Economics of Tobacco taxation

It’s all about economics

Fiscal policy should always consider its “wider market environment”. From a European perspective of the Internal Market, this means considering tobacco taxation in third countries sharing a border with the EU. Tobacco tax policy must delicately balance safeguarding government revenues, protecting fair competition and jobs as well as protecting public health whilst at the same time deterring illegal tobacco trade.

Fiscal policy is more efficient in safeguarding government revenues when it is consistent and ensures predictability. Tobacco taxation requires flexibility for Member States to set the appropriate taxation structure and rates that best fit the national context, its market specificities and its fiscal policy objectives. It is essential to maintain a differentiated tax treatment of fine-cut tobacco from cigarettes in order to facilitate the role of fine-cut tobacco as an affordable alternative to cigarettes and illicitly-traded products, preserving the tax-base.

Where Member States have initiated sharp increases in fine-cut excise duties, both direct effects and unintended consequences (increased illicit trade and cross-border purchases) have been registered. This has resulted in an erosion of the tax-base and a deterioration in public finances.

Buffer Function

The buffer function associated with fine-cut tobacco (cf. buffer function), and the relationship between excise duties and illicit trade, are an economic reality that Member States must carefully consider when drafting fiscal policy.

Fine-cut consumers are very different from cigarette consumers and are characterised by higher price-sensitivity and affordability constraints.

Substitution Effect

It is crucial to focus on both the income and substitution effects as both impact the total price effect. Since affordability factors are a determinant for fine-cut tobacco smokers, the income effect is more dominant than would normally be the case.