The government needs to rectify anomalies in tobacco taxation to avoid a shift to cheaper, substandard, unhygienic and illegitimate products
The existence of illicit markets is a matter of serious concern for any economy. More so, in India, where rapid technological advancement and economic liberalisation seems to have opened up avenues for the growth of a parallel economy dominated by such goods and services. It has been termed as the crime of the 21st century, due to its impact on all world economies. Legitimate businesses suffer on account of loss of profits and brand image. Governments lose tax revenues from black market sales and the common citizen is faced with job losses, and consuming substandard goods which are detrimental to health and safety.
A study by FICCI CASCADE (committee against smuggling and counterfeiting activities destroying the economy) has revealed the magnitude of illicit trade to be way beyond the common perception. For seven products, namely alcoholic beverages, auto components, computer hardware, FMCG packaged Foods, FMCG personal goods, mobile phones and tobacco products, the supply of unaccounted and untaxed goods has increased by 44.4% in two years between 2012 to 2014. As a result, genuine producers collectively suffered a loss of R32,412 crore, while government’s loss in tax revenue went up by R13,049 crore. The maximum loss is attributed to the tobacco sector, at a staggering R9,139 crore in 2013-14. According to the expert committee report, the share of grey market in tobacco products grew to 20.2% from 15.7% in these two years.
India is the second largest tobacco producer and exporter in the world after China. Cigarette and other tobacco products provide a source of livelihood to nearly 45.7 million of Indians—farmers, farm labour, women and tribals, and contribute a good deal to the rural economy. The industry generates a significant share of the country’s excise duty and state taxes, amounting to more than R30,000 crore annually. Exports of leaf tobacco and tobacco products generate foreign exchange earnings of around R6,000 crore. However, a growing consumption and trade in illicit cigarettes, which constitute a significant component of the tobacco industry, is a cause of grave economic and security concern. In India, one-fifth of cigarettes available in the market are illegal. Multi-agency studies involving Indian industry, government agencies and international entities such as USDA and Euromonitor International, show that consumption of illicit cigarettes has been growing steadily.
What incentivises a rapid growth in illicit markets is high tax rates, a point which is missed by the policy makers. According to WHO, cigarette taxes as a percentage of GDP are very high in India. On this consideration, taxes in India are 14 times higher than USA, seven times higher than China and five times higher than Australia. High and discriminatory taxation on cigarettes has encouraged shift to cheaper, revenue inefficient tobacco products and to illegal cigarettes. Learnings from the history of cigarette taxation indicate, very clearly, that in order to curb tax evasion on cigarettes two things are critical:
*Maximisation of the specific component of cigarette taxes
*Minimising tax arbitrage to ensure revenue maximisation.
Notably, while tobacco consumption in India has grown from 406 million kg in 1981-82 to 562 million kg in 2014-15, the consumption of cigarettes has declined from 21% to 11% of overall tobacco products. It is reported that about 68% of tobacco products, remains untaxed due to evasion and narrow tax base. Cigarettes constitute only 11% of the tobacco products, but pay 85% of tobacco taxes. The current practice in effect means that except for cigarettes, all other tobacco products bare only a nominal incidence of tax. This is against tobacco taxation goals, and the health agenda of the government. Due to high taxes on cigarettes, consumption has shifted to cheaper, substandard, unhygienic and illegitimate products causing loss of revenue to the government and posing a greater health risk to consumers. This is contrary to the two key government priorities, i.e., to protect tax revenue and protect citizen’s health.
We find that one landmark decision about taxation of cigarettes was taken in March 1987, when a new system of length-based, specific excise duty structure was introduced for cigarettes in order to remove the ambiguities associated with determination of value and to curb the flourishing trade circumvention and revenue leakage. The superiority of the length-based, specific duty system for cigarettes as against the erstwhile system of ad-valorem excise taxation is borne out by the fact that the specific duty system has withstood the test of time since 1987, and enabled sustainable revenue buoyancy. Notwithstanding the fact that cigarette volumes have declined over the last three decades, the compounded annual growth rate of revenue from cigarettes has been around 10%—practically a double digit growth of revenue year-on-year for almost 30 years.
The length-based, specific duty structure has also ushered in several other benefits including (i) high quality products for consumers at various price points—critical in the context of the wide income distribution of the Indian consumer, (ii) setting a floor price for cigarettes in each segment by virtue of the segment-wise minimum tax threshold, thereby protecting revenue, (iii) increased demand for high quality tobacco leading to higher earnings for the Indian farmer, (iv) securing of revenue at the factory-gate itself through a simple, transparent, single-point and robust tax collection system, (v) avoiding the possibility of leakages and tax escape inherent in multi-point tax collection across a large trade chain, and (vi) an end to valuation related disputes and litigation.
State level VAT was introduced in the country in 2005. Initially, cigarettes were taxed under VAT at the revenue neutral rate of 12.5%. However, within a very short span of time numerous states started raising the rate of VAT on cigarettes. Almost immediately, the arbitrage provided by the high and differential rates of VAT across state borders was exploited by the organised crime syndicates to indulge in wide-spread trade diversion and illicit trade.
So far, the government has not been able to strike a balance between tax revenue targets and consumer interest. At this historic moment, when GST is being rolled out, an exceptional opportunity is available to rectify tax anomalies and get the right balance. GST is set to bring about a transformational change in the indirect tax landscape of the country. The policy makers are, rightly, using the opportunity afforded by GST to correct some of the distortionary elements of taxation that have, over the years, crept into the existing cornucopia of central, state and local levies of indirect taxes.
Press reports suggest that a 28% GST levy is proposed for cigarettes. Given the fact that the current weighted average incidence of VAT on cigarettes is around 23% to 24%, to ensure revenue neutrality the rate increase of 4% to 5% under GST must be off-set against the levy of central excise duty that will continue for cigarettes in the GST regime. Press reports also suggest imposition of a GST compensation cess on cigarettes. The proposed cess should be in the single-point specific format such that it can be collected along with the central excise duty at the factory-gate itself. Moreover, overall incidence of GST, customs and excise duty and cess must remain revenue neutral. Tax credit (in line with current cenvat credit) should be allowed both for customs and excise duty and cess paid on tobacco-based input materials used in manufacture of final products.
It is necessary that all relevant aspects of revenue generation from tobacco products are duly considered while taking a final decision on taxation of this item under the GST regime. Since the decision to be taken now would affect the revenue administration for a long time in future, proper care needs to be exercised.
PC Jha is an advisor, FICCI CASCADE and was formerly chairman, Central Board of Excise and Customs. Views are personal