The return of cigarette smuggling

By Benjamin E. Diokno

CONGRESS SHOULD be extremely careful in redesigning the sin tax bill. With the proposed sharp rise in tax rates on, and hence the price of, cigarettes, the Philippine government might have to deal with the return of cigarette smuggling into the country. Studies show that increases in tax rates, and accompanied by improvements in anti-smuggling law enforcement, may lead to higher government revenues and reduction in smoking and smuggling. The critical factor for this conclusion is the accompanying "improvements in anti-smuggling law enforcement."

In an article entitled "Worldwide Organized Cigarette Smuggling: An Empirical Analysis" and published in Applied Economics (February 2010), A. Yurekli and O. Sayginsoy find that: "A tax-induced increase in real retail cigarette prices and an improvement in anti-smuggling law enforcement (as proxied by the corruption behavior) are found to significantly increase government revenues while decreasing global consumption and smuggling. Furthermore, when the tax increase is not accompanied by an improvement in law enforcement, then global smuggling of cigarettes would increase, but governments would still enjoy increased tax revenues."

One of the unintended consequences of the sharp rise in the real price of cigarettes in response to higher taxes is the strong incentive for smuggling. This happened in the UK, in the United States (movement of contraband from low-taxed states to high-taxed states), Greece, Spain, Canada, Brunei and many other countries.

Put differently, the return of massive cigarette smuggling in response to sharp increase in the cigarettes is a grim reality. Ignoring it will be a monumental mistake.

Right now, cigarettes smuggling does not exist in a big way because cigarettes are relatively inexpensive in the country. But a smuggling problem could easily develop if Congress approves the House bill.

As part of the Yurekli and Sayginsoy study, it is estimated that smuggling as percentage of predicted consumption for the Philippines was 1.3%, second lowest among ASEAN-5 countries. Indonesia has the highest smuggling incidence at 5.9%, Vietnam 2.0%, Thailand 1.6% and Malaysia 1.2%.

The study recognized the role of improving one’s anti-smuggling law enforcement (as proxied by the corruption behavior). The implication is that smuggling thrives in a society where corruption is pervasive and where law enforcement is weak.

But what’s the Philippines’ record on corruption and law enforcement? Dismal, among ASEAN-5 economies, worst and second worst. Based on the World Bank’s governance indicators, the Philippines is the most corrupt among ASEAN-5 countries. It scored 22.7 percentile rank in the "control of corruption" indicator. This means that 77.3 percent of the countries in the world are better than the Philippines in controlling corruption. There may be some improvements, but the Philippines is still many miles away from being a model country.

Malaysia scored 57.8, Thailand 44.5, Vietnam 29.9, Indonesia 27.5, and the Philippines 22.7.

In terms of rule of law, the Philippines ranked second worst among ASEAN-5 economies. In terms of percentile rank, the Philippines scored 34.7, meaning 65.3% of the countries in the world have a better legal system and enforcement record than the Philippines. Malaysia scored 66.2, Thailand 48.4, Vietnam 38.5 and Indonesia 31.0. 

Since effective law enforcement is a major determinant of revenues, what the President and Congress should find out is how much additional revenues would be generated by higher taxes on cigarettes, with or without improvement in anti-smuggling law enforcement. The analysis should be based on hard facts, not conjectures. 

Considering the country’s geographic characteristics, the challenge is daunting. The Philippines has a coastline of 36,289 kilometers, much longer than that of the United States. The cost of upgrading the government’s ability to police Philippine shores is going to be high since smuggling can take place in virtually all nooks and crannies of the archipelago -- the South, the North, the East and the West, or even in official ports (Manila, Subic, Cebu, Batangas and others).

An important lesson for policy makers is that a big part of the potential revenue gain from higher sin taxes may have to be spent for improving anti-smuggling law enforcement. In the worst case scenario, one may not rule out the possibility that tax evasion plus hefty spending for anti-smuggling law enforcement would wipe out totally the potential revenues from higher tax on cigarettes.

Another lesson is that illicit trade poses a serious threat to national security. The return of smuggling could provide new life to criminal syndicates and enemies of the State. Experiences in other countries show that smuggling provides financial muscle to organized crime and terrorist activities. Is the Philippine military establishment ready for this?

COMPROMISES

President Aquino should make sure that the sin tax bill that will emerge from Congress is the right one and not the product of compromises and flawed assumptions. 

Clearly, the House bill on sin taxes was a product of serious horse trading. One product was pitted against another. Liquor and beer which were allegedly supported by a major political party was favored to cigarettes. The outcome is a proposed tax system that remains complicated and with very high tax rates on cigarettes and reasonably moderate tax rates on liquor. The proposed taxes on cigarettes are too high, and will surely lead to the rise of smuggling of cigarettes into the county.

An ideal reform for cigarettes taxation is a return to uniform ad valorem tax. That was the reform embodied in the Tax Reform Program of 1986, a departure from specific tax system during the Marcos years.

A uniform, ad valorem tax system is a proportional tax. It is neither regressive nor progressive. There is no need for commodity classification which only complicates the tax system. The more complex the tax system, the more opportunities for corruption and evasion. 

Emerging economies in this part of the world, all latecomers in tax reform, like Vietnam, Cambodia and Laos, use ad valorem rates to tax tobacco and alcohol. These countries must have learned best practices from their foreign tax consultants, and they adopted ad valorem taxation. The Philippines is the only country in the region that uses specific rates.

The ad valorem rates on cigarettes are 10%, 65%, and 55% in Cambodia, Vietnam, and Lao PDR, respectively. The same rates more or less apply to alcoholic beverages.

That shift from ad valorem tax system to the complicated and less responsive tax system was in response to the practice of the dominant cigarette manufacturing of creating dummy corporations to reduce its tax liability. What a disaster! What happened was not real reform. As a result revenues from sin products plummeted for a long, long time.

The first best solution to the fictitious sale to dummy corporations was obvious: define through legislation that the said transaction is illegal and that heavy penalties (including imprisonment ) should be imposed on offending parties. There was no need to shift from ad valorem to specific taxation. There was no need to throw out the baby with the bath water.

In an ad valorem tax system, tax intakes automatically adjust as prices of taxed products adjust. There is no need for discretionary legislative measure or execution action. This makes the tax system easier to administer and responsive (elastic) to changes in economic activity. An ad valorem tax system is ideal in a political environment where it is difficult to get new tax measures passed by the Congress.

The challenge is for President Aquino is to make sure that the sin tax bill that will emerge from Congress will be responsive, simple and easier to administer, and will not lead to the return of smuggling of cigarettes into the country. Right now, smuggling of cigarettes into the country is practically nil. 

The administration has to do the tax reform right. The political reality is that this is perhaps the best time for Malacañang to pass revenue-raising changes in the tax system between now and 2016. The next elections are eight months away. And after the 2013 elections, most politicians will be geared toward the 2016 congressional and presidential elections, and will have little appetite for more tax increases.

This means that the President has to make sure that Congress produces a bill that will raise enough revenues, discourage drinking liquors and beers and smoking sufficiently, and at the same time not stimulate smuggling. 

ECONOMICS OF SMUGGLING

Smuggling is a function of law enforcement. I agree. A weak tax enforcement which implies low probability of getting caught and prosecuted encourages smuggling. But the reality is that smuggling of rice, oil products, and other consumer goods has remained unabated. This shows weakness, not strength, in law enforcement.

Smuggling is also a matter of incentives. The higher the tax rates, the higher the return on illicit trade. This is a proposition supported by reality. A few months after EDSA 1 and as part of the 1986 tax reform program, tariff rates were cut, invoking the theoretical argument that higher tariff rates lead to rampant smuggling. Low and behold, lower tariff rates resulted in higher revenues by the Bureau of Customs.

The sin tax proposal is supposed to raise an additional ₱30-60 billion, reduce smoking and not provoke smuggling. The House bill proposes to increase tax rates on cigarettes by about 700%. At that level, it would be a grave mistake to assume that it won’t induce massive smuggling of cigarettes.

Benjamin Diokno is professor of Economics at the School of Economics, University of the Philippines (Diliman). He was formerly secretary of budget and management in the Estrada Cabinet and undersecretary for budget operations in the Aquino 1 administration.