Smuggling and sin tax

Lucio Tan or his holding firm LT Group, Inc. is again in the news. The media quoted LT Group President Michael G. Tan, son of Lucio, that the company’s tobacco sales dropped by 40 percent in the first quarter of 2013.

This is the narrative of the Tan group, as reported by BusinessMirror (19 June 2013):

“The tobacco business of tycoon Lucio Tan under PMFTC Inc. took a heavy beating at the start of the year as a result of rampant smuggling of cigarettes into the country.

“The company said the smuggling of tobacco products worsened after the government imposed higher excise taxes on the so-called sin products.

“Michael Tan, president of LT Group Inc., said sales of PMFTC, maker of brands such as Marlboro, Fortune and Philip Morris, dropped by 40 percent.

“If the trend continues, Tan said, the government would also suffer as it stands to lose about P8 billion in taxes by the end of the year.”

The LT group is the co-owner of PMFTC, a merger of Philip Morris, Inc. and Fortune Tobacco Corporation. Since the merger, and in light of the most favorable treatment it got from the old law, PMFTC has become the most dominant tobacco manufacture, having more than 90 percent of the market share.

The message of the Lucio Tan group to the government and the public is: “We told you so.” During the intense debate on the sin tax, PMFTC led the assault to weaken the bill’s provisions, arguing, inter alia, that the increase in the tax rates would result in widespread smuggling, which in turn would reduce tax collection.

The LT Group and PMFTC are using the specter of smuggling to spook us, but their objective is to discredit the sin tax law.

But another tobacco manufacturer, PMFTC’s rival British American Tobacco (BAT), which surely would not countenance a rise in smuggling, dismisses Mr. Tan’s argument. BusinessMirror cites BAT that “the prices of cigarettes in the Philippines [are] still lower, compared to those in other countries even with the increase.”

Before the sin tax took effect, the direction of smuggling was actually outward—from the Philippines to other countries. The prices of Philippine tobacco products were significantly lower compared to the rest of the world or the rest of Southeast Asia.

The increase in tax rates, averaging 209 percent in the first year, has brought retail prices of Philippine tobacco products to the median level, as compared to the prices in other countries. Even then, comparing prices of cigarettes in the Southeast Asian countries (to strengthen the argument, we compare between the retail prices in the Philippines and the factory prices in other Southeast Asian countries), we observe that the price differentials are small and hence do not translate into a serious smuggling threat.

The retail price of a Marlboro produced in the Philippines is double the price of the factory price of a Marlboro in Indonesia. But smuggling involves huge costs—the transport costs, the storage and distribution costs, the crime network costs, the bargaining or bribery costs and other transaction costs. Such costs, plus the risks, wipe out the price differential. Only when the price differential is so big does incoming smuggling become menacing. The World Bank gives the example of Brazil and Paraguay, where the price differential was about 900 percent.

In fine, despite the new high tax rates, which PMFTC calls “disruptive,” the incentive for inward smuggling is weak. The argument about the rise in smuggling does not convince.

That the incentive to smuggle inward is limited is not an excuse for the Philippine authorities to sidestep the issue. To its credit, the government is taking steps to counter illicit trade, including the use of a unique identification marking on cigarette packs. An advanced system, which we hope government will eventually adopt, is tracking and tracing. This system or technology monitors production (the tax is imposed on the volume of production) and follows the movement of the tobacco products throughout the supply chain—from the factory, to the distribution chain, and to the point of retail sale.

Replying to Mr. Tan, Internal Revenue Commissioner Kim Henares said that the LT Group sales went down by 40 percent “but it’s not because of smuggling, it’s because some other companies have taken up their market share” (BusinessWorld, 21 June 2013).

The new sin tax law has removed the protection given to the legacy brands by removing the price classification freeze, in which the old brands were taxed based on their 1996 prices. The move to a unitary tax also translates into a level playing field at the same time that it discourages consumers from shifting to a higher-taxed brand to a lower-taxed product.

That sales have dropped precisely serves the objective of the sin tax. Time and again, the government has affirmed the principality of the health objective, by reducing consumption of sin products. The drop in sales by 40 percent is thus welcome news. This more or less validates what different models have predicted—a reduction of cigarette demand of up to 50 percent in the medium term.

Take note, too, that despite the sharp decrease in demand, tax collection has “already significantly increased,” according to Commissioner Henares. (She has yes to disclose the latest revenue figures from the sin tax.)

This is obviously bad news for the LT Group. Gone are the days when the Lucio Tan group boomed because of low taxes. It seems “LT” stands not for Lucio Tan but for “low taxes.”

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