Will the government once again forget the cigarette tax formula? – Opinion

Sri Lanka is currently facing the most serious economic crisis in its history. The main problem is that Sri Lanka’s debt has become unsustainable. This means that the revenue expected from the government is not enough to meet the planned expenditures to run the government and pay the interest on the public debt. One of the critical adjustments needed for economic recovery is to significantly increase government revenues.

In order to obtain an increase in income, a fuel and electricity pricing formula was discussed. The advantage of a formula is that it adjusts prices based on economic fundamentals in a timely and sustainable manner, overcoming the delays and inconsistencies created by leaving price adjustments to discretionary and ad hoc policy action.

However, at present, another pricing formula that was presented in previous budgets has been forgotten. This is the formula for pricing and taxing cigarettes.

Several past insights from Verité Research and similar research interventions from the Institute of Policy Studies as well as the National Tobacco and Alcohol Taxation Authority (NATA) have repeatedly pointed out that failure to s Engaging in the proper taxation of cigarettes has a significant impact on income.

A previous overview by Verité research calculated that the government would have raised an additional $20 billion in revenue from cigarette taxes in 2020 if the taxes had been adjusted in line with the indexation policy articulated in the 2019 budget; and if these tax adjustments were calibrated and applied rationally based on the length of the cigarette, to all the different brands of cigarettes on the market.

This overview presents the calculation of this revenue consequence from 2021 to 2023. It finds that Sri Lanka will have forfeited Rs. 85 billion from 2020 to 2022 due to the failure to implement the formula, and correcting this failure would increase revenue from cigarette taxation by Rs. 45 billion in 2023.

Will the new budget resume taxation on cigarettes, where it remained in 2019?
The March 2019 budget speech announced a policy to systematically index cigarette prices to nominal GDP growth.

In the words of the Minister of Finance at the time, “excise duty on cigarettes will henceforth be based on indexation with a minimum annual increase in duty taking into account annual inflation and GDP growth. This will ensure income protection and affordability control.

The methodological guidelines needed to implement the cigarette tax formula have been published and are available to the government (Verité Research, A Technical Case for Affordability Based Pricing of Cigarettes, September 2014). However, Sri Lanka has not since implemented this policy announced in the budget.

As Sri Lanka is about to announce a new budget, in the midst of its economic crisis, it would do well to implement the cigarette tax formula and recoup the significant revenue lost by not doing so.
The calculations reveal that if the indexation formula is implemented, the government can increase its revenue by 45 billion in 2023.

To put revenue collection into perspective, this additional revenue can double the support in the form of Samurdhi payments which are intended to relieve the poorest and most vulnerable bottom three income deciles in Sri Lanka. In addition to income benefits, social benefits in the form of reduced health harm from cigarette smoking are an additional social benefit that will also result in reduced health care costs, if the cigarette tax formula is properly implemented.

How to apply the cigarette tax formula?
The methodological and technical guidance for cigarette pricing and taxation in Sri Lanka based on Verité Research’s working paper (A Technical Case for Affordability Based Pricing of Cigarettes, September 2014) solves three critical analytical problems: (1) Finding the reference price for the most type of cigarette consumed (2) Specify the criteria on which the reference price of cigarettes must be updated (3) Apply a consistent method for price differences between the different types of cigarettes.

Application of the methodology according to the working paper shows that the current price of JPGL cigarettes is Rs 29 lower than the reference price (see graph). Applying the criterion of a 75% tax on the price of cigarettes, the targeted taxation per cigarette by brand is shown in the table.

The methodology requires an estimate of the benchmark price for JPGL which is calculated to maintain the same level of affordability the cigarette brand had from 1981 to 2000.

Affordability is maintained by increasing the price of JPGL cigarettes in line with nominal GDP growth. This figure is estimated at 25% in 2022 and 20% in 2023 (this is a conservative estimate, as explained below).

The prices of the other brands of cigarettes are then calculated by adjusting the reference price in relation to the length of the other brands in order to avoid substitution between cigarettes.

A tax of 75% on the price is applied to the price estimates which then provide the target tax rates. The calculated revenue loss is the difference between the tax revenue and the estimated tax and the estimated tax revenue under the policy, for the quantity sold.

The quantity sold is calculated by applying a price elasticity of demand of 0.5 (based on the international standard for calculating the demand for cigarettes) on the quantity sold in 2019, to predict sales.

Calculate revenue lost due to not applying the formula
This overview updates these calculations and finds that the recurring repercussions of the failure to implement the formula on the price and taxation of cigarettes resulted in a revenue loss of Rs. 29 billion for 2021 and will result by a further loss of revenue of Rs. 36 billion in 2022.

Therefore, extrapolating from 2019, the cumulative shortfall from 2020 to 2022 will be Rs. 85 billion, because the formula has not been applied. This equates to nearly two years of spending on Samurdhi social benefits, which are paid to more than a quarter of Sri Lankan households.

The price and tax formula calculations result from applying a cumulative cigarette price inflation of 50% for the two years from December 2021 to December 2023. The annualized inflation rate for the first four months of 2022 is 49.5%.

For food inflation, the annualized rate is 60%. Therefore, the cigarette price estimate is based on applying a conservative inflation projection to the formula for the next 20 months.

In other words, the actual increase in prices and taxes required by the formula may well turn out to be higher, when evaluated at the end of this period.

Failure to tax cigarettes since 2020
A previous overview, “Cigarette Tax Indexation, Getting It Right and Getting it Wrong” (Verité Research, August 2019) showed how the cigarette tax formula, despite being announced, was not properly implemented in 2019.
This pattern of failure continued and accumulated over the years that followed. There have been three cases in which cigarette taxation and prices have been changed since November 2019 (when a presidential election was held in Sri Lanka).

Initially (December 2019): Cigarette excise duty has been increased by amounts ranging from Rs 13.36 to Rs 13.36. Rs 48.35 per stick for different cigarettes. However, this only offset the removal of VAT and NBT taxes on cigarettes and therefore did not increase the price or tax on the price of cigarettes.

In the second case (2021): The price of the most consumed brand of cigarettes in Sri Lanka, JPGL was reduced from Rs 65 in 2020 to Rs 70 in 2021, with no change in taxation until November 2021.

In May 2022, it remained at the same price. In May 2022, the price of the rest of the cigarette brands except Capstan, which is less than 60 mm and Bristol, show an increase compared to 2021 prices.
Third instance (November 2021): The 2021 budget speech proposed an increase in the price of cigarettes by Rs. 5. The total tax rate on the price of cigarettes was however reduced in this budget.

And, for cigarettes under 60mm, which had the second highest market share, while the price tax rate did not decrease, the absolute amount of tax was reduced by nearly 50% with a similar price reduction. That is, the tax per cigarette has been reduced from Rs. 13.36 to Rs. 6.75.

The failure to implement indexation means that the government has given up and continues to give up an important stream of revenue. The cumulative shortfall from 2020 to the end of 2022 amounts to Rs 85 billion.
If the indexation is properly implemented, it is expected to generate additional revenue of Rs. social transfers to the poorest in society.

The benefits of implementing the formula also extend to a substantial reduction in health damage associated with cigarette smoking.

At a time when the government is required to raise revenue to ensure debt sustainability and seeks to raise VAT despite annualized inflation above 50%, there is a strong case for cigarette pricing enforcement and the tax formula to increase government revenue and reduce the tax burden on other forms of essential consumption.

(Verité Research is an independent Colombo-based think tank that provides strategic analysis to high-level decision makers in economics, law, politics and the media.
Comments are welcome. Email [email protected])

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