The principal aim of the European cigarette excise system is to improve public health. By setting excise duties on cigarettes and other tobacco products, the EU aims to reduce their consumption via increase in prices. Democratic societies tolerate damage inflicted on oneself unless it causes damage to others. Excise policy approach represents a different – paternalistic view towards consumers. Essentially, it implies that the EU seeks to change the preferences and choices of its citizens. In fact, individuals’ (consumers’) choices depend on personal evaluation of costs and benefits arising from certain activities, including smoking. Their choices and preferences should be respected. Intervention via excise duties violates the principle of tax neutrality, as it aims to change consumers’ behavior.
Excise duties on tobacco products might be justified on the grounds of internalizing negative externalities that smokers impose on society. However, there are substantial hindrances to achieving this aim by applying excise taxes. The major problem is that it is impossible to precisely measure the amount and extent of negative externalities. The weakness of the externality argument is revealed by the fact that excise duties are often used as a significant source of budget revenue rather than as a means to compensate for negative externalities.
Another idea behind the excise taxation is to create higher levels of harmonization (approximation) within the EU in order to eliminate or reduce “distortions of competition”. However, the harmonization argument is based on an incorrect interpretation of the principles of competition and common market. It is not uniform taxes, but the four freedoms of movement that create the EU common market. In fact, tax systems themselves are potential sources of healthy competition; harmonization shields national governments from competition of regulatory systems at the expense of their residents. In addition, harmonization prevents societies from seeking lower taxes and smaller, more efficient governments. It limits individual countries’ opportunities to adapt to their unique social, economic and geographic conditions. Finally, the aim to achieve tax harmonization in the EU is unrealistic, as member states can always set higher excise duties (because there is no limit on the maximum amount of excise tax). In fact, the excise tax regime has failed to achieve significant convergence, as price differences remain substantial.
Overall, the EU tobacco excise duties system is plagued by numerous flaws. First, as has already been mentioned, it is guided by paternalistic principles as well as by the unrealistic aim of tax harmonization which is in turn based on a wrong perception of competition. Furthermore, the current excise system puts heavy burden on consumers and companies, especially in the new member states. Large taxes significantly distort market information of supply and demand. In addition, they stimulate illicit trading as well as substitution towards cheaper and potentially unhealthier products as well as other intoxicating activities e.g. sniffing glue. This in turn undermines the health objectives of the excise system. Moreover, the EU tax system reduces countries’ flexibility in designing their tax systems and adjusting them to their particular contexts. Besides, it diminishes opportunities for healthy competition of regulatory systems. Finally, the EU excise system is volatile, complicated and lacks transparency. Clearly, it is in need of reform.
To begin with, minimum duties requirements (the 57% rule and the minimum requirement of 64 euros per 1000 cigarettes) should be substantially reduced due to the flaws of high and rigid taxation analyzed above. Preferably, minimum duties requirements should be completely eliminated. The minimum duty of 64 euros per 1000 cigarettes is particularly problematic, as it does not take into account purchasing power (affordability) differences within the EU.
One way to proceed with the reform would be to abolish the MPPC concept, eliminate the minimum requirement of 64 euros per 1000 cigarettes and the 57% rule. Instead, the EU could set significantly lower minimum excise requirements for the ad valorem component and the specific component respectively. In other words, member states would have to apply at least certain percentage of ad valorem taxation and at least certain amount of specific taxation per 1000 cigarettes. These significantly lower minimum requirements would be applied on all cigarettes.
Such design would be an improvement upon the existing system. It would be much simpler and more transparent. Furthermore, it would allow for excise differentiation depending on the specific context of individual countries. A further advantage of such proposal would be the recognition that excise tax harmonization in the EU is both unreasonable and illusionary. In fact, an even better solution would be to leave only the minimum requirement on ad valorem rates (the best solution, of course, would be not to set any minimum requirement at all). This is because ad valorem taxation has a number of advantages over specific taxation. Specific rates change relative prices and distort the behavior of market participants. They reduce the variety of products in the market, discriminate against cheaper products, arbitrarily reduce the range of available choices. Specific taxation does not take into account price and purchasing power differentials, and thus imposes excessive burden on lower-income consumers and countries, which encourages smuggling and substitution towards cheaper and potentially more harmful products.
There are worries that eliminating the minimum requirement for specific taxation would increase price differentiation and therefore encourage cross-border shopping within the EU. However, there are limits on the amount of cigarettes that are allowed to bring into the country for personal use. Furthermore, the problems of smuggling from third-countries (both in the new member states and in the old member states with high excise duties) are much greater than the ones arising from cross-border shopping within the EU.
The problems of excessive tax burden, high minimum requirements and lack of flexibility in setting tax rates are especially evident in the new member states. Even before the full implementation of minimum cigarette rates, cigarettes are in general much less affordable in the new member states than in the old EU countries. This fact explains the large amounts of illicit cigarette sales. According to surveys conducted by Transparency International, border services of Eastern Europe remain exceptionally sensitive to corruption despite substantial funding and training from EU provided to secure its external border. Despite this fact, the member countries are still obliged to make large increases in the near future. For instance, the Baltic countries will have to make several-fold tax increases. It must be remembered that historically countries entering the EU (Spain, Portugal, Greece) had longer transition periods. Consequently, the EU should start real discussions on the possibility of reducing the minimum tax requirements for the new EU member states and/or prolonging transition periods.
Below opinion on specific points of the Consultation Paper are provided:
4.1 The MPPC as a benchmark for the minimum requirements, 4.2 EU minimum requirements on all cigarettes
The Consultation Paper correctly identified the problems related to the MPPC. The MPPC concept creates technical and administration problems, it can become a competitive tool, its definition is unclear and it has no economic rationale behind it. As an alternative, the Consultation paper proposes to abolish the MPPC concept and start applying minimum duties on all cigarettes.
While such a step would make the excise system simpler and more transparent, it has to be mentioned that it would also contribute to the increase of the overall tax burden.
4.5. The maximum level of the specific element of the excise duty and specific versus ad valorem duties
One of the main principles of good taxation is that of tax neutrality. In other words, taxes should aim to distort market participants’ choices as little as possible. Since ad valorem taxation leaves relative prices unchanged, it should be given preference over specific taxation. Specific taxation increases relative prices of cheaper cigarettes, thus reducing the variety of products in the market. Furthermore, specific taxation does not take into account price and purchasing power differentials, and so imposes excessive burden on lower-income consumers and countries. Naturally, this increases motivation for illicit trade and/or substitution towards cheaper and potentially more harmful products, thus reducing the effectiveness of excise duties. On the other hand, it has to be pointed out that the restrictions on the maximum amount of specific taxation impose limits on countries’ possible choices and narrow opportunities for competition among tax systems.
4.6 Minimum excise duties on discount and low price cigarette brands
Minimum excise duties are essentially a type of specific taxation. Therefore, they are subject to the same drawbacks as specific excise duties (these have been mentioned above). Besides, the minimum excise can become a competitive tool used by companies producing more expensive products to drive cheaper products out of the market. Allowing for more flexibility in setting minimum excise duties, however, would contribute to the principle of tax competition and allow member states to make more adjustments in relation to their environments.
5.4. Closer approximation of rates
It has already been argued above that tax burdens and minimum tax requirements should be reduced and made more flexible. Naturally, they should not be increased. Further increases would exacerbate the analyzed problems. Besides, as rightly stated in the Consultation paper, higher minimum duties would “make cigarettes extremely expensive in terms of purchasing power in certain new member states, while it would be insufficient to achieve health objectives in other member countries”.
If the EU wants to reduce rate differentials, it would be advisable to introduce maximum limit for excise duties. Without maximum excise duties, countries can always set excise duties at a higher level thus creating significant differences in tax burden and prices. Nevertheless, such a solution has a disadvantage as it reduces countries’ flexibility in designing their tax systems.
5.5 Pre-tax price differentials
Existing pre-tax price differentials are a natural outcome of different market situations in various countries. Producers set their prices according to the specific market context. For example, countries with higher purchasing power will likely have higher demand for tobacco products which ceteris paribus should result in higher prices. Prices should be determined by supply and demand factors – only under these conditions the highest level of efficiency is ensured and the welfare for society is maximized. Any effort to “correct” the prices would reduce efficiency and overall welfare.
6. Taxation of other tobacco products
On the one hand, there is little ground to apply different taxation to cigarettes and other tobacco products. This suggests that taxation of other tobacco products should be brought into line with cigarette taxation. On the other hand, this would increase the overall tax burden on tobacco products even further. As argued above, the tax burden and minimum requirements should not be increased – they should rather be decreased. Consequently, the EU should eliminate taxation distortions between cigarettes and other tobacco products, but the right strategy to do this would be to reduce tax rates applied on cigarettes, not to increase those on other tobacco products.
Speaking about technical aspects, alignment should be carried out based on the weight measures, not the units of cigarettes (i.e. the weight of tobacco should be the basis for taxation). Basing alignment on the units of cigarettes may open up opportunities for various manipulations. Besides, from the health protection point of view, it is the amount of tobacco consumed that counts. Again, it should be mentioned that no such problems arise if ad valorem taxation is applied.