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Excise duties harmonisation and smoking in a model with cross-border arbitrage

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Abstract

We use the 2007–2018 monthly data for five Western Balkan (WB) countries to estimate the impact of harmonisation of excise duties with the EU rules on the demand for cigarettes and tax revenues by taking into account the cross-border shopping effect. Both in time series and panel regressions we find strong evidence on cross-border arbitrage. The price elasticity of demand for cigarettes in WB countries is close to − 1, while the cross-border elasticity is 0.24. Full harmonisation of taxes with the EU directives would trigger a substantial decline in the demand for cigarettes on the legal market in the WB of 25.5% (approx. 931,000 smoker equivalents). In spite of a considerable behavioural reaction, harmonisation would still have positive effects on tax revenues of almost a half percent of GDP. The impact on cigarette consumption and tax revenues in a particular country depends on the relative magnitude of its own and cross-border price elasticity and the relative size of its tax rate gap compared to neighbouring countries. Failing to account for cross-border arbitrage in evaluating the impact of an increase in cigarette taxes leads to the results on demand effects being significantly overestimated and tax revenue effects underestimated.

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Fig. 1

Source: Authors’ calculations based on European Commission data and Bisic and Randelovic (2018)

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Notes

  1. As excise duties on cigarettes are taxed simultaneously using both ad valorem and unit tax rates, the tax burden is stated as excise yield, indicating the amount of taxes (in euros), charged on one thousand cigarettes, which is equivalent to the effective tax rate. In due course effective tax rate and excise yield are used as synonyms.

  2. A brief overview of cigarette excise tax policy in EU and its impact on WB countries policy can be found in Bisić and Ranđelović (2018).

  3. Albania (ALB), Bosnia and Herzegovina (BIH), Montenegro (MNE), North Macedonia (MKD) and Serbia (SRB).

  4. With the exception of BIH which in 2019 achieved EU minimum yield criteria.

  5. Overview of changes in cigarette excise duty and VAT rates in WB, from 2007 to 2018 is presented in the Appendix (Table 7).

  6. Consumer price stands for the retail selling price, i.e. it includes all consumption taxes (excise duty and VAT). In all WB countries, but Albania, regulation mandates excise payer (manufacturer and/or importer) to define consumer price and bans wholesalers and/or retailers to sell cigarettes at prices different to those set by excise payer.

  7. Real price and income variables are calculated by deflating nominal values using Consumer Price Index in the respective country.

  8. When distance between jurisdictions is large and many jurisdictions are included in the sample, the transportation costs (measured using distance) may also be included in the model. Since in this case we have only five countries, which are relatively small (in terms of total area), transportation costs are not expected to have a significant impact.

  9. Increase in price of cigarettes can also trigger substitution effect towards other tobacco products (e.g. cut tobacco), but that effect is not expected to be large. In WB countries excise duties are imposed on other tobacco products too, the tax burden on these products being strongly linked to dynamics of the tax burden on cigarettes, in order to narrow the scope for substitution. WB markets are mostly oriented to consumption of cigarettes, while final consumption of cut tobacco is very limited (e.g. less than 1% of tobacco products excise revenues come from taxation of cut tobacco cigars and cigarillos, while more than 99% of revenue is derived from taxation of cigarettes).

  10. Although all estimated coefficients are statistically significant at 1%, while the R2 is relatively high (on average around 0.64), these statistical properties are not interpreted in cointegration models, due to super-consistency concerns, associated with regression estimations of I(1) series.

  11. As it can be argued that price dynamics can trigger shift in consumption, between lower and higher quality cigarettes, we have also estimated the augmented model, with an additional control variable (RQ), which describes shift in consumption composition (consumption share of premium, relative to low brands). That model also indicates strong cointegration relationship, but without significant impact on the income and price elasticity of demand (Appendix, Table 9). Results based on the augmented model, with shift in consumption structure, indicates that tax harmonisation would lead to decrease in cigarette consumption by − 32.6% (1.175 million equivalent smokers), which is close to decline in consumption of 31.9% (1.15 equivalent smokers) in the parsimonious model.

  12. Number of lags is determined based on the Akaike criterion. The test statistics (p values) are presented in Table 2.

  13. The equivalent number of smokers is calculated using the survey data on daily average number of smoked cigarettes in 2017 in each country.

  14. The negative revenue effect in Montenegro is the consequence of large tax yield gap and high price elasticity of demand. In 2018, Montenegro substantially increased the excise yield, thus triggering negative revenue effects, which is in accordance with our findings.

  15. Results of the estimations using augmented model with arbitrage, which includes the variable controlling for the shift in consumption structure are disclosed in the Appendix (Table 10).

  16. Using the elasticities derived from the augmented model (Table 10) decline in cigarette consumption is estimated at 27.5% which is close to the effects obtained under the parsimonious model.

  17. Both for panel unit root tests and the cointegration tests, lag length was determined using Akaike info criterion. For spectral estimation, the Newly–West bandwidth selection is used.

  18. We have also estimated the panel model in with the control variable which captures shift in consumption composition, between low and premium brands (Table 13, Appendix). However, inclusion of that control variable does not change considerably the net price elasticity of demand—the average elasticity without control variable is 0.68, while with control variable it stood at 0.72.

  19. Estimated coefficients are disclosed in the Table 14, Appendix.

  20. Relevant tests based on the quarterly data confirm cointegration relationship (Table 15, Appendix).

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Acknowledgement

This article is the outcome of the research conducted under the LSEE Visiting Fellowship Programme at the London School of Economics and Political Science—European Institute (Research on South Eastern Europe).

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Authors and Affiliations

  1. Faculty of Economics, University of Belgrade, Kamenicka 6, Belgrade, 11000, Serbia

    Saša Ranđelović

  2. Faculty of Economics, Finance and Administration, Metropolitan University, Bulevar Zorana Djidjica 44, Belgrade, 11070, Serbia

    Milica Bisić

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  1. Saša Ranđelović
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  2. Milica Bisić
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Correspondence to Saša Ranđelović.

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Appendix

Appendix

See Figs. 3, 4, 5 and Tables 7, 8, 9, 10, 11, 12, 13, 14, 15.

Fig. 3
figure 3

Source: World Health Organisation database 2016

Adults tobacco smoking prevalence (%).

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Fig. 4
figure 4

Source: Authors’ calculations, based on Eurostat and national Ministry of Finance data

Tobacco excise duties revenues, % of GDP (2007–2017 average).

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Fig. 5
figure 5

Source: Authors’ calculations based on the industry data

Dynamics of volume, prices and taxes on cigarettes in the WB.

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Table 7 Overview of changes in cigarette excise duty and VAT rates in WB (2007–2018)
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Table 8 Time series unit root tests
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Table 9 Time series cointegration regression results—augmented model without arbitrage
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Table 10 Time series cointegration regression results—augmented model with arbitrage
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Table 11 Panel unit root tests
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Table 12 Panel cointegration tests (monthly data)
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Table 13 Panel cointegration regression results—augmented model (monthly data)
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Table 14 Panel cointegration regression results (quarterly data)
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Table 15 Panel cointegration tests (quarterly data)
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Ranđelović, S., Bisić, M. Excise duties harmonisation and smoking in a model with cross-border arbitrage. Empirica 48, 507–532 (2021). https://doi.org/10.1007/s10663-020-09478-2

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