Case Study Report Classification Quantification Evaluation of Council Directive 92/83/EEC 1
1. Introduction This case study should be read as an accompaniment to the case study on classification issues. In this section, we present illustrative quantifications of the tax impacts associated with products that have been identified as being difficult to classify in order to provide an indication of the potential magnitude of the problem. We first set out the approach we have taken and the data sources used before going on to present the results. 2. Approach to quantification In order to be able to assess the tax implications of classifying certain alcoholic products differently, we need to estimate the change in quantity of the product sold in response to a change in tax, i.e. had that product been classified differently for taxation purposes, assuming that this change in tax is passed on to the final consumer to some degree. The equation below, which is derived from the formula for own-price elasticity of demand, sets out how this would be calculated, and therefore, the data that are required to estimate the tax impacts. In particular, the equation states that the change in quantity demanded for product i ( q i ) is equal to the percentage change in price for that product ( pi p 0 i ) multiplied by the own-price elasticity of demand (εi ) and the original quantity demanded (q 0 i ) at the original price before any change in taxation (p 0 i ): q i = pi p 0 i ε i q 0 i It follows that data are required on the prices volumes sold of relevant products, and assumptions are required on the price elasticity of demand for that product and the change in price for that product that would result from a change in tax were that product to be classified differently. The main case study on classification issues identified a range of alcoholic product types that have characteristics that make those products difficult to classify for taxation purposes; namely: ready-to-drink (RTD) products; medium-strength fermented beverages or mixtures (10-15 per cent); high-strength fermented beverages or mixtures; beer plus distilled alcohol; and wine-based drinks (flavoured wine and aperitifs). The stakeholder engagement exercise with Member States and economic operators identified problems in a number of countries. In order to generate a manageable quantification exercise (and bearing in mind the need to purchase data), we agreed with the Commission to focus on the following countries: Poland, France, Germany, Ireland and the Netherlands. The authorities of all of these Member States had indicated the existence of classification challenges within their respective jurisdictions. The problems identified in these Member States were with particular product groups, rather than with particular branded products (although some products were identified on an exemplary basis). We therefore focus our quantification exercise on these Member States. The Euromonitor database identifies data for only some of the problematic categories. We have therefore focused on these and have been able to carry out calculations (based on the equation above) for the following: May, 2016 2
Wine-based RTDs. Euromonitor defines this as an alcoholic beverage which is pre-mixed prior to packaging and based on wine, fruit juice, sugar, and carbonated water. These drinks have an alcohol content of around 5% although in some countries this may higher. Spirit-based RTDs. Euromonitor defines this category as an alcoholic drink which is pre-mixed prior to packaging and based on a mix of spirits and soft drinks. Examples include pre-mixed gin and tonic, vodka and orange or Smirnoff s Vodka Mule, Bacardi Breezer. These drinks have an alcohol content of around 5% although in some countries this may be higher. High-strength pre-mixes. Euromonitor defines this as Premixes containing a high percentage of alcohol of around 15%+ combined with juice or any other soft drink are included here. These are usually marketed as a product to be drunk neat with ice, to mix with an energy drink and/or to make cocktails. Fruitflavoured, vodka-based spirits with an alcohol content of between 16-21% are classified here. We have identified the above categories as being difficult to classify for taxation purposes drawing on the results of the stakeholder consultation. However, the categorisation within Euromonitor does not always map directly to the categories identified in the stakeholder consultation (e.g. RTDs have been directly identified by stakeholders, but in a more anecdotal or descriptive way). Therefore, there is the possibility that some of the specific products covered within the three categories above are not considered to be difficult to classify, while other products which may be considered difficult to classify are not captured within these three categories. This can be seen as a further signal of classification challenges at this level of granularity. Nonetheless, given the data available, this enables us to carry out an approximate calculation which would not be possible otherwise. To mitigate these potential issues with product coverage, we conduct a series of sensitivity tests (which we describe in more detail later) in order to generate ranges of the potential financial impact. We set out below the different data that were used in our calculations. 2.1 Volumes The charts below set out the volumes of different RTDs and high-strength premixes from 2009-2014 (the years for which data are available). As can be seen, the consumption of such products has risen substantially in Germany (especially demand for spirit- and wine-based RTDs), and more modestly in Poland. Otherwise this market has been broadly flat (or even in decline). May, 2016 3
Figure 1: RTDs/High-strength premixes Source: Euromonitor. Figure 2: Spirit-based RTDs Source: Euromonitor. May, 2016 4
Figure 3: Wine-based RTDs Source: Euromonitor. Figure 4: High-strength premixes Source: Euromonitor. 2.2 Prices The table below presents average retail prices, i.e. including taxes, per litre of alcohol (at purchase strength). This covers a range of different products within each category, different forms of sale (e.g. multipacks, larger bottles, etc.) and different points of purchase (e.g. hypermarket, internet-based retailer, etc.). Table 1: Average unit prices ( /litre) Wine-based RTDs Spirit-based RTDs High-strength premixes Poland 6.57 France 13.76 10.94 10.81 Germany 6.54 8.23 10.34 Ireland 11.66 10.81 14.88 Netherlands 9.87 11.84 May, 2016 5
Source: Europe Economics calculations using Euromonitor data. 2.3 Elasticities Price elasticities of demand are typically estimated using econometric techniques to model demand functions. This type of estimation is often difficult and subject to statistical problems that need to be overcome (such as endogeneity), and requires good data on all relevant variables that might affect demand. Naturally, therefore, it is possible to arrive at different estimates of price elasticity of demand depending on the model specification and on the data used. This is reflected on the literature which does not provide a satisfactory set of price elasticity estimates for the types of products we are concerned with here (i.e. RTDs) that can be considered to be definitive for our purposes. The tables below set out some of the estimates which are available in the public domain (many of these represent, in turn, reviews of the then current available academic literature). The European Commission published a study in 2010 which reported a range of estimates in different Member States for different types of alcoholic beverage (in line with the excise duty categories) drawing on available literature. As can be seen, the estimates vary substantially: Table 2: Estimates of price elasticities in different Member States Product Country Elasticity Beer Germany -3.0 Denmark -0.2 Spain -0.5 Ireland -1.3 Netherlands -0.3 UK -1.5 Cider Germany -2.0 Ireland -0.7 UK -2.0 Wine Denmark -0.3 Ireland -1.9 UK -1.0 Ethyl Denmark -0.3 alcohol Ireland -1.6 Netherlands -1.5 UK -1.0 Source: European Commission (2010) Study analysing possible changes in the minimum rates and structures of excise duties on alcoholic beverages More recently, HMRC, the tax authority in the UK, published a report which surveyed a large number of studies that estimated price elasticities of demand in the UK: Table 3: Estimates of price elasticities in the UK Alcohol type Literature median Literature mean Literature range Beer -0.44-0.6-0.09 to -3.20 Wine -0.78-0.86-0.14 to -2.42 Spirits -0.72-0.75-0.08 to -1.60 Source: HMRC (2014) Estimation of price elasticities of demand for alcohol in the United Kingdom" As can be seen in the table above, the review by HMRC concludes that the mean and median elasticity is more inelastic (i.e. more positive) than those suggested by the EC May, 2016 6
study for the UK; however, HMRC finds that the ranges are very broad for each category of product. The HMRC goes on to generate its own estimates of price elasticity, including crossprice elasticities of demand between different products, covering both on-trade and off-trade : Figure 5: Price elasticities of demand for alcohol in the UK estimated by HMRC Source: HMRC (2014) Estimation of price elasticities of demand for alcohol in the United Kingdom" HMRC s own estimates for beer and spirits are broadly in line with the literature that has been reviewed in the same study, though the estimates for wine are much more inelastic. Importantly, however, this study provides an estimate for the price elasticity of demand for RTDs. The off-trade estimate of -0.52 is also in line with the estimate that the Institute of Fiscal Studies (IFS) used for alcohol in general in its study to analyse price-based measures to reduce alcohol consumption. 1 Clearly, there is no definitive estimate available. Further, the nature of demand (e.g. taste parameters), as well as the starting price point, will vary from Member State to Member State, making the use of a single set of estimates somewhat unsatisfactory. With this in mind, we have used the price elasticity of demand estimates shown in the table below. This is based on an overall judgement that is both in line with the estimates available in the literature but with a breadth between the high and low estimates that also reflects the degree of uncertainty in the data (i.e. this range represents our sensitivity analysis). Table 4: Price elasticity of demand estimates used in calculations More inelastic Central More elastic Elasticity -0.1-0.5-0.9 2.4 Taxes It is important to note that this evaluation cannot assume, or judge, that a particular classification given in a certain Member State to be incorrect. As such, any analysis of excise duty loss resulting from duty differences can only be seen as potential. This isbased on transparent scenarios resulting from assumptions constructed on the basis of collected evidence of classification difficulties and disputes collected under part 1 of this case study.. Based on the evidence from the stakeholder consultation (presented in detail above), we have identified the following as possibly relevant for taxation of the identified products: Wine-based RTDs: Other fermented beverages or Intermediate products. 1 IFS (2013) "Price-based measures to reduce alcohol consumption". May, 2016 7
Spirit-based RTDs: Other fermented beverages or Ethyl alcohol. High-strength pre-mixes: Intermediate products or Ethyl alcohol. On this basis, drawing on the January 2016 publication of the excise duty tables, we have identified the following taxation rates for use in this quantification exercise: Table 5: Wine-based RTDs Other fermented beverages ( /HL) Notes Intermediate products ( /HL) Notes France 3.77 Only one relevant rate 188.41 Only one relevant rate Germany 51 Assumed Sparkling < 6% vol based on products in Euromonitor price list 136 Assumed sparkling <15% based on products in Euromonitor price list Ireland 218.44 Assumed Still & Spark.>6% <=8,5% vol based on products in Euromonitor price list Source: DG TAXUD (2016) Excise duty tables: Part I Alcoholic Beverages Table 6: Spirit-based RTDs Other fermented beverages ( /HL) Notes 424.84 Assumed still <15% based on products in Euromonitor price list Ethyl alcohol ( /HL of pure alcohol) Notes Poland 37.21 Assumed "Other fermented beverages" 1343.41 Only one relevant rate France 3.77 Only one relevant rate 1737.56 Only one relevant rate Germany 51 Assumed Sparkling < 6% vol based on products in price list 1303 Only one relevant rate Ireland 218.44 Assumed Still & Spark.>6% <=8,5% vol based on products in price list 4257 Only one relevant rate Netherlands 48.25 Assumed Sparking <8.5% vol based on products in price list 1686 Only one relevant rate Source: DG TAXUD (2016) Excise duty tables: Part I Alcoholic Beverages Table 7: High-strength pre-mixes Intermediate products ( /HL) Notes Ethyl alcohol ( /HL of pure alcohol) Notes France 188.41 Only relevant one rate 1737.56 Only relevant one rate Germany 153 Assumed >15% 22% vol based on products in price list 1303 Only relevant one rate Ireland 424.84 Assumed Still < 15% vol based on products in price list 4257 Only relevant one rate Netherlands 254.41 Assumed Sparkling >15%-22% vol based on products in price list 1686 Only relevant one rate Source: DG TAXUD (2016) Excise duty tables: Part I Alcoholic Beverages Where the ethyl alcohol category may be appropriate, it is important to note that the taxation rates are based on hectolitres of pure alcohol. It is therefore necessary to May, 2016 8
make an assumption about the strength of the products that are considered to be difficult to classify. Drawing on information in the Euromonitor database for the specific products considered within each category, we estimate the average strength of spiritbased RTDs to be 8 per cent and the average strength of high-strength pre-mixes to be 16 per cent. In addition to the relevant taxation rates identified above, France also has a national tax of 11 per decilitre of pure alcohol for Premix on mixed beverages (alcoholic beverages mixed with non-alcoholic beverages or mix of alcoholic products) which have more than 1,2 % vol. alcohol but less than 12 % vol. alcohol. As mentioned above, given the current drafting of the Directive, it is not possible to say with certainty that one of the tax categories identified above are correct. Therefore, we consider moving from one category to the other in both cases: Table 8: Taxation scenarios for analysis Wine-based RTDs Spirit-based RTDs High-strength pre-mixes Scenario 1 Scenario 2 Other fermented beverages Intermediate products Other Intermediate products fermented beverages Other fermented beverages Ethyl alcohol Other fermented Ethyl alcohol beverages Intermediate products Ethyl Ethyl alcohol Intermediate alcohol products The extent to which the changes in taxes resulting from the scenarios outlined above would materialise in changes in retail prices would depend on the degree of cost passthrough by suppliers. Cost pass-through is a complex area of economics and the extent of costs that are passed on to consumers depends on an array of factors, including market structure, as illustrated in the diagram below which presents various results from theoretical microeconomics: Figure 6: Differing levels of pass-through Given that we are concerned with scenarios in which changes in taxation would lead to industry-wide cost increases, we adopt the following pass-through assumptions in our estimation: May, 2016 9
Table 9: Cost pass-through rates used in calculations Low High Pass through 50% 100% 3. Tax impacts Using the data and assumptions presented in the previous section, we have estimated the potential tax impacts associated with the lack of clarity in the Directive which makes certain products difficult to classify for excise duty purposes. We stress that the results below are indicative only and are based on scenarios that have been developed drawing on the results of the stakeholder engagement. In some instances, the responses to the stakeholder consultation suggest that a certain classification for tax purposes is currently being applied in practice, but that an alternative could be applied. Where this is the case, we have highlighted what appears to be the current scenario (i.e. the base case) in bold, as this reflects the scenario that is more likely in that Member State. Where it is not clear what taxation treatment is currently adopted, the estimates for both scenarios are presented in bold. As described above, given the inherent uncertainty in the calculations being carried out here, we have conducted sensitivity analysis reflecting different scenarios for taxation, the rates of pass-through of changes in taxation to end consumers, and price elasticity of demand. The combination of all of these different scenarios in their various permutations creates a large volume of results. In order to present the results in a meaningful way, we have opted to present ranges based on the minimum and maximum potential impacts based on the sensitivity analysis, reflecting the uncertainty in some of the assumptions required to undertake this analysis. In practice, the distinction is likely not this clear cut, and even if Member States had adopted a strict approach to the taxation of these products, there would be likely to be certain products that would still prove to be difficult to classify (or that Member States are unaware of) resulting in multiple possible classifications. As a result, the potential tax impacts presented below (which are based on total volumes being taxed under one category and being moved to another category) are likely to overestimate the potential impact. Nonetheless, they provide a useful indication of the possible magnitude of the issue. Table 10: Wine-based RTDs tax impact ( m) Scenario 1 (Other fermented beverages Intermediate products) Scenario 2 (Intermediate products Other fermented beverages) Min Max Min Max France 14 16-16 -16 Germany 50 61-62 -57 Ireland 3 4-5 -4 Source: Europe Economics estimations Table 11: Spirit-based RTDs tax impact ( m) Scenario 1 (Other fermented beverages Ethyl alcohol) Scenario 2 (Ethyl alcohol Other fermented beverages) Min Max Min Max Poland 116 127-128 -128 France 60 67-67 -67 May, 2016 10
Germany 190 200-201 -200 Ireland -169 185-185 -185 Netherlands 102 110-110 -110 Source: Europe Economics estimations Table 12: High-strength premixes tax impact ( m) Scenario 1 (Intermediate products Ethyl alcohol) Scenario 2 (Ethyl alcohol Intermediate products) Min Max Min Max France 115 124-125 -124 Germany 214 225-225 -224 Ireland 4 4-4 -4 Netherlands 91 92-92 -92 Source: Europe Economics estimations As previously mentioned, France has a national tax for RTDs in place that allows it to impose a tax of 11 EUR per decilitre of pure alcohol for alcohol beverages mixed with non-alcoholic products or mixes of alcoholic products which have more than 1.2 per cent but less than 12 per cent alcohol. Our calculations estimate that the average strength of high-strength premixes is 16 per cent; therefore, much of this category would not be eligible for the French tax. For spirit-based RTDs, which we estimate to be 8 per cent in strength on average, this tax could be applied. It is important to note that 11/decilitre of pure alcohol (i.e. 11,000/hectolitre) is well in excess of other tax rates that are applied in France, including the rate for ethyl alcohol (of 1737.56/hectolitre of pure alcohol). We therefore see potential revenue losses in most cases if spirit-based RTDs were classified as other fermented beverages or ethyl alcohol instead of RTDs: Table 13: Spirit-based RTDs in France tax impact ( m) Scenario 1 (RTDs Other fermented beverages) Scenario 2 (RTDs Ethyl alcohol) Min Max Min Max France -426-426 -325 243 Source: Europe Economics estimations Conclusion As expected, we see potential gains in tax revenue if Member States were to adopt classifications entailing higher rates of excise duty, and potential tax revenue losses if the converse were true. As mentioned above, in reality even if Member States had adopted a strict approach to the taxation of these products (e.g. by taxing all spiritbased RTDs using the ethyl alcohol rate) there would be likely to be certain products that would still prove to be difficult to classify, or certain products would be missed as Member States are unaware of the specific details of the product. This can be seen as inherent in the nature of the problem. As a result, in practice there would most likely continue to be multiple possible classifications. As a result, the potential tax impacts presented above (which are based on total volumes being taxed under one category and being moved to another category) are likely to overestimate the potential impact. Nonetheless, this exercise represents the best estimates that can feasibly be quantified. As can be seen in the tables above, the issue of classification of these types of products is a material one, with potentially hundreds of millions of Euros of tax revenue at stake per annum. Unsurprisingly, the impacts are particularly large for spirit-based RTDs and May, 2016 11
high-strength premixes where Member States could opt for the generally much higher ethyl alcohol tax rate. The effect is particularly pronounced in Germany, where consumption of these products has grown substantially in recent years. May, 2016 12