Price and Tax

Tobacco tax and price are key to the tobacco industry for several reasons.

• First, tax and price increases are one of the most effective means of reducing tobacco use, according to the World Bank. They work by encouraging current smokers to quit and discouraging young people to take up the habit.
• Second, tax structures can have important impacts on tobacco company profits and market shares.
• Third, price is increasingly used as a marketing tool when other methods of marketing tobacco are restricted.
• Importantly, tobacco tax increases lead to increased tobacco tax revenues.

This page explains the issues around price and tax in further detail.

Also see the overview of pages in the Category: Plain Packaging in Australia

Pricing as a Corporate Social Responsibility Tactic

In 2010, British American Tobacco New Zealand proposed fixed minimum tobacco prices and made the case that this could prevent tobacco companies competing on price, and thus prevent them attracting children via cheap prices. This position was part of BAT's socially responsible package to protect children from smoking, and it was sanctioned by David Crow the CEO of BAT Australia and also a Director of BAT in New Zealand (before that he was BAT Australia’s head of marketing).

Fixing a minimum price was rejected by the New Zealand parliamentary select committee on the grounds that an aggressive tobacco tax regime was a more appropriate answer. Minimum prices help increase industry profits but do not increase public revenue. An effective tax regime will bring public health benefits while simultaneously benefiting the public (rather than just the industry) purse.

This BAT proposal is an example of Corporate Social Responsability as a strategy, to propose voluntary regulation or mild policy changes in order to fend off stronger measures.

Pricing as a Tactic Against Plain Packaging

That the company was not serious about the minimum price proposal was confirmed by a press conference in May 2011. BAT threatened to flood Australia with half-price cigarettes and make the government liable to billions of dollars in compensation if forced to remove branding from cigarette packets. The Australian Daily Telegraph quoted Crow saying:

"When you look at the four Ps (product, price, place and promotion), pricing's the big one and that's the only one we have left. We will end up fighting on price." He said that the cheap prices "basically means more people will smoke, more kids will smoke".

"It's going to backfire and go bad and lead to more people smoking, which is just mad if you're sitting at a government desk," he added.

Crow's new position is that his company was comfortable with governments trying to reduce smoking across the board (saying: "No one could argue with that.")

According to the same newspaper report, Australia's Health Minister Nicola Roxon dismissed the industry's claims as baseless and another sign of how desperate the companies are, saying: "Big tobacco are fighting to protect their profits, but we are fighting to save lives."

The Tobacco Industry’s Pricing Power

Perhaps the most remarkable change in the tobacco industry in recent years is the increase in its pricing power: its ability to ensure that prices (and thus profits) increase more quickly than volumes fall.

An estimated 92% of revenue in the global tobacco market was generated from cigarettes (2010 data). Yet since 2000 growth in global cigarette sales has slowed to under 1% annually and if China is excluded, global volumes are already falling, research by the University of Bath has found.

Despite this picture, industry profits continue to rise. As the research highlights, the value of global cigarette sales has risen by 84% in the past decade, with increases in value even in markets experiencing major volume declines.

Earlier work by the University of Bath explains this in full. The pricing power occurs in large part because tobacco is an addictive product with few substitutes and because there is very limited competition in the global tobacco market. (Just four transnational tobacco companies - Philip Morris International, BAT, Japan Tobacco International and Imperial Tobacco - dominate the global market outside China). This enables the companies to increase prices almost at will, making the manufacture of tobacco products uncommonly profitable and ensuring that profits rise even when volumes fall. Indeed the profit margins in the tobacco sector way outstrip those in other consumer staples industries.

How High Tax Rates can Benefit the Industry

Evidence is also starting to emerge that the industry's pricing power (and thus its profitability) is facilitated by tobacco tax policies. When tobacco tax rates are high, manufacturer's profits represent only a small share of the retail price. Increases in these profits, because they make relatively little contribution to the overall price rise, can be disguised as part of the tax increases. In the words of Morgan Stanley, ‘high taxes … can be good for profits’.

A good example is the UK which manages to be one of Europe’s most profitable markets, despite having some of its highest tobacco tax levels. In Ireland, the industry repeatedly argued that tax increases would lead to smuggling, while at the same time it raised the prices on top of the higher tax levels. Indeed, in the last decade over a third of the raises in price was initiated by the industry, and thus undermining the industry’s own arguments that tax and price increases lead to smuggling.

Recent research, drawing together evidence from financial analyst reports and industry documents, suggests that regular, moderate tax increases can benefit the industry while large intermittent tax increases may have a greater impact on demand. Analysts, for example, note that “steady, small tax increases can be helpful for the industry”, while “large unforeseen increases are one of the most effective means of reducing smoking prevalence”.

BAT noted back in 1992:

The psychology of smoker demand is such that they are more likely to absorb smaller and more frequent price increases than larger and less frequent price increases. During negotiations with government therefore it is preferable to seek the former excise environment.

Exploiting Loopholes

In most countries different forms of tobacco are taxed at a different rate. Cigarettes are normally subject to the highest rate of tax, followed by loose tobacco for making 'Roll your own' cigarettes, while pipe tobacco and cigars are taxed at a relatively low rate. There can also be differentiation within categories, with king-sized cigarettes taxed at a higher rate than normal length cigarettes, and large cigars at a higher rate than smaller cigars.

Tobacco manufacturers have been known to exploit these differing rates of taxation in order to undermine the impact of tax policy and to preserve or increase profits. Such efforts include manufacturing cigarettes one millimetre smaller than the definition of king-size cigarettes in Poland.

As outlined in the section on product innovation, various forms of ‘make your own’ cigarettes have been launched in an apparent attempt to undermine tax policy. Documents from the tobacco archives show that Philip Morris devised ‘make your own’ cigarettes as an anti-tax device. Project ROYCE, based on the acronym for ‘roll-your-own’ cigarette, was developed in anticipation of a 75 US cents per pack federal tax increase in the mid-1990s.

Price Cap Regulation in the Tobacco Sector

The extent of market failure and the resulting excess industry profits, and worries about the use of price as a marketing tool as outlined above, recently lead to a proposal for price cap regulation for the sale of tobacco and cigarettes. Price cap regulation sets a cap on the price that can be charged for services or products. After the rising costs of inputs (inflation) and the prices charged by competitors are considered, price cap regulation is introduced to protect the consumers while ensuring that the business can remain profitable. This form of economic regulation is commonly used in the United Kingdom to regulate utility providers.

The Bath research summarised the potential benefits of such a proposal:

Under such a system, well established in the utilities sector, industry profits would be capped and the excess profits transferred to the government as additional excise revenue while maintaining high tobacco prices for consumers.

This would produce significant additional government revenue and, by reducing industry profit, remove the TTCs' incentive and ability to oppose tobacco control policies and offset losses in emerging markets through the excess profits generated elsewhere. It could thereby curtail the ultimate size of the global tobacco epidemic.(...)

Price cap regulation would also remove the industry's ability to use price as a marketing tool, provide a means of controlling cigarette smuggling (because the industry could only profit from legal sales) and prevent underhand marketing by limiting or eliminating the marketing budget.”