Taxation

Tobacco tax policy must be delicately balanced to safeguard government revenues and protect fair competition, jobs and public health, whilst also deterring illegal tobacco trade. Precipitous taxation of tobacco spurs the sale of illegal tobacco products, increases criminality and risks billions in EU tax revenue. Smart tax policy balances market realities with health objectives and the dangers of tobacco smuggling.

In 2020 alone, excise taxes on tobacco products raised almost €89 billion for EU governments (approximately €110 billion VAT included).

Tobacco smuggling and sales of illegal tobacco products threaten this income and society at large. Sales of illegal products mean that governments and citizens lose out on tax revenue, which instead flows into the hands of criminals who also traffic drugs and guns into Europe. Proceeds from the sale of illegal tobacco may also be used to fund terrorism. The fight against illegally traded tobacco is therefore a fight to protect EU citizens.

Authorities state that, from a health perspective, consumers are put at risk when they consume counterfeit tobacco products. These products are not held to EU quality standards and are passed off as legitimate products in Europe. As these illegal products are not subject to the same rigorous scrutiny as legal tobacco products, authorities assert that consumers cannot be sure of what they contain.

Fine-cut tobacco plays a vital role in reducing the risk of counterfeit cigarettes and securing government tax revenues. High unemployment and falling wages over the last ten years, combined with steady increases in tobacco taxation, have significantly reduced price-sensitive consumers’ ability to afford legal tobacco products. While rising cigarette prices force consumers to seek out cheaper products, consumers who can no longer afford cigarettes find in fine-cut tobacco a legal and affordable alternative to illegally traded cigarettes. Fine-cut tobacco therefore acts as a buffer between legal and illegal products, due largely to its lower price reflecting its semi-finished nature.

Smart tax policy should maintain this tax differential with cigarettes, allowing fine-cut tobacco to fulfil its buffer function between legal and illegal tobacco trade.

Most of ESTA’s members are mid-sized or small, often family-owned, operations. Many ESTA members operate in rural and economically disadvantaged areas where employment opportunities are scarce. Their activities contribute to the local economy and society. Poorly conceived taxes on tobacco can have disproportionate effects on smaller manufacturers, driving them out of the market, thereby further increasing market concentration. A well-balanced tobacco tax policy should take into account local industries by addressing the differences between smaller and large manufacturers.

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Excise Duties and Differentiated Tax Treatments

An excise duty is a tax applied to certain goods at the moment of manufacturing, rather than at the time of sale. Maintaining different excise tax levels for different tobacco products is necessary to reflect varying levels of consumer price sensitivity, manufacturer profiles, and modes of production for different products.

As a semi-finished product, fine-cut tobacco is a different consumer good compared to cigarettes. Smokers must make separate purchases of rolling paper, or tubes, before investing time to manually prepare fine-cut smoking articles for use. This aspect gives fine-cut tobacco a lower tax-bearing capacity compared to finished-product cigarettes, a fact that has been recognised by both Member States and the European Commission.

Consumers of fine-cut tobacco are predominantly more price sensitive than consumers of cigarettes. A rise in taxes on cigarettes and fine-cut tobacco will result in a higher proportion of fine-cut tobacco smokers looking for cheaper alternatives, which tend to be illegal tobacco products. A uniform tax on tobacco products is, therefore, counterproductive in combating illegal trade and erodes tax revenues.

The manufacturing of fine-cut tobacco also differs from that for cigarettes, further adding to the disparity in tax-bearing capacity. The fine-cut tobacco manufacturing process is relatively labour intensive compared to cigarettes. Manufacturers of fine-cut tobacco are often small and mid-sized enterprises, many of which are family owned and located in rural and economically disadvantaged areas where they are important employers. A uniform tax that is sustainable for large multinationals would disproportionately and unfairly penalise smaller producers and their consumers.

Different products have different characteristics, different manufacturers, different production processes, different consumer groups and obviously different market share and degrees of maturity. For the market to function properly and fair competition to be safeguarded, taxation policy must reflect these differences. Comparisons between products without considering the product’s and consumers’ characteristics as well as the underlying economic realities does not provide a solid foundation upon which successful policy choices can be made.

For all of these reasons, it is important to maintain an excise tax differential between fine-cut tobacco and factory-made cigarettes.

Member States’ Prerogative

Taxation is a national competency in the EU, with Member States having the individual freedom to set their own levels of taxation, and to a certain extent, their own structure. There are very good economic reasons for Member States keeping this ability. Different national markets have different structures and consumer profiles. For example, applying the same tax in different countries would unfairly distort the market as consumers will likely have a different relative demand and different affordability.

A uniform excise duty would not work in all markets. It would result in the erosion of tax revenues for some national governments and fuel illegal trade. A sustainable tax rate in one market may push trade onto the black market in another. Taxes on tobacco products must be sensitive to the differences between national markets and the specificities of each market.

National governments are best placed to address the particular circumstances of their markets in their tax codes. Some Member States, for example, rely more on tax revenue from tobacco than others. These countries should be able to design their respective tax codes accordingly. The same holds for health policies and priorities, which differ between Member States and are best handled by national governments.

For fine-cut tobacco, the European legal framework for tobacco taxation leaves additional flexibility to Member States to adapt the tax structure (specific and/or ad valorem) as to best fit their objectives and market characteristics. This is mainly due to, unlike cigarettes, the absence of one identifiable EU market for fine-cut tobacco. In reality, there are 27 national ones, as the share of fine-cut tobacco in total tobacco consumption can range from approximately 0.2% to 53% in the different Member States.

Revision of “Excise Directive” 2011/64/EU

The Council Directive 2011/64/EU on the structure and rates of excise duty applied to manufactured tobacco, also referred to as the Excise Directive, has been very successful in its aim of raising excise requirements while also allowing Member States flexibility in implementing the Directive.

The last review of the Directive resulted in step increases in the minimum excise requirements for fine-cut tobacco from 40% of the weighted average retail selling price (€40 per kg) in 2010 to 50% of the weighted average retail selling price (€60 per kg) in 2020. The structure of the Directive allows national governments to increase this minimum gradually over ten years and to set tax rates while taking account of national issues, such as the tax charged in neighbouring countries, illegal trade and smoking tobacco traditions.

The European Commission recently communicated on its intention to revise this Directive once again, mainly to provide a legal framework for new products introduced on the market. The European Commission also indicates this new revision will be the opportunity to raise the minimum EU taxation levels for the various products categories. Decisions on minimum taxes will without a doubt influence illicit trade, and therefore, government revenues, in one direction or another. This revision process should therefore deliver rational decisions, based on facts and evidence, accounting for market mechanisms and differences in terms of national circumstances.

Maintaining a price differential between lower-priced fine-cut tobacco and cigarettes has an essential role in combating illegal tobacco smuggling. Standard economic logic dictates that demand for tobacco does not fluctuate greatly in response to changes in price. While it is true that demand for tobacco is, per se, highly inelastic, the demand for duty-paid tobacco is more sensitive to a change in price. In the absence of a cheaper legal option, price-sensitive consumers faced with more expensive cigarettes will turn to the illegal market to find a cheaper alternative. Due to its nature as a cheaper, legal alternative to cigarettes, fine-cut tobacco fulfils a vital buffer function between legal cigarettes and illegal products. Price-sensitive consumers turning away from expensive cigarettes and looking for more affordable options can purchase fine-cut tobacco, instead of switching to illegal products.

For many European governments, the public health objective of tobacco regulation is to decrease the prevalence of smoking by making tobacco products less affordable. However, that objective is not achieved when lower income consumers shift their tobacco purchases from a legal to the illegal market. There is, therefore, a fine balance to strike taking into account the public health objective and varying income levels of individual consumer groups.

Recent developments underscore the importance of the buffer function of fine-cut tobacco in excise policy. During the economic crisis, fine-cut tobacco sales volumes grew at an average annual rate of 5.1% between 2009 and 2012. As the economic situation across Europe stabilised, fine-cut tobacco sales declined by 2.5% between 2013 and 2015. Cigarette volumes grew by just over 1% during the same period, according to a European Commission study, and the illegal trade in cigarettes in the EU remained more or less stable, ranging between 9% and 11%. This illustrates the fact that fine-cut tobacco can act as an alternative to illegal tobacco products for price-sensitive consumers turning away from legal cigarettes. More recently, the closure of borders during the COVID-19 outbreak demonstrated that those consumers who would usually source their cigarettess cross-border, shifted towards domestic fine-cut tobacco in absence of cheaper alternatives.

On several occasions, the European Commission suggested the existence of a “tax-induced substitution” of cigarettes by fine-cut tobacco, implying that tax levels are set with the view to push a smoker towards the second category rather than the first. There is no such “tax-induced substitution” in the EU. Substitution of cigarettes by fine-cut tobacco when arising is predominantly “affordability-driven”, and the existence of a tax (hence price) differential allows Member States to mitigate the negative impact of priced-out cigarette consumers that would have otherwise sought cheaper and no, duty-paid alternatives.

The updated London Economics studies published in 2018 and 2021 reinforce the point that affordability is a key driver amongst fine-cut tobacco smokers.