Business World, 8 October 2014


Forewarned is forearmed. During the congressional deliberations on the sin taxes, some analysts warned that too high a tax on cigarettes could lead to a rise in illicit trading. Economic theory says that the higher the tax rates, the greater the incentive to engage in illicit trade.

The Department of Finance authorities downplayed this risk. Legislators went along reluctantly.

New disturbing evidence has emerged recently. It supports the view that illicit trade is rising and that, as a result, significant tax loss has been incurred by the government. For the Philippines, it is estimated that the tax loss from illicit consumption of cigarettes rose from P2.615 billion ($6.2 million) in 2012 to P15.601 billion ($368 million) in 2013, or an increase of 496.6%, according to a recent study by Oxford Economics.

The study looked at 14 Asian countries in the ascending order of illicit consumption (number of cigarettes): Laos, Brunei, Cambodia, Singapore, Thailand, Indonesia, Hong Kong, Myanmar, Australia, Taiwan, Malaysia, Pakistan, Philippines and Vietnam.

The Philippines registered the highest increase in illicit consumption (as % of total consumption), up by 12.2 percentage points, from 5.9 percentage points in 2012 to 18.1 percentage points in 2013. The average for Asia-14 in 2013 was 10.9%.

In terms of illicit consumption (number of cigarettes), the Philippines has the highest increase — up by 12.7 billion sticks or by 198.4%. The number of illicitly consumed cigarettes was 6.4 billion in 2012 while it was 19.1 billion cigarettes in 2013.

One of the selling points of the higher tax rates on cigarettes is that it will reduce smoking. However, the evidence supports only a marginal decline in smoking: total cigarette consumption declined from 108.7 billion cigarettes in 2012 to 105.5 billion cigarettes in 2013, or by minus 3%.

The slight decline in cigarette consumption is more than offset by a significant rise in total illicit consumption: 6.4 billion cigarettes in 2012 to 18.1 billion cigarettes in 2013. As a result, the estimated tax loss soared by almost five-fold. The taxes foregone rose from P2.6 billion in 2012 to P15.6 billion in 2013.

The tax loss is not trivial. It represents 3% of all taxes on domestic goods and services. On the spending side, it could finance at least 31,200 classrooms.

Another feature of the sin tax reform that took effect on Jan. 1 this year is that 85% of the estimated extra revenues of $6.03 billion over five years, will be earmarked by government for improving health care provisions in the country.

But does earmarking really work? No it doesn’t. Many noted economists have written against earmarking.

First, earmarking results in loss of macroeconomic control over public finances. It limits the ability of the President and Congress to respond to change economic conditions (say, the Asian financial crisis and the recent global recession) or to allocate the budget optimally.

No one has a full handle of what the future holds. Many things could go wrong. A strong recovery could result in higher interest rates, and hence higher debt servicing. The retirement costs of the military and the police could balloon in the near future and hence put pressure on government spending and higher deficits. A much slower economy could result in lower revenues. All these suggest that a fiscal crisis cannot be ruled out in the future.

What if the government had to cut spending in order to reduce its ballooning budget deficit, but fiscal authorities are barred from touching the earmarked funds for the health sector? Then we might end up in a perverse budget scenario: that while the budget deficit is threatening to reach unmanageable levels, the subsidy to tobacco growers and workers will continue to expand, the surplus of PhilHealth will continue to swell, and new hospital buildings or extensions will continue to be built.

Second, earmarking limits future Congresses in their exercise of the power of the purse. As an increasing part of government revenues is earmarked, it reduces the amount of “unrestricted” funds that the Executive and the Legislature will decide on.

Third, earmarking unduly complicates the budget process, tax administration, and monitoring for compliance. Ideally there should only be one fund to which all government resources will go and from which all appropriations will emanate.

Fourth, earmarking will increase lobbying and political pressure to increase spending for potentially lower priority areas from earmarked revenues. For example, the earmarking of funds from additional revenues from taxes on cigarettes and alcohol have resulted in competing demand for higher public construction of public hospitals and greater allocation for public health insurance. But with limited absorptive capacity, the extent of underspending in this sector has become quite serious.

Fifth, earmarking has adverse distributional impact: why should the smokers (generally the poor) subsidize the expensive medical procedures for all (including but mostly the rich)? Health care is not totally free in the Philippines, as it involves a large out-of-pocket expense.

The early evidence of rising illicit trading of cigarettes, and their adverse impact on revenue generation and rising criminality (who else benefits from illicit trading?), should warn executive officials and legislators on the need to put in place strict remedial measures to make illicit trading less profitable.

A discretionary change in the cigarette tax system within the next few months is not feasible given the present political climate. The presidential and national elections are just around the corner. Tax reforms done close to an election almost always turn out to be weak and watered-down.