Tobacco Taxation in the European Union and United States
Sijbren Cnossen
October 19, 2009
Tobacco tax systems differ across countries not only with regard to the overall tax level, but also the mix between specific and ad valorem taxes. What does economics have to say about how governments should tax tobacco?
Both the level and the structure of tobacco taxes differ markedly between, as well as within, the European Union and United States. (The focus here is on cigarettes alone, as they constitute over 90 percent of tobacco consumption.) Within EU member states, the total tax burden (excises and value added taxes, or VAT) is around three quarters of the retail price of cigarettes, or over 300 percent of the pre tax price. The southern member states favor predominantly ad valorem taxes (that is, percentage rates on the value of a pack of cigarettes) whereas in the northern member states, specific taxes constitute more than half of the total tobacco tax burden.
In the United States, tobacco taxes are almost wholly specific. The federal government levies a tax of 39 cents per pack (of 20 cigarettes), state governments levy taxes that average about 60 cents per pack, and the Master Tobacco Settlement Agreement, concluded in 1998 (under which tobacco companies are expected to pay $206 billion to settle product liability suits) effectively added a further 30 cents per pack. Nonetheless the total tax (excise and retail sales taxes), about $1.30 per pack, amounts to about 37 percent of the retail price, or about half the rate in the European Union.
What does economics have to say about the appropriate level, and structure, of tobacco taxation?
What Costs do Smokers Impose on Others?
The causal link to future health problems from smoking is extremely well documented smoking is a primary cause of lung cancer, emphysema, chronic bronchitis, and a major cause of heart disease and stroke. Smoking by pregnant women leads to low birth weight babies, neonatal death, and sudden infant death syndrome.
While the health consequences of smoking are important, in principle they are irrelevant to public policy unless the costs imposed are external (that is, imposed on others rather than borne privately by the smoker). The principle of consumer sovereignty implies that a rational person who weighs all the costs and benefits of his actions should be free to smoke as long as he does not impose costs on others and is fully informed about the consequences of his choices.
Virtually all empirical research suggests that the external costs of smoking are relatively small. The burden of medical payments on government due to smoking related illness is one potential source of external cost. However, this near term burden is at least partly offset in a lifecycle context, as the average smoker lives a shorter life, which saves on pensions and health care costs of age related disease. Bans on smoking in public places have greatly reduced the external costs of environmental or second hand tobacco smoke. However, little has been or can be done about the health problems experienced by children and nonsmoking partners within the family at home. Perhaps economists assume too easily that such costs are largely internalized by the smoker through altruism or negotiation among family members.
Sijbren Cnossen is Professor of Economics at the University of Maastricht and Emeritus Professor of Tax Law at Erasmus University, Rotterdam.
Information and Addiction Failures
If smokers, especially teenagers, are poorly informed about the costs of smoking, then to that extent, the costs of smoking are effectively external. However, if inadequate information is the problem, this is best addressed through warning labels and information dissemination programs about health hazards. In fact, evidence suggests that 90 percent of U.S. consumers are aware of the long term health effects of smoking.
Nonetheless, the fact that nicotine is addictive may undermine the consumer sovereignty argument against government intervention. If smokers behave myopically in choosing to consume an addictive drug, the rationality condition ceases to apply, because the addictive smoker is, to some extent, a different person than the one who decided to start smoking. Furthermore, consumers may excessively discount the longer term costs of addiction. Consequently, they may therefore have self control problems, referred to as internal costs, where they continually plan to smoke less in the future than they actually can. In this case, cigarette taxes may help to reinforce a commitment to quit in the future.
In fact, higher taxes seem to be most effective in reducing smoking prevalence among teenagers who are better able to kick the habit, because addiction has not yet taken hold. Evidence suggests that a 10 percent increase in cigarette prices is associated with about a 4 percent reduction in smoking among adults, but an 8 percent reduction among teenagers.
Evidence suggests that tobacco tax levels, even in the United States, are difficult to justify on externality grounds, let alone those levels prevailing in the European Union. High taxes may reflect a form of paternalism, such as a desire to discourage young people from taking up smoking. The internal cost argument for higher taxes has not yet been settled.
What s the right way to tax tobacco?
Tobacco is far from a homogeneous product. The United States and northern European countries tend to produce higher quality brands than southern European countries. Ad valorem taxes raise the prices of different brands in the same proportion and therefore they do not distort a consumer s choice between high and low quality brands. This makes economic sense, to the extent that the purpose of tobacco taxes is to raise revenue.
Taxing cigarettes according to their external costs leads to a very different conclusion, however. The damage caused by cigarette smoking is independent of the price at which it is sold, so that correction of externalities favors specific over ad valorem taxes. All else equal, the share of specific taxes in total tobacco taxation should be smaller when the importance of raising revenue is greater, and the case for correcting externalities, correspondingly smaller. To some extent, this reasoning is consistent with the high ad valorem tax element in EU tobacco tax systems and its absence in U.S. structures.
Some variation in specific taxes across different tobacco products may in fact be appropriate. Since health damages are correlated with the tar content of cigarettes, taxes on high tar cigarettes should be higher too. However, some research shows that addicts smoke low tar and low nicotine cigarettes differently, inhaling more to increase the amount of nicotine they ingest. So corrective taxes might not be proportional to tar content, but some differentiation is likely to still be appropriate. Moreover, a tar tax would give manufacturers an incentive to develop palatable low tar cigarettes, which would have long term health benefits.
A Complex Question
The question of what the right level and structure of tobacco tax should be is a complex one, given the multiple objectives of policymakers. The reasons for levying high taxes on tobacco products are the predictability of the revenue, the desire to discourage youths from taking up smoking, and the belief that smokers should pay for the burden they impose on others. The reasons for moderating the level of tobacco taxes are the principle of consumer sovereignty and the finding that the external costs of smoking may be low. And the choice between specific and ad valorem taxation depends on whether the primary goal of policy is to discourage smoking or raise revenue.
Further Readings
Cnossen, Sijbren and Michael Smart. 2005. Taxation of Tobacco. In The Theory and Practice of Excise Taxatio
n, edited by Sijbren Cnossen. Oxford Oxford University Press.
Manning, Willard G., Emmet B. Keeler, Joseph P. Newhouse, Elizabeth M. Sloss, and Jeffrey Wasserman. 1989. The Taxes of Sin Do Smokers and Drinkers Pay Their Way? Journal of the American Medical Association 261 1604 1609.
Europa – communiques de presse – communique de presse – european commission and philip morris
international sign 12-year agreement to combat contraband and counterfeit
cigarettes
The European Commission, together with 10 Member States of the European Union 1 and Philip Morris International (PMI), today announced a multi year agreement that includes an efficient system to fight against future cigarette smuggling and counterfeiting and which ends all litigation between the parties in this area. Through the Agreement, Philip Morris International will work with the European Commission, its anti fraud office OLAF, and law enforcement authorities to help in the fight against contraband, including the rapidly growing problem of counterfeit cigarettes. The agreement includes substantial payments by Philip Morris International, which could total approximately USD 1.25 billion over twelve years. I welcome the conclusion of the negotiations of this important agreement. This agreement is to the advantage of the EU to protect its financial interests, said Commission President Romano Prodi. This Agreement represents a major step forward in the battle against contraband and counterfeit cigarettes, said Commissioner Michaele Schreyer, responsible for budget and the fight against fraud We believe that it will enhance the ability of the European Commission and the Member States to combat the illegal trade in cigarettes, which results in the loss of substantial tax and customs revenues each year. Contraband and counterfeit products cheat everyone governments, consumers and legitimate businesses , she added.
Fight against counterfeit
The Commission and the EU Member States point to several reasons why they view expanded anti counterfeit and anti contraband efforts as requiring significant priority. Among other reasons, the European Community and the Member States are losing hundreds of millions of Euros in unpaid taxes from counterfeit cigarettes. In addition, counterfeit and other forms of contraband create a parallel illegal supply chain that invades and compromises legitimate distribution channels and competes unfairly with genuine products distributed through legitimate channels.
Over the last few years, the incidence of contraband Philip Morris cigarettes has been greatly reduced, but during the same time period, counterfeit cigarettes have become a growing threat to the European Community and the Member States. The Commission has therefore announced that it will build on existing efforts to combat the illegal trade in cigarettes by
- Vigorously investigating cigarette counterfeiting in close cooperation with the Member States and law enforcement officials in critical locations worldwide
- Targeting and interrupting the production of counterfeit cigarettes with the goal of preventing counterfeit cigarettes from being introduced into the European Community and
- Recording and pursuing seizures of counterfeit cigarettes in the European Community to identify the source of the product and other relevant information.
Fight against contraband and money laundering Know your customers and tracking and tracing
The Agreement builds on the efforts of all parties and introduces new and innovative procedures to combat the diversion of Philip Morris International s products into contraband channels in Europe and around the world. Today s agreement reflects the reality that success in defeating the contraband and counterfeit cigarette trade can be aided greatly through a joint agreement whereby major manufacturers like Philip Morris International and European law enforcement combine their resources and enhance their coordination in combating contraband and counterfeiting.
In addition to Philip Morris International s already existing fiscal compliance policy, the Agreement contains strong provisions, approved by all parties, which provide them with a mechanism for the long term prevention of any large scale smuggling of genuine Philip Morris cigarettes in the European market. The Agreement requires Philip Morris International to build on its existing review process for selecting and monitoring customers, to enhance its capabilities to track and trace certain packaging, and to provide expanded support to European law enforcement in its battle against the illegal trade in cigarettes. Under the Agreement, Philip Morris International agrees to continue limiting its sales to volumes commensurate with legitimate market demand. The Agreement also incorporates and builds into a comprehensive contractual framework Philip Morris International s existing anti money laundering policies.
Historically, a key concern for the European Community has been the introduction of contraband cigarettes into the European Community. For that reason, the European Community has taken aggressive action to address cigarette smuggling. European law enforcement efforts have resulted over the past several years in the reduction of the amount of cigarettes that enter the EU as contraband. The European Commission has determined that constructive agreements, such as this Agreement with Philip Morris International, are a useful tool in addressing these issues.
The initiative includes far reaching product tracking procedures that will facilitate law enforcement efforts to determine the point at which any genuine product is diverted from the authorised sales channel. Consistent with the Agreement, Philip Morris International will mark certain packaging with information indicating the intended market of retail sale, mark master cases of cigarettes with machine scannable barcode labels, and implement other procedures useful for the tracking and tracing of its products.
These obligations embody the first major joint tracking and tracing initiative and are consistent with the anti contraband provisions of the WHO Framework Convention on Tobacco Control.
Payments under the Agreement
The European Community and ten Member States will receive substantial payments over a number of years. The amount of Philip Morris International s payments under the Agreement will vary based on a number of factors, and could total approximately USD 1.25 billion.
The Agreement also includes an initiative whereby PMI has agreed to make payments in the event of future seizures in the European Community of its genuine products above defined quantities. These payments will be made without regard to fault or wrongdoing by Philip Morris International. If other Member States sign the Agreement, including the new Member States, they will also be entitled to receive these payments.
Ending past disputes
While all these provisions are forward looking, the Agreement also contains the parties resolution of all past disputes relating to contraband cigarettes. In particular, the Agreement also brings to an end all litigation between the European Community and the ten Member States and Philip Morris International relating to contraband cigarettes. The Agreement also resolves Philip Morris International s case against the European Commission pending on appeal before the European Court of Justice.
The Commission is always prepared to have discussions with manufacturers who are willing to commit the necessary resources to improve ways to combat illegal trade in their products and associated criminal activity, such as money laundering. Producers also have a responsibility to fight illegal trade in their products. This Agreement should therefore serve as a model for other cigarette companies.
Background
In the negotiations with Philip Morris International, the Commission represented the European Community and the ten Member States. The Legal Service and OLAF conducted the negotiations for the Commission.
1 Belgium, Finland, France, Germany, Greece, Italy, Luxembourg, Netherlands, Portugal, and Spain.