Research Note: Tobacco Taxation in Ukraine

The EU-Ukraine Association Agreement (Article 352) envisions cooperation in fighting illicit excise goods, which includes, inter alia, “gradual approximation of excise rates for tobacco products”. The EU excise policy entails systemic increasing of excise rates for reduction of consumption of tobacco products. Since 1 July 2006, the minimal rate of the excise per 1,000 cigarettes has been established at 64 EUR, while since 1 January 2004 this rate has been elevated up to 90 EUR.

On 24 December 2015, the Verkhovna Rada of Ukraine adopted the Law “On Making Changes to the Tax Code of Ukraine and Certain Legislative Acts of Ukraine with regard to Securing Budget Proceeds in 2016”, which, inter alia, envisions, increasing the minimal rate of the excise on tobacco goods by 40% starting 1 January 2016.

Ukraine has had the following minimal excise rates per 1,000 filtered cigarettes: in 2013 – 217.6 UAH (20 EUR), in 2014 (July-August) – 289.63 UAH (18 EUR), since September 2014 – 304.11 UAH (13 EUR) and since 1 January 2016 – 425.75 UAH (15EUR). Therefore, the excise rates have not been harmonized in reality, since the EUR-denominated excise rate in 2016 is lower than that in 2013.

It is proposed that a further substantial (at least by 30% per annum) increase should be envisioned for the minimal rate of the excise on tobacco products in 2017 and beyond with an objective of achieving the effective EU level of the cigarette excise in 2023.

Taxation of tobacco products in 2015

Over January-December 2015, the State Budget of Ukraine has received from the tobacco excises 22.2 bln UAH, which is 4 bln more than one year before.

The proceeds rose without an increase in the sales of cigarettes which remained at the level of 2014, i.e. 73 bln pieces. The revenues grew because in the first semester of 2015 the excise rates were substantially higher than in the respective period of the preceding year, as the rates were hiked in July and September 2014. Furthermore, the rates for non-filtered cigarettes were elevated up to the level of those for filtered ones. As a result, the average pack of non-filtered cigarettes grew from 6 to 11 UAH, while their sales shrank from 12.7 bln pieces in 2014 to 5.8 bln pieces in 2015. In addition, imports narrowed in 2015: from 6.5 to 4 bln cigarettes. In 2015, the manufacturing output advanced by 8%, from 86 to 93 bln pieces, which was caused by the growth of exports from 18 bln cigarettes in 2014 to 23 bln cigarettes in 2015, and by decreased imports. Despite the increased excises, the real (inflation-adjusted) prices of tobacco goods did not rise: the 2015 consumer price index was 143.3%, while the prices of tobacco products grew by 18.4% only.

Notably, in Quarter 4, 2015, the sales of cigarettes increased up to 22 bln pieces, while in the previous 3 quarters they equaled 17 bln per quarter on average. The growth in sales was artificial and caused by the “price wars”. Starting October, these wars have been arranged by tobacco corporations with an objective of averting a hike in the excise rates in 2016. However, the “price wars” expanded the sales of cigarettes and thus excise proceeds to the budget advanced to 6.6 bln UAH in Quarter 4, while in the previous quarters they averaged at 5.2 bln pieces. The sales of cigarettes in Quarter 4, 2015, were artificially increased on the threshold of an anticipated sharp upsurge in the excise starting January 2016, in order to pay the excise at the 2015 rates, while keeping cigarettes in stock and dispatching for retail sales as late as in 2016.

Taxation of tobacco products in 2016

Law of Ukraine # 909-VIII dated 24 December 2015 “On Making Changes to the Tax Code of Ukraine and Certain Legislative Acts of Ukraine with regard to Securing Budget Proceeds in 2016” set forth the following increases in the excise rates: 1) Specific excise rates for all tobacco products increased by 40% (Article 215.3.2 of the Tax Code), in particular the minimal excise on cigarettes (Article 215.3.3 of the Tax Code) grew from 304.11 UAH per 1,000 cigarettes to 425.75 UAH per 1,000 cigarettes (or 8.52 UAH per pack of 20 cigarettes); 2) The procedure for calculation of the ad valorem excise tax on cigarettes changed: starting January 2016, it is calculated as a Tax Code-defined percentage of the minimal retail price established by the manufacturer or importer, including VAT (Article 214.1 of the Tax Code). In reality, this means that the ad valorem excise rate increases from 10% to 12% of the minimal retail price.

In Quarter 1, 2016, tobacco corporations were still waging the “price wars”. In January 2016, the maximum retail prices of some cigarette brands were set at the level of 8.5-10 UAH per pack, while the minimal excise was 8.52 UAH per pack starting January 1, and the prices of less than 10.5 UAH per pack, inclusive of VAT, were loss-making for manufacturers. The “price wars” were continued to squeeze on the government which had to set the minimal retail prices of cigarettes (15-17 UAH per pack) following the Final Provisions of Law # 909. This was supposed to compensate manufacturers for the losses which they faced in the course of the “price wars” triggered by themselves. However, the setting of the said minimal prices will not raise excise proceeds to the State Budget, since the uniform minimal excise rate (8.52 UAH per pack) is effective in 2016 for all cigarettes with the cost of less than 18 UAH per pack. Furthermore, the Verkhovna Rada did not envision punishments for sellers who would trade in cigarettes below their minimal prices, which is why this provision will not be in effect in reality. In view of the above-said, the minimal prices of cigarettes were not established and tobacco corporations were forced to increase the prices of their cigarette brands on their own. For example, some brands of the cigarettes had the price of 9 UAH per pack in January, while in April they cost 14-15 UAH per pack already. In January-April 2016, the maximum retail prices of cigarettes grew by 3 UAH per pack on average, which is in line with the tax burden increase (2.43 UAH for the excise + 0.4 UAH for VAT). According to the State Statistics Committee, the average prices of tobacco products added 3.5% in April and 3.3% more in May.

The artificial reduction of the prices of cigarettes in Quarter 1, 2016, initiated by tobacco corporations (according to the State Statistics Committee, the average price of filtered cigarettes of domestic brands constituted 12.04 UAH per pack in February 2016 and 13.67 UAH in October 2015), has resulted in an increase in their sales. In January-April 2016, the volume of manufacturing was 29.6 bln cigarettes, which is 3.8 bln cigarettes more than in the respective period of 2015, although this was partly caused by the fact that exports expanded by 1.7 bln cigarettes. Bigger sales of cigarettes combined with the substantial upsurge in the excise rates resulted in a record-breaking increase of proceeds: in January-May 2016, the State Budget received 12.9 bln UAH from the excises on domestic and imported tobacco products, which is 62% or almost 5 bln UAH more than in January-May 2015.

Higher prices of cigarettes that tobacco corporations were forced to introduce will bring about a decrease of their sales in the following months of 2016, but the excise rate increase by 40% will secure larger budget proceeds. Even if the sales of cigarettes decrease to 70 bln pieces (i.e., 3 mln pieces less than in 2015) in 2016, average excise proceeds to the State Budget will constitute no less than 31 bln UAH in 2016, i.e., 9 bln more than in 2015.

Problem of illicit cigarette trade

Currently, the prices of cigarettes in Ukraine are much lower than in neighboring countries. For instance, the price of a Winston Blue pack, as of June 2016, was: in Ukraine – 20 UAH; in Russia – 100 rubles (=39 UAH); in Belarus – 22,000 Belarussian rubles (=29 UAH) and in Moldova – 22 leis (=28 UAH). Neighboring EU member-states had the following average prices of cigarettes: Romania – 3.15 EUR; Slovakia – 3.12 EUR; Poland – 3.13 EUR and Hungary – 3.38 EUR (90 UAH on average). This situation creates pre-conditions for mass cigarette trafficking FROM Ukraine, while the trafficking of cigarettes to Ukraine has no sense.

In December 2015, the World Customs Organization (WCO) published the “2014 IllicitTrade Report”[1] . Among other things, the WCO report contains data on the number and volumes of seized illicit cigarettes and other tobacco products. In 2014, Ukraine was ranked #1 worldwide as a country of origin of counterfeit cigarettes, with 354 cases of seizure. Report data evidences a large increase in the volumes of illicit cigarettes from Ukraine in 2014.

In June 2016, KPMG, a marketing company, published another report[2] about the volumes of illicit trade in European countries. According to it, the volumes of illicit cigarette trafficking from Ukraine to EU countries skyrocketed in 2015 as compared to 2014, for example, by a factor of 10 from Ukraine to Poland.

The vast majority of illicit cigarettes is produced by legal manufacturers, but due to a significant difference in the excises and prices, these cigarettes were tried to be brought illegally to countries where the excises and taxes are higher. There is only one reliable way for Ukraine to be no longer the country of origin of illicit cigarettes, i.e. to have a significant increase in the rates of the cigarette excises in order to make illicit trade in them non-profitable. The 40% increase of the excise starting January 2016, initiated by the Ministry of Finance, is the first step on this path only.

Higher excises on tobacco products improve the population health status

As noted by the World Bank[3], tobacco consumption is an impediment for development across the globe. Smoking-associated diseases put a heavy burden on countries and cost billions of dollars due to losses in labor productivity, pre-mature deaths of experienced workers and higher expenses on health care. US$2.1 trillion is spent globally on treatment of smoking-associated diseases through direct and indirect expenses of the health care system.[4]

In order to respond to the tobacco epidemics, in 2003 the WHO Framework Convention on Tobacco Control (WHO FCTC) was adopted as the first ever international legal document of binding nature in public health. Ukraine ratified the WHO FCTC in 2006. In 2014, the Conference of the Parties to the FCTC passed guiding principles for implementation of Article 6 of the FCTC.[5] Section 3.2 of the Guiding Principles notes: “Tax rates should be … increased … a regular basis, potentially annually, taking into account inflation and income growth developments in order to reduce consumption of tobacco products.’

Ukraine increased the average excise burden per pack of cigarettes from 0.5 UAH to 3 UAH in the period of August 2008 – July 2010 (6-fold over 2 years). This led to both a significant reduction of the consumption of cigarettes and to a rapid growth in state budget proceeds from tobacco excises: from 2.5 bln UAH in 2007 to 13.1 bln UAH in 2010 or by 424$ over the course of three years, with the volume of taxed cigarettes decreasing from 125 bln to 95 bln. In 2011-2015, the tempo of excise increases slowed down. Budget proceeds increased from 13.1 bln UAH in 2010 to 22.2 bln UAH in 2015 or by 70% over the course of five years, with the volume of taxed cigarettes decreasing from 95 bln to 73 bln.

According to annual surveys of the Ukrainian State Statistics Committee, in the last seven years (2008-2015), the prevalence of smoking in Ukrainians aged 12+ dropped from 25.6% to 18.4%, i.e., by 7.2 percentage points or by 28%. A report by the Health Ministry showed that the lower prevalence of smoking has already resulted in reduction of tobacco-associated mortality and morbidity rates.

Proposals

  1. It should proposed that the specific and minimal specific rates of the excises are to be increased by 30% starting 1 January 2017, so that the minimal excise rate be equal to 554 UAH per 1,000 cigarettes (in Russia, the minimal excise rate will constitute 1,930 rubles (=700 UAH) starting 1 January 2017).
  2. It should be proposed that the ad valorem excise rate is to be increased from 12% to 15% starting 1 January 2017.
  3. It should be proposed that the specific and minimal specific rates of the excises are to be increased by 30% annually in 2018-2022, while the ad valorem rate should rise 2 percentage points annually.

Projected consequences

  1. Subject to the proposed increase of the excise starting 1 January 2017, the prices per pack of cheap cigarettes are supposed to grow by 3 UAH and per pack of expensive cigarettes – by 3.5 UAH. The average price of the pack of cigarettes will grow from 15 UAH to 18 UAH (provided that tobacco corporations will not changes the prices sharply in any direction) or by 20%, which will allow increasing the prices of cigarettes above the inflation rate. At that, the prices of cigarettes will remain lower than in neighboring countries, so there will be no economic pre-conditions for illicit cigarette trafficking to Ukraine.
  2. The ad valorem excise will extend to all cigarettes that are more expensive than 18.6 UAH per pack, i.e., approximately to 50% of their market.
  3. Starting 1 January 2017, the average excise rate will increase approximately up to 600 UAH per 1,000 cigarettes. Even if the market of cigarettes shrinks down to 60 bln cigarettes in 2017, state proceeds from the tobacco excises are to reach 0.6*60=36 bln UAH in 2017, i.e., additional state budget proceeds from the tobacco excises will be at least 5 bln UAH in 2017.
  4. If following introduction of the proposed excise rates in 2014 (with the minimal specific excise being 90 EUR or 2,500 UAH per 1,000 cigarettes) the tobacco market decreases to 40 bln cigarettes (due to reduction of illicit cigarette trade Ukraine and decreased tobacco consumption), annual budget proceeds will constitute no less than 2.5*40 = 100 bln UAH.
  5. Reduction in tobacco consumption in Ukraine will bring about further decreases in tobacco consumption-associated mortality and morbidity rates in Ukraine.

Kostiantyn Serhiyovych Krasovskyi,

Head, Tobacco Control Sector,

Ukrainian Institute for Strategic Research of the Ukrainian Health Ministry

June 2016

Kyiv

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