Section B

1. Section B Causes of Illicit Trade

2. Outline • Financial incentives and the role of excise taxes • Government responses to smuggling • Other important factors that contribute to smuggling

3. Incentive for Illicit Trade: Price Difference Price Differences: High-Income Countries Source: adapted by CTLT from U.S. Department of Agriculture. (1999).

4. Incentive for Illicit Trade: Price Difference Price Differences: Low-Income Countries Source: adapted by CTLT from U.S. Department of Agriculture. (1999).

5. Illicit Trade and Tax Policy • Price difference • Most widely used argument against policy on excise tax increase by governments and industry • Is tax difference responsible for the price difference among countries?

6. Pre- and Post-Tax Price Level • Pre- and post-tax price level in EU financial incentive already exists under pre-tax price • Average pre-tax price among EU member countries in 2004 in EUR/1000 Source: Alexander Wiedow. (September, 2006). Hungary Tax Seminar.

7. Governments’ Response to Illicit Trade • Governments often think reducing excise taxes will halt smuggling activities • Reducing excise taxes (evidence from developing countries) • Georgia: excise taxes reduced by half in 2002* • Kyrgyz parliament discussed reducing excise taxes during budget discussions in 2004† • Uzbekistan: excise rates were changed from ad valorem to specific and the rates were reduced‡ * Source: IMF Country Report; †Source: Personal communications with the Ministry of Finance of the Kyrgyz Republic, ‡Source: Personal communication with the Ministry of Finance of Uzbekistan.

8. Tax Decrease in Sweden • Seventeen percent reduction due to fear of smuggling in 1998 • Between 1997 (pre-tax reduction) and 1999 (pro-tax reduction) period: • Public health lost since consumption increased by 18% • Government lost since revenue did not reach 1997 level! • By 2000 consumption increased more than 20% (revenue reached 1997 level) • Outcome: public health and government lost due to lower excise taxes • The government ignored the long-term cost of increased consumption by concentrating only on short-term revenue gains Source: Nordisk Tobaksstatistik. (1970–2002); author’s calculation.

9. Reducing Excise Taxes: Not a Solution • Canadian government reduced tobacco tax rates dramatically in February, 1993

10. Reducing Excise Taxes: Not a Solution • After the tax reduction • Countries still face smuggling • Cigarettes become affordable and consumption increases • Revenues are not necessarily increased as much as expected • Long-term costs have been ignored for short-term gains

11. Other Causes of Illicit Trade • Level of risks associated with smuggling and the corruption level in the country • Inability of customs to detect and halt smuggled goods due to lack of: • Up-to-date technology at customs and communication between customs • Collaboration with the World Customs Organization • Judicial and legal systems supporting customs’ activities • In many countries, customs and tax administrations are aware of smuggling, but they have no technical capacity, manpower, and strong laws to support their action • Moldova • Turkey • Some Latin American countries

12. Other Causes of Illicit Trade • Irresponsible exporting and accountability of the industry and exporters • Industry’s involvement to illicit trade in the U.S. and the EU: • Court cases against industry in many countries • Brazilian cigarettes re-exported illegally back to country—irresponsive exporters • Lack of political commitment by the government • Lack of implementation and enforcement of controlling illicit trade • Many factories established near the Brazilian border in Paraguay are the main sources of smuggled cigarettes to Brazil* *Source: Roberto Iglesias. (2005). Mercosur study from Brazil.

13. Illicit Cigarette Trade Increases with Corruption! Source: adapted by CTLT from Yurekli and Sayginsoy. (2006).

14. Inability of Customs or Increasing Illicit Activities? Source: adapted by CTLT from World Customs Organizations Report. (2004)

15. Other Causes of Illicit Trade • Trade restrictions • Smokers’ positive perception of foreign brands • Partly because of the lack of variety and appealing domestic brands (under the state or private monopoly) • Low household income and high prevalence among poor population • Evidence shows that cheap cigarettes are smuggled more into countries with high poor-smoker populations (e.g., Ukraine, Uzbekistan)

16. Other Causes of Illicit Trade • High percentage of youth population • Future smokers-to-be: • Take risks in terms of tobacco-associated diseases and deaths • Are a price-sensitive but brand-cautious population • Increasing the purchasing power of population and female employment • Economic independence and sophisticated appearance

17. Government’s Commitment: China • In 2002, State Tobacco Monopoly Agency (STMA) and the Ministry of Public Security jointly launched several major crackdowns on illegal cigarette activities • Hired 24,000 people to investigate counterfeit production in the country • Inspected 320,000 cases of suspected illegal cigarettes • Confiscated 4.97 billion counterfeit cigarettes • Closed down 2,476 illegal manufacturing operations • Seized 1,375 pieces of equipment used in these illegal operations • Arrested 4,075 people Source: Unofficial U.S. Department of Agriculture data in attaché reports. (2003).

18. Government’s Commitment: Spain • How? • Choked off container supply, by intelligence activity and cooperation, technology, anti-smuggling legislation, close cooperation among five countries plus the European Anti-Fraud Office (OLAF) • Not by reducing taxes, arresting street sellers • 1997: sales of legal cigarettes rose 78 billion and tax revenues increased 25% Source: adapted by CTLT from Joossens and Raw. (2000).

19. Agreement between EU and Philip Morris • 2004: European Commission and Philip Morris International signed a twelve-year agreement to combat contraband and counterfeit cigarettes • The EU agreement requires Philip Morris to implement several measures to combat cigarette smuggling; these include: • Improved tracking, tracing, labeling, and record-keeping requirements to help law enforcement determine the source and track the path of contraband cigarettes • Better monitoring of its sales and distribution practices and vendors to ensure they are in compliance with legal requirements • Establishment of additional monetary penalties Philip Morris must pay if its cigarettes continue to be smuggled in large quantities

20. Agreement between EU and Philip Morris • Payments under the agreement • The agreement also includes an initiative whereby PMI has agreed to make payments in the event of future seizures in the European Community of its genuine products above defined quantities • These payments will be made without regard to fault or wrongdoing by Philip Morris International • If other member states sign the agreement, including the new member states, they will also be entitled to receive these payments • The European Community and 10 member states will receive substantial payments over a number of years • The amount of Philip Morris International’s payments under the agreement will vary based on a number of factors and could total approximately $1.25 billion

21. Counterfeit Production and Trade • Is this an emerging new threat or newly recognized threat? • Counterfeit cigarette factories were destroyed in Poland, Germany, Russia, and Dubai • In Russia • 2005: six million counterfeit cigarettes were destroyed • 2004: 40 million counterfeit cigarettes were destroyed • In Dubai • In 2003: 3.8 million counterfeit cigarettes were seized • Counterfeit cigarettes reached Canada through trade: • 2003: seized 43,000 cartons of counterfeit cigarettes (worth $2.6 million)

22. More Counterfeits Are Seized Compared to Originals Source: adapted by CTLT from WCO database. (2004).

23. Increasing Number of Seized Counterfeits Source: adapted by CTLT from WCO Customs and Tobacco Report. (2004).

24. Evidence from Economic Studies • An increase in tax and enforcement level would fit both governments’ and public health advocates’ objectives for: • Reducing smuggling activities • Reducing global cigarette consumption • Increasing government tax revenues • The enforcement level plays a significant role in controlling the worldwide smuggling activities and also reduces global consumption Source: Yurekli and Sayginsoy. (2006); Merriman, et al. (2000).

25. Evidence from Economic Studies • A 10% increase in average retail and import prices and 10% increase in law enforcement (lower corruption), assuming no change in income, will: • Decrease smuggling activities by 5.4% • Reduce global consumption by 2.3% • Increase governments’ tax revenues by 7.8% despite 4% total tax revenue lost due to smuggling *Source: Yurekli and Sayginsoy. (2006).

26. Summary • What can be done about illicit cigarette trade? • Existing evidence suggests that government commitment is the key for success • What can governments do? • Require manufacturers to put tax-paid markings/stamps on packages • End duty-free sales, including cigarettes produced in duty-free zones • Require license and detailed records for all cigarette exporters, manufacturers, and distributors; require a unique identifying code on all cigarette packs and a chain of custody information so that smuggled cigarettes can be traced • Require export-bonds from exporters until the cigarettes reach their final legal destination

27. Summary • Enhancing customs officials • Technical, financial, legal capacity as well as human resources for detecting and prosecuting • Ensure official communication and collaboration with other customs and the WCO • Prosecute and impose high penalties for those-actual-players who are responsible for smuggling • Not targeting to street sellers only