Review of Ernst & Young s Report on New Zealand s Illicit Tobacco Market. Report to ASH New Zealand

Review of Ernst & Young s Report on New Zealand s Illicit Tobacco Market Report to ASH New Zealand 22 April 2010

About NZIER The New Zealand Institute of Economic Research (NZIER) is a specialist consulting firm that uses applied economic research and analysis to provide a wide range of strategic advice to clients in the public and private sectors, throughout New Zealand and Australia, and further afield. NZIER is also known for its long-established Quarterly Survey of Business Opinion and Quarterly Predictions. Our aim is to be the premier centre of applied economic research in New Zealand. We pride ourselves on our reputation for independence and delivering quality analysis in the right form, and at the right time, for our clients. We ensure quality through teamwork on individual projects, critical review at internal seminars, and by peer review at various stages through a project by a senior staff member otherwise not involved in the project. NZIER was established in 1958. Authorship Prepared by: Quality approved by: Version: Nimisha Tailor and Johannah Branson John Yeabsley Final report 8 Halswell St, Thorndon P O Box 3479, Wellington Tel: +64 4 472 1880 Fax: +64 4 472 1211 econ@nzier.org.nz www.nzier.org.nz NZIER s standard terms of engagement for contract research can be found at www.nzier.org.nz. While NZIER will use all reasonable endeavours in undertaking contract research and producing reports to ensure the information is as accurate as practicable, the Institute, its contributors, employees, and Board shall not be liable (whether in contract, tort (including negligence), equity or on any other basis) for any loss or damage sustained by any person relying on such work whatever the cause of such loss or damage.

Executive summary British American Tobacco (BAT) commissioned Ernst & Young to profile the illicit tobacco trade in New Zealand, the characteristics of black market smokers and the impacts of changing the relative levels of excise duty on tailor made cigarettes (TMC) and roll your own tobacco (RYO). 1 ASH New Zealand has asked NZIER to provide an independent review of Ernst & Young s report. Given time constraints, we do not provide a comprehensive review of the relevant literature and other evidence on illegal tobacco markets, overseas and in New Zealand, and the impacts of tobacco control measures, with which to support or refute Ernst & Young s assertions, assumptions and estimates. Instead, we focus at a high level on whether, in our view, Ernst & Young s methodological approach is sound and its analysis sufficiently convincing to enable reasonable confidence in its findings. The Ernst & Young report After outlining reported tobacco consumption in New Zealand, on which excise duty is paid, Ernst & Young: explores and estimates unreported tobacco consumption, on which excise duty is not paid: legal duty free and home grown for personal consumption and illicit duty free and New Zealand grown to give or sell to other people and smuggled for personal consumption or to give or sell to other people examines the characteristics of consumers of illicit tobacco and assesses the impact on reported and unreported tobacco consumption of changing the relative levels of excise duty on TMC and RYO (the indexation rate ). Its main findings are: total tobacco consumption in New Zealand is higher than reported, given that official statistics do not include duty free, New Zealand grown and smuggled tobacco although illicit tobacco represents a much smaller proportion of total tobacco consumption in New Zealand than in other countries, Ernst & Young estimates it to be three times as large as previous estimates (at 3.3% of total tobacco consumption) illicit tobacco represents a larger proportion of total RYO consumption (7.5%) than total TMC consumption (1.0%) 1 Ernst & Young (2010) Out of the Shadows - An Independent Report of New Zealand s Illicit Tobacco Market, report to British American Tobacco. NZIER Review of Ernst & Young s Report on New Zealand s Illicit Tobacco Market i

despite the increase in excise duty on RYO in 1995, Ernst & Young estimates that, given average tobacco content per cigarette, the level of excise duty is still considerably lower on RYO than TMC but increasing the excise duty on RYO relative to that on TMC (lowering the indexation rate) may: cause some consumers to switch from reported RYO to reported TMC cause some consumers to switch from reported RYO to legal home grown tobacco and illicit tobacco, on which excise duty is not paid increase total reported tobacco consumption increase illicit tobacco consumption and decrease Crown revenues from excise duty and GST. Its conclusion is therefore that policy makers should beware that lowering the indexation rate by increasing the excise duty on RYO relative to that on TMC could have the above unintended consequences. Our review Although we query the sources and validity of the assumptions adopted in estimating legal and illicit unreported tobacco consumption and the robustness of the consequent estimates, we have graver concerns about how Ernst & Young assesses the impact of changing the relative levels of excise duty on TMC and RYO. Our main concerns are: the report does not sufficiently identify the sources or bases of its assumptions in estimating legal and illicit unreported tobacco consumption, nor does it provide sensitivity analysis the report does not provide details of the survey findings and linear predictive model used for modelling switching between RYO and TMC and provides no supporting evidence for its modelling of switching to home grown and illicit tobacco despite substantial evidence, overseas and in New Zealand, of a negative price elasticity of demand for tobacco (such that an increase in price would cause some reduction in demand), the two scenarios modelled in the report assume no net change in the number of smokers and no net reduction in total tobacco consumption if the excise duty on RYO was increased the first of the report s two main reasons against lowering the indexation rate by increasing the excise duty on RYO is that this may increase total tobacco consumption; not only does this ignore the substantial evidence of a negative price elasticity of demand for tobacco; the report s analysis that the 1995 increase in excise duty on RYO increased total reported consumption is unconvincing; with no increase in total reported consumption under scenario 1 and a significant decrease in total reported consumption under scenario 2, due to switching from reported RYO to unreported home grown and illicit tobacco, the two scenarios NZIER Review of Ernst & Young s Report on New Zealand s Illicit Tobacco Market ii

modelled in the report contradict this reason against lowering the indexation rate, even ignoring the negative price elasticity of demand for tobacco the second main reason given in the report against lowering the indexation rate by increasing the excise duty on RYO is that this may increase home grown and illicit tobacco consumption; not only does this ignore the substantial evidence of a negative price elasticity of demand for tobacco; the modelling presented in the report also ignores that there may be limits to the extent to which consumers are willing and/or able to substitute illicit tobacco for RYO and TMC, whether due to its poorer quality, difficulty in accessing or illegality, and not everyone has the facilities or skills to produce home grown tobacco; the modelling further ignores that an increase in the excise duty on RYO would cause the price of illicit tobacco to rise and therefore the quantity of illicit tobacco consumed would not increase by as much as if its price remained constant the report argues that this switching from RYO to home grown and illicit tobacco in response to lowering the indexation rate by increasing the excise duty on RYO would cause a loss in excise duty and GST revenues to the Crown; the scenarios modelled in the report omit the increase in tax revenue from the majority of consumers who continue to buy RYO and pay the higher excise duty on this remaining consumption; the increase in tax revenue from these consumers significantly outweighs the loss in tax revenue from consumers who switch to home grown or illicit tobacco under both scenarios modelled in the report, contradicting this reason against lowering the indexation rate even in circumstances where an increase in excise duty did cause a net decrease in tax revenues to the Crown, whether or not this would be a reason not to increase the excise duty on RYO depends on whether the government s objective in levying excise duty on tobacco is simply to raise tax revenue or to discourage tobacco consumption; we believe it is primarily the latter and the report does not consider the impacts on total tobacco consumption and the illicit tobacco market of any other measures for discouraging tobacco consumption Our review leaves us with some uncertainty about Ernst & Young s estimates of the magnitude of unreported tobacco consumption in New Zealand. More seriously, our review leaves us with no confidence in Ernst & Young s assessment of the impacts of changing the relative levels of excise duty on TMC and RYO. We consider this assessment fundamentally flawed by unrealistic scenarios and incorrect results even for these scenarios. We consider the findings of this assessment of no value in informing debate on policy measures to reduce tobacco consumption. We consider Ernst & Young s report to fall well below the standards required for a piece of economic evidence. NZIER Review of Ernst & Young s Report on New Zealand s Illicit Tobacco Market iii

Contents 1. Purpose... 1 2. The Ernst & Young report... 1 3. Our review... 2 3.1 Estimates of unreported tobacco consumption... 2 3.2 Effects of intervention on unreported tobacco consumption... 3 3.3 Impact of lowering the indexation rate... 4 3.3.1 Switching from reported RYO to reported TMC, home grown and illicit tobacco... 4 3.3.2 Increase in total reported tobacco consumption... 6 3.3.3 Increase in home grown and illicit tobacco consumption... 10 3.3.4 Decrease in excise duty and GST revenues... 11 4. Conclusion... 12 NZIER Review of Ernst & Young s Report on New Zealand s Illicit Tobacco Market iv

1. Purpose British American Tobacco (BAT) commissioned Ernst & Young to profile the illicit tobacco trade in New Zealand, the characteristics of black market smokers and the impacts of changing the relative levels of excise duty on tailor made cigarettes (TMC) and roll your own tobacco (RYO). 1 BAT presented Ernst & Young s report to the Māori Affairs Select Committee inquiry into the tobacco industry in Aotearoa and the consequences of tobacco use for Māori. As part of the inquiry, the Select Committee intends to consider policy and legislative measures to address its findings. ASH New Zealand has asked NZIER to provide an independent review of Ernst & Young s report. Given tight time constraints, we do not provide a comprehensive review of the relevant literature and other evidence on illegal tobacco markets, overseas and in New Zealand, and the impacts of tobacco control measures, which supports or refutes Ernst & Young s assertions, assumptions and estimates. Instead, we focus at a high level on whether, in our view, Ernst & Young s methodological approach is sound and its analysis sufficiently convincing to enable reasonable confidence in its findings. 2. The Ernst & Young report After outlining reported tobacco consumption in New Zealand, on which excise duty is paid, Ernst & Young: explores and estimates unreported tobacco consumption, on which excise duty is not paid: legal duty free and home grown for personal consumption and illicit duty free and New Zealand grown to give or sell to other people and smuggled for personal consumption or to give or sell to other people examines the characteristics of consumers of illicit tobacco and assesses the impact on reported and unreported tobacco consumption of changing the relative levels of excise duty on TMC and RYO. Its main findings are: total tobacco consumption in New Zealand is higher than reported, given that official statistics do not include duty free, New Zealand grown and smuggled tobacco although illicit tobacco represents a much smaller proportion of total tobacco consumption in New Zealand than in other countries, Ernst & Young estimates it to be three times as large as previous estimates (at 3.3% of total tobacco consumption) 1 Ernst & Young (2010) Out of the Shadows - An Independent Report of New Zealand s Illicit Tobacco Market, report to British American Tobacco. NZIER Review of Ernst & Young s Report on New Zealand s Illicit Tobacco Market 1

illicit tobacco represents a larger proportion of total RYO consumption (7.5%) than total TMC consumption (1.0%) despite the increase in excise duty on RYO in 1995, Ernst & Young estimates that, given average tobacco content per cigarette, the level of excise duty is still considerably lower on RYO than TMC but increasing the excise duty on RYO relative to that on TMC may: cause some consumers to switch from reported RYO to reported TMC cause some consumers to switch from reported RYO to legal home grown tobacco and illicit tobacco, on which excise duty is not paid increase total reported tobacco consumption increase illicit tobacco consumption and decrease Crown revenues from excise duty and GST. Its conclusion is therefore that policy makers should beware that increasing the excise duty on RYO relative to that on TMC could have the above unintended consequences. 3. Our review Although we query the sources and validity of the assumptions adopted in estimating unreported tobacco consumption and the robustness of the consequent estimates, we have graver concerns about how Ernst & Young assesses the impact of changing the relative levels of excise duty on TMC and RYO. 3.1 Estimates of unreported tobacco consumption In estimating legal and illicit unreported tobacco consumption, Ernst & Young has to contend with the lack of data on duty free, home grown, New Zealand grown and smuggled tobacco. The way in which Ernst & Young considers each of these unreported sources in turn to build up a picture of total tobacco consumption, reported and unreported, seems to us to be sensible and informative. That this requires Ernst & Young to make a number of assumptions where information is not available is inevitable. Unfortunately, in this section of the report, Ernst & Young does not identify the sources or bases of all of its assumptions in terms of supporting literature or other evidence, which leaves the reader uncertain about the validity of these assumptions and/or likely biases in estimates. The reader can only take these assumptions at face value and has no means to gauge whether they are representative and unbiased. In other sections of the report, Ernst & Young is more diligent in identifying sources and citing supporting evidence. It is possible that in some cases there was no specific supporting evidence available and Ernst & Young had to form assumptions on the basis of what seemed reasonable. This is sometimes necessary to overcome data limitations that would otherwise present obstacles to modelling, but Ernst & Young fails to set out the basis NZIER Review of Ernst & Young s Report on New Zealand s Illicit Tobacco Market 2

and derivation of these assumptions. Sensitivity analysis is especially important in such cases, to show how much the resulting estimates would differ were the assumptions adopted somewhat lower or higher. Ernst & Young does not provide sensitivity analysis of its estimates of legal and illicit unreported tobacco consumption. Again, the reader can only take the estimates at face value and has no means to gauge how robust they are and how much they would differ with different assumptions. This leaves the reader uncertain how much confidence can be had in the estimates and their implications. Ernst & Young estimates New Zealand s illicit tobacco market to be three times the size of previous estimates, at 3.3% of total tobacco consumption compared with 1.1% and 1%. 2 3 This is still small by international standards. For example, Joossens et al. (2009) estimates 11.6% of the global cigarette market to be illicit 9.8% in high income countries and 16.8% in low income countries. Illicit tobacco consumption is not nearly as big a problem in New Zealand as in countries in Europe and North America, where tax rates on tobacco differ significantly between tax jurisdictions in close proximity. New Zealand s geographical isolation and small size provide less opportunity and incentive for smuggling. Smuggling is therefore much less of a problem and illicit tobacco here is dominated by growing. That Ernst & Young s estimate of illicit tobacco consumption is considerably higher than previous estimates is, however, significant in terms of the potential for growth in the illicit tobacco market with an increase in excise duty on RYO, assessed later in the report. For its estimates to be taken seriously, the report needs to be open about all of its data sources, assumptions and models. 3.2 Effects of intervention on unreported tobacco consumption Before commenting on how Ernst & Young assesses the impact of changing the relative levels of excise duty on TMC and RYO, we would like to highlight that increasing excise duty is just one of a wide range of possible measures for intervening to discourage tobacco consumption. Different measures may have different impacts on not only total tobacco consumption, but also how much of this is home grown and illicit tobacco. It would have been interesting to see an assessment of how the impacts on total, home grown and illicit tobacco consumption of changes in excise duty compare with other options that the government may be considering. If the purpose of the report was to estimate the size of the illicit tobacco market and to show how this market may be affected by intervention, it should certainly have included other possible measures. Ernst & Young s brief seems, however, to have been confined to changes in relative levels of excise duty between TMC and RYO. 2 Euromonitor International (2009) Tobacco in New Zealand. 3 Joossens, L., Merriman, D., Ross, H. and Raw, M. (2009) How Eliminating the Global Illicit Cigarette Trade Would Increase Tax Revenue and Save Lives. NZIER Review of Ernst & Young s Report on New Zealand s Illicit Tobacco Market 3

Its quantitative estimates of the impacts on tobacco consumption and excise duty and GST revenues have been further confined to a lowering in the indexation rate by increasing the excise duty on RYO whilst holding constant the excise duty on TMC. It does not assess the impacts of other possibilities such as increasing the excise duty on both RYO and TMC, either equivalently or by proportionately more on RYO. Given the narrow scope of Ernst & Young s assessment, we limit our comments to Ernst & Young s assessment of the impacts of lowering the indexation rate. 3.3 Impact of lowering the indexation rate Ernst & Young defines the indexation rate as the ratio of excise duty levied on TMC to that levied on RYO. For example, from 1 March 2010 the rates of excise duty are $314.43 per 1,000 cigarettes for TMC, not exceeding 0.8 grams tobacco content per cigarette, and $393.03 per kilogram of tobacco content for RYO. 4 The indexation rate is therefore $314.43/$393.03 = 0.8. If the average tobacco content of TMC is 0.8 grams per cigarette, TMC and RYO carry equivalent levels of excise duty, given their tobacco contents. Achieving this equivalence was the purpose of the 1995 lowering in the indexation rate by increasing the excise duty on RYO whilst holding constant the excise duty on TMC. Ernst & Young presents evidence on the average tobacco contents of TMC and RYO cigarettes in New Zealand and argues that TMC and RYO do not carry equivalent levels of excise duty, with excise duty still considerably lower on RYO than TMC. Ernst & Young cautions against further lowering the indexation rate by further increasing the excise duty on RYO, however, due to the unintended consequences. These consequences include consumers switching to other tobacco products, increased total reported tobacco consumption and increased home grown and illicit tobacco consumption, causing a decrease in excise duty and GST revenues. We discuss each of these consequences below. 3.3.1 Switching from reported RYO to reported TMC, home grown and illicit tobacco Where substitutes are available, it is to be expected that some consumers will switch to them when the price of a good increases. Economists measure this as the crossprice elasticity of demand. It is calculated as the percentage change in quantity of good B divided by the percentage change in price of good A and is positive for substitutes (and negative for complements goods that are consumed together). In assessing the impact of lowering the indexation rate by increasing the excise duty on RYO, Ernst & Young uses a linear predictive model developed by IMRB International, based on survey data on the propensity of smokers to switch between tobacco products as their prices change. 5 4 Ernst & Young (2010), p.31. 5 Ernst & Young (2010), p.35. NZIER Review of Ernst & Young s Report on New Zealand s Illicit Tobacco Market 4

Whilst we support the use of empirical evidence on switching, we question how representative IMRB International s data are and how applicable they are to the New Zealand market. Are the survey findings consistent with other evidence on crossprice elasticities of demand for tobacco products? Was the survey international or specific to New Zealand? Ernst & Young does not provide details of IMRB International s survey findings nor of the linear predictive model used in its subsequent modelling. Furthermore, IMRB International s survey and model are limited to substitution between reported RYO and reported TMC products, by market segment. They do not investigate switching to home grown and illicit tobacco. For the latter, Ernst & Young forms its own assumptions in defining two scenarios to reflect a range in possible response. 6 Scenario 1 represents some switching from reported RYO to reported TMC, by market segment, based on the findings of IMRB International, given no switching to home grown and illicit tobacco. Scenario 2 represents some switching between reported RYO and reported TMC, given the amount of switching to, and therefore increase in, home grown and illicit tobacco that would occur if home grown and illicit tobacco were fully interchangeable with the budget segment of the RYO market and the increase in excise duty on RYO did not cause any increase in the price of home grown and illicit tobacco. Its results suggest a large (34% to 40%) increase in growing for personal consumption or illicit purposes. We recognise that these scenarios are intended to provide lower and upper bounds, between which Ernst & Young suggests the most likely scenario would fall. Scenario 2 does not, however, seem to be supported by any empirical evidence on propensities to substitute home grown and illicit tobacco for RYO and TMC. There may well be limits to the extent to which consumers are willing, and indeed able, to switch to home grown and illicit tobacco. Not everyone has the facilities or skills to produce home grown tobacco. The Colmar Brunton survey data presented in Ernst & Young (2010) indicate typically a low frequency and short duration of smoking illicit tobacco. 7 81% of smokers of illicit tobacco reported that they smoke it at most once a month. 44% of smokers of black market tobacco reported that they have been buying it for less than six months. This may reflect limits to the extent (in terms of both volume and length of time) to which consumers are willing and/or able to substitute illicit tobacco for RYO and TMC, whether due to its poorer quality, difficulty in accessing or limited supply. Furthermore, that it involves breaking the law may deter some consumers from switching to illicit tobacco. The results of Ernst & Young s modelling are highly sensitive to the assumptions adopted, for scenario 2 in particular. Given the importance of these results to Ernst & Young s conclusions on how much lowering the indexation rate may increase home grown and illicit tobacco consumption and reduce excise duty and GST revenues, it is critical that this modelling be adequately grounded in reality, supported by evidence and openly presented if readers are to have confidence in its results. 6 Ernst & Young (2010), pp.37-38. 7 Ernst & Young (2010), pp.25-26. NZIER Review of Ernst & Young s Report on New Zealand s Illicit Tobacco Market 5

3.3.2 Increase in total reported tobacco consumption Ernst & Young presents two main reasons against lowering the indexation rate. 8 The first reason is that Lowering the indexation rate may increase tobacco consumption, as occurred when the indexation rate was last lowered in New Zealand in 1995. a) Reported tobacco consumption First, we note that there is a critical word missing from the above statement, which Ernst & Young includes in all other references to this empirical observation it should read Lowering the indexation rate may increase reported tobacco consumption. The data from which Ernst & Young draws this finding (the chart on Ernst & Young, 2010, p.34) pertain to reported tobacco consumption only and exclude duty free, home grown and illicit tobacco. We examine these data below (p.9). If, as we suggest in Section 3.3.3 below, an increase in excise duty on RYO would cause some increase in the price of illicit tobacco also, there could feasibly be some switching not only from RYO to TMC, but also from illicit tobacco to TMC or even RYO, depending on the price rises and consumer preferences between TMC, RYO and illicit tobacco. As TMC is reported and illicit tobacco is not, this could feasibly result in an increase in reported tobacco consumption, even if total tobacco consumption, reported plus unreported, decreased (i.e. reflecting a shift away from products that have a higher incidence of unreported substitutes loose tobacco to products that have a lower incidence of unreported substitutes TMC, in New Zealand at least). b) Negative price elasticity of demand Contrary to Ernst & Young s assertion, there is a considerable amount of evidence that an increase in price, whether due to an increase in excise duty or other reasons, reduces the demand for tobacco products. Although this does not relate to the indexation rate per se, which is the relativity in levels of excise duty between TMC and RYO, this evidence is still highly informative of how the demand for RYO may respond to an increase in excise duty on RYO, as would occur if the indexation rate was lowered by this means. Economists measure the response of consumers to a change in price as the (own) price elasticity of demand. It is calculated as the percentage change in quantity of good A divided by the percentage change in price of good A and is negative for normal goods, reflecting that a rise in price will cause consumers to reduce demand. 8 Ernst & Young (2010), p.33. NZIER Review of Ernst & Young s Report on New Zealand s Illicit Tobacco Market 6

There is substantial evidence of a negative price elasticity of demand for tobacco products: Ernst & Young finds the price elasticity of demand from ad hoc changes in excise duty over the period 1990 to 2009 to be -0.489, with on average each 2% increase in price resulting in around a 1% decrease in reported consumption 9 on specifically the 1995 increase in excise duty on RYO, Ministry of Health (2005) reports that: 10 there was a 38% increase in the excise on loose tobacco only, with no changes to the excise on manufactured cigarettes. This change (which equalised the excise on loose tobacco and manufactured cigarettes) was associated with almost no change in total tobacco consumption. The consumption of loose tobacco did, however, decrease by 17%, while consumption of manufactured cigarettes increased by 5%. Ministry of Health (2005) reports other tax increases in 1998 and 2000 to have resulted in decreases in total tobacco consumption: May 1998: there was a 50-cent (GST exclusive) increase in the excise on a packet of cigarettes, with similar increases for other tobacco products. This change was associated with a 6% decrease in total tobacco consumption. May 2000: there was a price increase of around 20% for tobacco products. This increase coincided with an approximate 14% tax increase of $1 per pack of 20 cigarettes and was accompanied by a tobacco company price increase. These changes were associated with an 18% decrease in total tobacco consumption; loose tobacco consumption increased by 1% while manufactured cigarette consumption decreased by 23%. data on supermarket sales of cigarettes before and after the 1991, 1998, and 2000 Budgets, which included increases in tobacco taxes, show, four to six weeks afterwards, sales fell 11%, 10%, and 16% for price rises of 21%,15%, and 23% respectively 11 Laugesen (2009) reports that in each of 1991, 1998 and 2000, when the price of cigarettes rose by a dollar or more per packet, within a week sales had fallen to a new level around 2 million cigarettes less per week; these price responses imply elasticities of -0.64, -0.72 and -0.80 12 9 Ernst & Young (2010), p.35. 10 Ministry of Health (2005) Tobacco Facts 2005. These figures come from comparing nine month periods before and after the tax increase, excluding the months immediately before, during and after the increase, which often exhibit atypical consumption. 11 Cancer Society of New Zealand (2000) Tobacco Statistics. 12 Laugesen, M. (2009) Tobacco Taxation and Smuggling Control: New Zealand, World Health Organization. NZIER Review of Ernst & Young s Report on New Zealand s Illicit Tobacco Market 7

O Dea and Thomson (2007) adopts a price elasticity of demand of -0.5, based on examination of New Zealand and overseas literature 13 according to Wilson and Thomson (2005), the New Zealand evidence indicates increases in tobacco prices to be associated with decreases in tobacco consumption in the general population over the long run; the estimated overall price elasticity of demand for all smoking households over the period 1988 to 1998 implies that a 10% price rise would reduce demand by 5% to 8% 14 Thomson et al. (2010) finds there to have been a close inverse relationship between real cigarette prices and per capita tobacco consumption since 1984, with price increases driving reductions in consumption 15 over 1981 to 1991, eight economic studies of tobacco demand, using monthly, quarterly or annual data on cigarettes released from factories to proxy retail sales, found price rises to reduce demand; short-run price elasticities ranged from -0.08 to -0.15 and long-run elasticities from -0.07 to -0.52; these elasticities suggest that a 10% price increase would cause demand to fall by between 0.7% and 5.2% in the long run 16 internationally, the World Bank states that price increases discourage nonsmokers, particularly the young, from taking up smoking and induce many existing smokers to quit or to reduce their consumption 17 overseas studies have found most smokers to be price sensitive, with higher cigarette prices reducing consumption, although also promoting the seeking of lower priced or lower taxed cigarette sources, from which less effort may be made 18 19 to quit most recently, Adda and Cornaglia (2010) found higher taxes on tobacco an efficient way to reduce passive smokers exposure to tobacco smoke. 20 13 O Dea, D. and Thomson, G. (2007) Report on Tobacco Taxation in New Zealand, report to the Smokefree Coalition and ASH New Zealand. 14 Wilson, N. and Thomson, G. (2005) Tobacco tax as a health protecting policy: a brief review of the New Zealand evidence, New Zealand Medical Journal, vol.118, no.1,213, pp. 15 Thomson, G., O Dea, D., Wilson, N. and Edwards, R. (2010) Government paralysis? Stable tobacco prices mean preventable deaths and disease persists, along with health inequalities in New Zealand, New Zealand Medical Journal, vol.123, no.1,308, pp.74-80. 16 NZIER (1995) A review of tobacco taxation, in Public Health Commission (1995) Tobacco Taxation as a Health Issue, discussion document. 17 de Beyer, J. (2001) Tobacco Control Policy, The Challenge of Raising Tobacco Taxes Global, Regional and Country Experience, presentation at World Health Organization/World Bank meeting of Health and Finance Ministries of Mediterranean Countries in Malta, September 2001. 18 Hyland, A., Bauer, J.E., Li, Q., Abrams, S.M., Higbee, C., Peppone, L. and Cummings, K.M. (2005) Higher cigarette purchase prices influence cigarette purchase patterns, Tobacco Control, no.14, pp.86-92. 19 Hyland, A., Laux, F.L., Higbee, C., Hastings, G., Ross, H., Chaloupka, F.J., Fong, G.T. and Cummings, K.M. (2006) Cigarette purchase patterns in four countries and the relationship with cessation: findings from the International Tobacco Control (ITC) Four Country Survey, Tobacco Control, no.15, pp.iii59-iii64. 20 Adda, J. and Cornaglia, F. (2010) The effect of bans and taxes on passive smoking, American Journal of Applied Economics, vol.2, no.1, pp.1-32. NZIER Review of Ernst & Young s Report on New Zealand s Illicit Tobacco Market 8

c) 1995 lowering in indexation rate Ernst & Young estimates that the 1995 lowering in indexation rate by increasing the excise duty on RYO increased total reported domestic tobacco consumption by 2.8%. The data and model from which it derives this result are illustrated in the chart on p.34 of Ernst & Young (2010). In fitting the model to the data, Ernst & Young has sought to isolate the effect of the change in indexation rate from two other factors the general downward trend over 1990 to 2009 in reported tobacco consumption (- 0.5% per year) and the negative price elasticity of demand in response to changes in excise duty over this period (-0.489). Reasons to doubt Ernst & Young s finding that the 1995 lowering in indexation rate increased total reported domestic tobacco consumption by 2.8% include: Ministry of Health (2005) found the 1995 increase in excise duty on RYO to have had almost no impact on total tobacco consumption the data illustrated in the chart on p.34 show significant increases in reported tobacco consumption in 2000, 2002, 2005 and 2008 (and all but the last seem larger than the 1995 and 1996 increases 21 ; Ernst & Young s model does not appear to explain these increases; what caused these increases and could the same causes have contributed, in part or full, to the 1995 increase? the model does not explicitly include any other explanatory variables that might represent drivers of tobacco consumption other than excise duty; economic, demographic and social drivers and the effects other government policies to discourage smoking and pro-smoking advertising and promotion by the tobacco industry, as well as changes in tobacco prices for reasons other than excise duty, in effect may have been combined in the -0.5% per year general downward trend in reported tobacco consumption over 1990 to 2009; to assess Ernst & Young s model, we would need to see the results of diagnostic tests, including for goodness of fit and omitted variables was there a particular increase in advertising and promotion by the tobacco industry targeted at mitigating the effects of the 1995 increase in excise duty on RYO? and although empirical evidence from historical examples can be useful for deriving or calibrating assumptions, 1995 provides only one observation; Ernst & Young does not present any evidence to demonstrate whether this observation is representative or typical of the effects of lowering the indexation rate and, even if it once was, whether it is still so 15 years on. In light of the above that the amount of evidence of a negative price elasticity of demand for tobacco in New Zealand and overseas is substantial and that Ernst & Young s finding that the 1995 lowering in indexation rate increased total reported tobacco consumption is not convincing we disagree with Ernst & Young s assumptions that there would be no net change in the number of smokers and no net reduction in tobacco consumption if the indexation rate was lowered. The two scenarios modelled in Ernst & Young (2010) reflect switching between tobacco products only, with no reduction in total tobacco consumption in response to the price 21 Given that the increase occurred in December 1995. NZIER Review of Ernst & Young s Report on New Zealand s Illicit Tobacco Market 9

rise. These scenarios seem unrealistic and therefore of little value in informing debate on policy measures to reduce tobacco consumption. Indeed, with no increase in total reported consumption under scenario 1 and a significant decrease in total reported consumption (due to switching to unreported home grown and illicit tobacco) under scenario 2, Ernst & Young s modelling contradicts the first of its reasons against lowering the indexation rate that this may increase total reported tobacco consumption. 3.3.3 Increase in home grown and illicit tobacco consumption The second main reason given by Ernst & Young against lowering the indexation rate is that this may increase home grown and illicit tobacco consumption, causing a reduction in excise duty and GST revenues to the Crown. As discussed in Section 3.3.1 above, we agree that some switching to other tobacco products that are substitutes for RYO is likely, including home grown and illicit tobacco. It is also likely, however, that an increase in the excise duty on RYO would cause the price of illicit tobacco to rise and therefore the quantity of illicit tobacco consumed would not increase by as much as if the price remained constant. This is depicted in simplified form in Figure 1, in which an increase in excise duty on RYO causes the demand curve for illicit tobacco, as a substitute for RYO, to shift from D1 to D2. The shift in demand curve to D2 reflects that, at any given price, consumers now demand more illicit tobacco than they did previously under D1 due to the increase in price of the alternative, RYO. With this shift in demand, the price of illicit tobacco (in equilibrium, where demand equals supply) would not remain constant but rise from P1 to P2. This rise in price would moderate the increase in quantity from Q1 to Q2, rather than the full amount of the shift in the demand curve to right. The increase in illicit tobacco consumption therefore depends on the gradient of the supply curve (reflecting the price elasticity of supply). The supply curve may be steep in the short run, constrained by both production and consumer access to suppliers, but flatter in the longer run as suppliers are able to expand production and distribution, subject to the need to avoid detection. Even in the longer run, however, unless the supply curve is perfectly elastic (completely flat), there would be at least some increase in equilibrium price of illicit tobacco, providing some moderation of the increase in quantity and extent of switching from other tobacco products. Furthermore, as noted in Section 3.3.1., there may be limits other than supply to the increase in demand for illicit tobacco (and therefore the size of shift in demand curve to the right in Figure 1), including its poorer quality, difficulty in accessing and illegality. NZIER Review of Ernst & Young s Report on New Zealand s Illicit Tobacco Market 10

Figure 1 Increase in demand for illicit tobacco Source: NZIER 3.3.4 Decrease in excise duty and GST revenues We agree that some reduction in excise duty and GST revenues could occur with an increase in excise duty on RYO. This may result not only from some switching to tobacco products that do not carry excise duty and GST, but also from a reduction in total tobacco consumption in response to higher prices. As we discuss above, there is considerable evidence internationally that a rise in price encourages smokers to reduce consumption and, in some cases, to stop altogether and discourages nonsmokers from starting smoking. The net effect on excise duty and GST revenues depends on the price elasticity of demand for RYO and cross-price elasticities of demand for its substitutes, including home grown and illicit tobacco, as well as the relative tax rates on different RYO and TMC tobacco products. Although some consumers may switch to other tobacco products or reduce consumption, some consumers may maintain their consumption and pay the additional excise duty. The increase in tax revenue from the latter could, in some circumstances, outweigh the loss in tax revenue from the former. This is, in fact, the case under both of Ernst & Young s two scenarios, which model switching only and no reduction in tobacco consumption. Under scenario 1, consumers switch 21 tonnes of RYO consumption to TMC to avoid the 14% increase in excise duty on RYO, but continue to buy 835 tonnes of RYO (856 tonnes minus the 21 tonnes switching to TMC) and pay the 14% higher excise duty on this remaining consumption. The excise duty lost from consumers switching to TMC is $1.156 million (21 tonnes multiplied by 14% of the current level of excise duty on RYO, $393.03 per kilogramme). The increase in excise duty paid by consumers who stay with RYO is $45.945 million (835 tonnes multiplied by 14% of $393.03 per kilogramme). Under scenario 2, consumers switch 12.2 tonnes of RYO consumption NZIER Review of Ernst & Young s Report on New Zealand s Illicit Tobacco Market 11

to TMC to avoid the 14% increase in excise duty on RYO and 42.8 tonnes of RYO to home grown or illicit tobacco to avoid all excise duty, but continue to buy 801 tonnes of RYO (856 tonnes minus 12.2 tonnes and minus 42.8 tonnes) and pay the 14% higher excise duty on this remaining consumption. The excise duty lost from consumers switching to TMC is $0.671 million (12.2 tonnes multiplied by 14% of $393.03 per kilogramme) and from consumers switching to home grown or illicit tobacco is $19.177 million (42.8 tonnes multiplied by the full amount of 114% of $393.03 per kilogramme). The increase in excise duty paid by consumers who stay with RYO is $44.074 million (801 tonnes multiplied by 14% of $393.03 per kilogramme). Thus, under both scenarios, even as defined by Ernst & Young, excise duty revenue to the Crown would show a net increase of between $24 million (scenario 2) and nearly $45 million (scenario 1). That Ernst & Young omitted to count the increase in excise duty paid by the majority of consumers who continue to buy RYO seems an incredible oversight. Even in circumstances where an increase in excise duty did cause a net reduction in tax revenue to the Crown, whether or not this is a reason not to increase the excise duty on RYO depends on whether the government s objective in levying excise duty on tobacco is simply to raise revenue or to discourage tobacco consumption. We believe it is primarily the latter. 4. Conclusion In conclusion, we have some uncertainty about Ernst & Young s estimates of the magnitude of unreported tobacco consumption in New Zealand. More seriously, we have no confidence in Ernst & Young s assessment of the impacts of changing the relative levels of excise duty on TMC and RYO. We consider this assessment fundamentally flawed by unrealistic scenarios and incorrect results even for these scenarios. We consider the findings of this assessment of no value in informing debate on policy measures to reduce tobacco consumption. We consider Ernst & Young s report to fall well below the standards required for a piece of economic evidence. NZIER Review of Ernst & Young s Report on New Zealand s Illicit Tobacco Market 12