LFMI’s position on the European Commission‘s proposal to increase excise duty on manufactured tobacco

1. Current excise duties on manufactured tobacco in the European Union and in Lithuania

Under European Union directive on the structure and rates applied to manufactured tobacco, Member States must apply a minimum excise duty which has to fulfill two requirements. Minimum fixed amount of excise duty is EUR 64 per 1000 cigarettes and excise duty must be at least 57% of the retail price of the most popular price category cigarettes (proportional minimum). Member States that apply an excise duty above EUR 101 per 1000 cigarettes do not have to fulfill the 57% requirement.

Excise duty on manufactured tobacco that is currently applied in Lithuania comprises of EUR 22.9 per 1000 cigarettes specific excise duty and 20% ad valorem excise duty calculated based on the maximum retail price. By 2010 Lithuania is obliged to reach the minimum excise duty requirements set out in the European Union directive – EUR 64 and 57% of MPPC retail price.

Thus, European Union directive requirements and excise duty for cigarettes reglamented by Lithuania‘s Law on excise duty can be summarized as such:

· EU directive requirements:
o Minimum excise duty: EUR 64 per 1000 cigarettes
o Proportional minimum: 57% of MPPC retail price
· Taxation according to Lithuania‘s Law on excise duty:
o Specific excise duty: EUR 22.9 per 1000 cigarettes
o Ad valorem excise duty: 20% of maximum retail price

2. European Commission‘s proposal to change the method for calculating excise duty and to increase excise duty

European Commission is proposing to reform the tobacco excise duty system. The reform comprises of several proposals:

· To replace MPPC with weighted price average (WAP) as the benchmark for proportional minimum requirement. Also as a result of this change, minimum excise duty rate requirement set out in the European Union directive will apply not only to MPPC cigarettes (as is currently provisioned), but to all the cigarettes sold in the country. Weighted average price is calculated by dividing the product of the number and price of cigarettes sold by the total number of cigarettes sold. Effect on the size of the excise duty may be twofold. If relatively expensive cigarettes are more popular in a certain country, then the minimum excise duty calculated using weighted average price as a benchmark would be smaller than excise duty calculated using MPPC. And vice versa: if relatively cheaper cigarettes are more popular, excise duty calculated based on weighted price average would be larger compared to the one calculated based on MPPC. If the most popular cigarettes are in the middle range price category, excise duty would be the same with either method.

· To increase minimum excise duty for cigarettes in line with internal market price harmonization and health considerations. It is proposed to increase minimum excise duty on Jan. 1, 2014 from EUR 64 to EUR 90 per 1000 cigarettes and the proportional minimum from 57% to 63% of weighted price average. According to this proposal, Lithuania would have to implement these requirements starting from Jan. 1, 2016.

· To widen the band of specific excise duty share of total tax burden from 5% – 55% to 10% – 75% in order to make excise duty structure more flexible.

· To bring gradually the minimum rates for fine-cut tobacco intended for the rolling of cigarettes into line with the rate for cigarettes. The chosen taxation relationship between fine-cut tobacco and cigarettes is 2/3. Thus, the minimum excise duty for fine-cut tobacco should be EUR 43 per kilogram, and the proportional minimum requirement should be 38% of weighted average price. Applying the aforementioned relationship on the proposed excise duty increases for cigarettes from Jan. 1 2014, excise duty on fine-cut tobacco would be increased to EUR 60 and 42%.

· To adjust for inflation the minimum requirements for cigars, cigarillos and smoking tobacco. This is needed to take into account inflation for the period 2003 to 2007, which has been 8% according to Eurostat data on the annual rate of change of the harmonised index of consumer prices. It is proposed to increase minimum requirement to EUR12 for cigars and cigarillos and EUR22 for other smoking tobacco.

· To amend and toughen the definition for cigarettes, cigars and pipe-tobacco in order to avoid tobacco product name manipulations aiming for the lowest excise duty.

· European Commission regularly examines the structure and rates of excise duty in Member States and uses information on the quantities and prices of the tobacco products released for consumption. In order to ensure an efficient and effective collection of this information from all Member States, new rules are proposed regarding the provision of information as well as the definition of the necessary statistical data.

3. Effects of raising excise duty on cigarette prices in Lithuania

To Lithuania, the most important change proposed in the directive is the increase of the minimum excise duty which will lead to the increase in tobacco product prices. The most popular price category (MPPC) cigarettes in Lithuania cost EUR 1.45. Considering that since March 2008 the specific excise duty per 1000 cigarettes is EUR 22.9, excise duty amounts to EUR 0.46 per cigarette pack. According to the combined excise duty calculation method and the Law on excise duty, ad valorem for cigarettes is calculated as a percentage of maximum retail price indicated on the pack. Currently ad valorem is 20%, consequently ad valorem of the most popular price category cigarettes amounts to EUR 0.29. Thus, combined excise duty amounts to EUR 0.75 or 51.6% of the cigarette price.

By Jan. 1, 2010 Lithuania is obliged to reach the minimum excise duty requirement of EUR 64 and 57% of MPPC retail price. For that, an amendment to the existing law has been put forth proposing EUR 38.5 specific excise duty per 1000 cigarettes and ad valorem of 25% of maximum retail price.

Once these requirements are enforced, specific excise duty would increase by 67% to EUR 0.77, ad valorem would increase by 80% to EUR 0.52 and the price of most popular price category cigarettes would increase by 43.8% to EUR 2.08. Excise duty per cigarette pack would reach EUR 1.29, or 61.7%.

Once the proposed European Commission requirements are imposed to increase minimum excise duty to EUR 90 on Jan. 1, 2016, specific excise duty per cigarette pack would rise 2.4 times to EUR 1.13 and ad valorem would rise 2.8 times to EUR 0.82. Price of one cigarette pack of the currently most popular price category would rise by 110.8% to EUR 3.06. Excise duty per cigarette pack would rise to EUR 1.95 and would amount to 63.8% of the cigarette price.

Table I. Excise duty per cigarette pack
Per cigarette pack
Specific excise duty
Ad valorem excise duty
Total excise duty
Excise duty share of MMPC price
As of Jan. 1, 2010
According to the proposal, as of Jan. 1 2016
Table II. Excise duty per 1000 cigarettes
Per 1000 cigarettes
Specific excise duty
Ad valorem excise duty
Total excise duty
Excise duty share of MMPC price
As of Jan. 1, 2010
According to the proposal, as of Jan. 1 2016

4. Possible consequences of raising excise duty

Raising excise duty would further increase cigarette smuggling and the illegal market. Smuggling is an economic activity to which laws of supply and demand apply. Raising excise duty increases the price difference between legal and smuggled cigarettes and as a result, demand for smuggled cigarettes rises. When their demand rises, the prices of smuggled cigarettes increase, making smuggling more profitable and leading to a rise in smuggling. In Lithuania as well as in other new Member States price and other factors are favourable to the expansion of smuggling: prices in neighbouring countries to the East are becoming relatively cheaper, new Member States have few border patrol resources, border patrol is plagued by corruption, so the amount of shadow economic activities is considerable. Lithuania‘s geographic location and public perceptions of smuggled goods are also favourable to smuggling. According to an opinion poll carried out by the Lithuanian Free Market Institute in 2008, as many as 38.9% of surveyed people justify or tend to justify smuggling. When investigating the conditions for the development of smuggling and an illegal market it is important to consider the amount of corruption and shadow economy not only in Lithuania but also in the potential sources of smuggling – the neighbouring states. The case is such that corruption in Belorussia and in Russia is even more widespread[1].

Seeking to harmonise the tax system with the EU, excise duty has been sharply increased in 2002 – 2004 in Lithuania (between 2001 and 2004 excise duty burden increased by 121%). This has led to a sharp increase in cigarette prices. Raising excise duties reshaped the tobacco market. Sales of legal cigarettes decreased, while smuggling and the illegal market grew in size. According to LFMI research, in 2004 market share of legal and illegal market (counting units sold) almost equaled. Due to the rise in excise duty, there was a sharp increase in price difference between prices in Lithuania and those in the main source of smuggled products – Russia. The amount of smuggled products detained rose almost 13 times between 2001 and 2004.

When evaluating excise duty effectiveness it is crucial to consider changes in gross consumption of cigarettes (that is both legal and illegal consumption). International experience shows that price rises tend to decrease legal sales rather than change gross consumption, and this effect is due to expansion of the illegal market. This is what happened in Lithuania as well: when excise duty was increased in 2002 – 2004, gross consumption dereased but this change was not as vivid as the decrease in legal cigarette sales.

Due to differences in cigarette prices in different countries brought about as a result of different excise duties, growing smuggling can create such conditions whereby raising excise duty would lead to a further rise in excise duty. It is possible that when excise duty is large enough and smuggling has increased considerably, the first group of cigarettes that goes into the shadow market are the cheapest ones. As a result, the weighted average price (according to which minimum excise duty is calculated) of the legally sold cigarettes rises. In such a case, in order to comply with the European Commission‘s minimum requirement, the government will be forced to further increase excise duty, further stimulating smuggling. Thus, we get trapped in a situation where excise duty stimulate smuggling and more smuggling makes us raise excise duty. This is why the European Commission‘s proposal to increase minimum proportional requirement is harmful.

Cigarette price rises due to higher excise duty would decrease consumers‘ purchasing power. Compared to older EU Member States, standard of living in Lithuania is still low, people spend a larger part of their income on primary commodities. Although cigarette prices in Lithuania are much lower than in old EU Member States, when assessed at purchasing power cigarettes in Lithuania are not more affordable. It is more common that in countries with lower standard of living a larger part of income is spent on alcohol and tobacco products. Thus higher prices would have more effect on consumers in Lithuania compared to consumers in EU Member states with higher standard of living.

Cigarette demand is relatively inelastic. This means that an increase in cigarette prices does not cause a large drop in consumption. For this reason, once cigarette prices rise consumers may respond in two ways. Some may be forced to spend less money on other goods, so their purchasing power would decrease. Others would begin purchasing lower quality, and thus even more harmful cigarettes.

Raising excise duty does not necessarily increase budget revenue. Due to a rise in smuggling and illegal trade, and also due to the possible popularity of cheaper cigarettes, it is possible that instead of increasing budget revenue, raising excise duty would have an opposite effect. Once excise duty taxation grows, followed by growth of the illegal market, a decrease in budget revenue due to the growing illegal market may actually be larger than the increase due to higher excise duty. Consequently, budget revenue may decrease.

When excise duty was raised in 2002 – 2004, budget revenue from tobacco products did not decrease since falling legal sales effect was outweighed by higher tax rate effect. On the other hand, budget lost a considerable amount of potential income due to growing illegal sales. According to LFMI research, in 2004 the budget did not receive about half of potential tobacco excise duty revenue due to the shadow market. In 2005 – 2006 legal sales grew sharply and consequently so did budget income from tobacco excise duty.

Raising excise duty would increase inflation. The proposed sharp increase in excise duty for cigarettes would raise cigarette prices, contributing to a rise in consumer price index.

5. Conclusions and proposals:

· The European Commission‘s proposal to bring gradually the minimum rates for fine-cut tobacco into line with the rate for cigarettes, and toughen the definition for cigarettes, cigars and pipe-tobacco in order to avoid tobacco product name manipulations aiming to apply the lowest excise duty is commendable.

· We propose not to approve raising minimum excise duty from EUR 64 to EUR 90 per 1000 cigarettes, since the proposed excise duty rise in Lithuania would be harmful: it would negligibly reduce consumption, reduce potential budget revenue, reduce consumers‘ purchasing power and increase inflation.

· The main reason for proportional requirement is harmonisation of excise duty in EU, yet it does not achieve that. Increasing proportional minimum requirement would lead to raising excise duty in those countries where excise duty is already large in absolute terms, compared to the EU average. For this reason we propose either to abolish the proportional minimum requirement or not to accept its increase from 57% to 63%.

[1] More on the effects of excise duty on smuggling and public perceptions of smuggling heavier taxed products can be found here:
1. A study on economic causes of smuggling
2. Opinion poll on public perceptions of smuggling