Tobacco excise: historical trends and forecasting methodology

O'Bannon, Jonathan; Clark, John Working Paper Tobacco excise: historical trends and forecasting methodology Treasury Working Paper, No. 2019-03 Provided in Cooperation with: The Treasury, The Australian Government Suggested Citation: O'Bannon, Jonathan; Clark, John (2019) : Tobacco excise: historical trends and forecasting methodology, Treasury Working Paper, No. 2019-03, The Australian Government, The Treasury, Canberra This Version is available at: https://hdl.handle.net/10419/210404 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/3.0/au/legalcode TOBACCO EXCISE: HISTORICAL TRENDS AND FORECASTING METHODOLOGY Jonathan O’Bannon, John Clark 1 Treasury Working Paper 2 2019-03 Date created: June 2019 1 The authors worked on this paper while in Tax Analysis Division, Revenue Group, The Treasury, Langton Crescent, Parkes ACT 2600, Australia. We thank Adam Hollis and Joshua Pooley for their work on earlier drafts of this paper. Correspondence to: [email protected] 2 The views expressed in this paper are those of the authors and do not necessarily reflect those of The Australian Treasury or the Australian Government. © Commonwealth of Australia 2019 This publication is available for your use under a Creative Commons BY Attribution 3.0 Australia licence, with the exception of the Commonwealth Coat of Arms, the Treasury logo, photographs, images, signatures and where otherwise stated. The full licence terms are available from http://creativecommons.org/licenses/by/3.0/au/legalcode. Use of Treasury material under a Creative Commons BY Attribution 3.0 Australia licence requires you to attribute the work (but not in any way that suggests that the Treasury endorses you or your use of the work). 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Other uses Enquiries regarding this licence and any other use of this document are welcome at: Manager Media Unit The Treasury Langton Crescent Parkes ACT 2600 Email: mediali[email protected] Tobacco Excise: historical Trends and Forecasting Methodology 2019-03 June 2019 ABSTRACT Tobacco excise has grown strongly over the last few years as significant increases in the excise rate have been only partly offset by declining rates of smoking. This paper examines historical trends in tobacco excise, focussing on the recent past including the impact of significant policy changes over the last decade, and then discusses how tobacco excise is forecast and the key challenges in doing so. Keywords: Tobacco excise 1 INTRODUCTION Excise has been a significant and stable source of tax revenue as it relies on comparatively regular patterns of economic behaviour and tax payments from year to year. This contrasts with revenue sources such as company tax, where factors ranging from commodity prices to the operation of the tax payments system can have a large bearing on receipts in any given year. Being relatively stable, excise has generally been forecast with greater accuracy than many other taxes. Tobacco excise, the focus of this paper, has grown strongly over the last few years as significant increases in the excise rate have been only partly offset by declining rates of smoking. This paper will examine the historical trends in tobacco excise, focussing on the recent past including the impact of significant policy changes over the last decade, and then discuss how tobacco excise is forecast and the key challenges in doing so. TOBACCO EXCISE Tobacco excise is applied to processed tobacco leaf 3 , predominately in the case of cigarettes, cigars and loose leaf tobacco. As an excise, it is imposed on the product according to the quantity of the excisable substance in the product, consistent with the excise regimes applying to fuel and alcohol. This contrasts with other taxes, such as the Goods and Services Tax (GST), which are levied on the value of the products. The rates of excise taxes in Australia are typically indexed to increase with either inflation or wages. Cigarettes, cigars and loose tobacco are excisable goods if they are produced or manufactured in Australia. This excise is collected by the Australian Taxation Office (ATO). Imported tobacco products are subject to an equivalent customs duty instead of excise duty, collected by the Department of Home Affairs, in order to maintain a consistent tax treatment regardless of whether the product is manufactured domestically or imported. Along with other taxes, tobacco excise and tobacco excise equivalent customs duty are both parts of the consolidated revenue of the Commonwealth. For the purposes of this paper, both are simply referred to together as ‘tobacco excise’. There are two broad categories of excisable tobacco: sticks (cigarettes), which are taxed on a ‘per stick’ basis, and loose leaf (cigars, loose tobacco and other tobacco products), which are taxed according to weight 4 . For taxation purposes, the loose leaf and tobacco excise rates are set to be broadly equivalent according to the weight of tobacco in each 5 . 3 Excise Tariff Act 1921, The Schedule. 4 A full list of tobacco taxation product categories can be found on the Department of Home Affairs website. 5 Until 2017-18 the equivalence was based on the assumption that a cigarette contained 0.8 grams of excisable tobacco. In the 2017-18 Budget the Government announced that this assumption would change to 0.7 grams of tobacco per cigarette. In order to maintain equivalence, the excise rate on loose leaf tobacco would be raised accordingly. The adjustment began in September 2017 and will be phased in over four years, from 2017 to 2020, with a step-up on the loose leaf tobacco rate beyond the regular indexation and previously announced excise rate increases on 1 September each year. 2 How tobacco excise is collected Tobacco excise is levied on tobacco products as they are cleared from licenced warehouses in which they are stored after they are manufactured (if they are manufactured in Australia) or imported (if they are manufactured overseas). 6 As shown in Chart 1, in recent years there has been a shift in the collection of tobacco excise from the ATO to the Department of Home Affairs. This is because the manufacture of licit commercial tobacco products sold in Australia, dominated by a few large multinational corporations 7 , has moved from being mostly in Australia to being entirely overseas. As of 2016-17, all tobacco excise is being collected by the Department of Home Affairs. There is currently no legal tobacco product manufacturing in Australia. After the tobacco products are cleared there is still some time before they are purchased by consumers, due to the distribution process, which may include further warehousing. The relocation of tobacco production offshore in particular has altered the timing of the distribution process, as discussed later. Chart 1. Tobacco excise collected by the Department of Home Affairs and the Australian Taxation Office 6 Note as part of the Government’s Illicit Tobacco Package (2018-19 Budget), from 01 July 2019, the taxing point of tobacco is being brought forward to the point of importation or manufacture and warehousing will be abolished. Tobacco will be taxed when it enters the country rather than being stored initially in a pre-tax state. Legislation for this core proposal has passed. 7 The three dominant manufacturers and/or importers in the Australian market are: British American Tobacco; Phillip Morris; and Imperial Tobacco. 0 2 4 6 8 10 12 0 2 4 6 8 10 12 2007-08 2009-10 2011-12 2013-14 2015-16 2017-18 $billion$billion Department of Home Affairs Australian Taxation Office 3 HISTORICAL TRENDS IN THE TOBACCO MARKET IN AUSTRALIA Policy history Long-term trends in tobacco excise have mostly been driven by a declining volume of tobacco products cleared, more than offset by an increasing rate of tobacco excise (Chart 2), such that total tobacco excise has increased over time. Declining volumes have been driven by growing societal awareness of the negative health effects of smoking and Government policy to reduce its total consumption. On a per-capita basis 8 , rates of smoking decreased by around 53 per cent over the decade from 2006-07 to 2016-17. The effectiveness of particular policies is difficult to distinguish from other policy and from the general societal trend towards less smoking, but there is a clear relationship between higher prices – partly because of the excise rate – and lower consumption, as discussed below. Chart 2. Tobacco clearances 9 (sticks and stick equivalents) and excise rate Policies can be broadly divided into two mechanisms; those that increase the price of tobacco and those that reduce demand for tobacco by reducing its appeal, for example by health warnings or limiting the locations for smoking. Chart 3 shows the annual growth in consumption and price for tobacco since 1975-76. Policy changes are mapped against the annual price growth series for those affecting the excise rate and other taxes on tobacco, and against the annual consumption per capita growth series for those targeted at demand for tobacco products. A brief description of some of the major policies follows. 8 Australia’s resident population aged 18 years and over, ABS series 3101.0 9 ‘Clearances’ refers to the quantity of tobacco products, largely cigarette sticks, cleared for home consumption. Quantities of loose-leaf tobacco products are converted to sticks assuming 0.7 grams per stick-equivalent. 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0 5 10 15 20 25 30 2005-06 2007-08 2009-10 2011-12 2013-14 2015-16 2017-18 $ per stick billion Clearances (LHS) Excise rate (RHS) 4 Excise rate policy before 1999 Tobacco has been subject to excise and customs duty in Australia since Federation, with excise schedules regularly updated to increase the rate. In 1983 the excise and customs duty rates were indexed to consumer price index (CPI) to automatically update bi-annually, in 1987 the tobacco rate was set constant across cigarettes, cigars and loose leaf, and in 1995 the rates of excise and customs duty were equalised. There was a series of additional rate rises that amounted to around 50 per cent in three years from 1992 to 1995. Between 1974 and 1989 every state and territory introduced business franchising fees that included a percentage of sales levy on tobacco products. These fees were continuously raised until business franchising fees were ruled unconstitutional in 1997 10 , as they were essentially an excise and beyond the powers of states and territories to impose. It was agreed between the Commonwealth and States that the loss of these business franchise fees would be compensated through the GST, and that the excise payable on cigarettes would be no lower than the existing level of duty. Between August 1997 and June 2000 compensation to the States operated via an excise surcharge. 10 Ha v New South Wales (1997) 189 CLR 465 5 Chart 3. Yearly growth in per capita household consumption of tobacco and the relative price of tobacco Consumption per capita is based on the yearly chain volume in ABS series 5204.0 divided by the 18+ population in series 3101.0. Relative price is based on quarterly ABS series 6401.0, using tobacco price inflation less CPI inflation through the year to the June quarter. -15 -10 -5 0 5 10 15 20 25 -15 -10 -5 0 5 10 15 20 25 1975-76 1978-79 1981-82 1984-85 1987-88 1990-91 1993-94 1996-97 1999-00 2002-03 2005-06 2008-09 2011-12 2014-15 2017-18 Per cent Per cent Consumption per capita Relative price 1975 to 1989: Imposition of state franchise/licence fees. 1978-79: Excise rate increase around 18% June 1982 to June 1984: Excise rate increases around 13%. Excise indexed to CPI in 1983-84 June 1992 to June 1995: CPI indexation + series of additional increases raise excise around 50%. 1999: 'per stick' regime introduced 2010: 25% excise rate increase 2013: First of eight 12.5% annual rate increases and indexation to AWOTE 2012: Introduction of plain packaging 2000: Introduction of the GST 1976: Ban on television and radio advertising 1986 -2006: Phased in bans on smoking in workplaces and public places 1973: Health warnings on packs 2006: Graphic health warnings on packs. 1993: Complete prohibition on broadcast and published advertising 12 Growth in AWOTE is forecast in the context of the labour market as a whole, including employment supply and demand, and general wage and price pressures. In the medium-term, which covers the period beyond two years in the future, these parameters are projected consistent with Treasury’s economic projections framework, which assumes that the ‘output gap’ is closed over several years 26 . In addition to the economic parameters, estimates for revenue for the current year also incorporate recent trends in tax collections and other relevant factors such as the number of collection days in each month 27 . In recent years the forecasts have accounted for the switch in collections of tobacco excise from majority ATO to entirely Department of Home Affairs. This temporarily increased the difficulty of interpreting clearances, as importers may have cleared their stock in a different annual pattern compared to when they were manufacturing in Australia – this is discussed further below. Changes in policy, particularly to the excise rate, have had a large effect on how much tobacco excise has been collected recently and will be collected over the next few years 28 . In general, forecasts are first generated on a ‘no policy change’ basis, followed by the addition of new policy decisions. The impacts of policy changes may later be incorporated into the modelling (‘endogenised’). FORECASTING CHALLENGES AND RISKS Stockbuilding While tobacco consumption is used as the tax base for tobacco excise, in practice excise is levied on clearances of tobacco goods through the excise system. Clearances patterns do not precisely reflect consumption as there is typically a lag between the product being cleared by the importer or wholesaler and being sold to the consumer. Tobacco products cleared but not sold will enter the inventories (stocks) of the wholesaler or retailer, which vary over the course of each year partly reflecting seasonal patterns in demand. In recent years, there has been an increase in the stocks held by tobacco distributors. Chart 10 shows the estimated aggregate value of tobacco products held as stock at year’s end. This increase in stockbuilding has contributed to the difficulty in forecasting. 26 For a description of Treasury’s economic projection framework in the medium term, see Budget 2018-19 p. 7-18 27 In the past, tobacco excise collected by the ATO was paid on a Monday, such that months may have had four or five collection days. Recent years of 53 Mondays were 2007-08 and 2013-14, with the forecasts being around two per cent higher in those years than they would have been otherwise. 28 An additional policy change affecting future tobacco excise was announced at Budget 2018-19. From 1 July 2019, importers of tobacco will be required to pay all duty and tax liabilities upon importation. This is a change from the current system, where tobacco can be imported and stored in licensed warehouses prior to tax being paid. 13 Chart 10: Aggregate value of stock held 29 If tobacco is cleared as stock and then not sold, it can be cleared back through the tax system for a refund of the excise. Refunds of excise are negligible compared to the excise, however, so it is assumed that all tobacco products cleared are eventually consumed. The build-up in stocks is likely to be partly a result of the relocation of the tobacco manufacturers offshore, ending domestic production and hence requiring transitional stocks and a different strategy on stocks-to-sales in the long term. The build-up may also reflect clearances before excise rate increases. The future trajectory of the stocks-to-sales ratio, and hence the relationship between clearances and consumption, will depend on the relative (but unknown) importance of these two factors. Switch to lower-priced substitutes One possible effect of increasing tobacco prices is that consumers switch to low-priced substitutes rather than lowering their tobacco consumption. This presents an upside risk to the tobacco excise forecast which predicts smokers cutting back consumption consistent with past patterns. Substitution to lower-priced licit tobacco has no impact on excise collections, as tobacco excise is levied on the quantity of tobacco rather than its value. There is evidence that this substitution to lower priced licit tobacco has been taking place. In the period 2010 to 2014, based on supermarket data, sales of ‘super-value’ (low-cost) brands rose sharply while mainstream, premium and value brands all fell, as total sales fell slightly. Some brands have been relaunched as super-value, such as Rothmans in 2014 30 , in an effort to maintain or regain volume shares while the excise rate is increasing. If substitution behaviour by consumers and producers continues, then collections may be higher than forecast, at least in the short term. The duty free and illegal tobacco markets One ongoing difficulty in forecasting tobacco excise is the extent of black market tobacco consumption. While tobacco consumption has a relatively steady base due to the high proportion of a given population of smokers that are likely to still be smoking the next year, the size of the excise base is less 29 Unpublished ABS data (quarterly business indicators), including an allowance for stocks held by retailers and smaller wholesalers. Figures are for the end of each financial year. 30 http://www.tobaccoinaustralia.org.au/chapter-10-tobacco-industry/10-7-market-share-and-brand-share-in-australia 0 400 800 1,200 1,600 2,000 0 400 800 1,200 1,600 2,000 Jun 2010 Jun 2011 Jun 2012 Jun 2013 Jun 2014 Jun 2015 Jun 2016 Jun 2017 $million$million 14 predictable if those smokers are substituting illegally-sourced tobacco for legally purchased tobacco, or if crackdowns on the availability of illegally-sourced tobacco force smokers back into the legal market. From this forecasting perspective, tobacco excise is modelled on a ‘base-plus-growth’ approach, where the latest known outcomes are forecast to grow according to the relevant economic parameter. This means that the forecasts implicitly allow for black market consumption, to the extent that it exists in the historical base year. Changes in the size of the illegal tobacco market are driven by the demand and supply for the product. The demand is likely to be driven by a range of factors, including the price of legal tobacco, and as such it would be expected that demand for illegal tobacco would increase as the excise rate increases. Efforts to counter this increased demand have been targeted at restricting the supply side. In recent years the chain of supply has been affected by the cessation of legal Australian tobacco production, as in the absence of legal local producers illegal tobacco would now be sourced primarily from foreign countries, with a small quantity of local illegal production still presenting a small revenue risk 31 . Illicit tobacco goods weighing around 406 tonnes were detected at the border in 2017-18 32 . Large changes in the extent of the illegal tobacco market present a risk to the tobacco excise forecasts. The use of illicit tobacco may continue to present challenges to tobacco excise forecasting in the future. The 2018-19 Budget included the measure Black Economy Package — combatting illicit tobacco, which increases funding to tackle the main three sources of illicit tobacco in Australia: smuggling, leakages from licensed warehouses and domestic production. It is anticipated that this measure will reduce the size of the illicit tobacco market through additional enforcement capabilities. In turn, this measure is estimated to have a gain to revenue as some smokers switch from illicit to licit tobacco, which is subject to excise. SUMMARY Tobacco excise forecasting must account for underlying trends in tobacco consumption, driven by popular awareness of health risks, and the effect of policy changes, including changes to the excise rate. While tobacco consumption as the theoretical base of tobacco excise could be expected to be relatively predictable, the effect of policy changes and risks to the forecast from changing producer and consumer behaviour and the illegal tobacco market pose a challenge to accurately forecasting how much tobacco excise the Government will receive each year. 31 ATO submission to the Inquiry into Illicit Tobacco by the Parliamentary Join Committee on Law Enforcement, March 2016. 32 2017-18 Department of Home Affairs Annual Report