not cause an increase in the level of smuggling and gave growth to budget revenues.

4.2. Large-scale organized smuggling