Monday, 23 November 2015

Understanding the tobacco tax gap

HMRC published their latest estimates of the tobacco tax gap last month. This is the amount of tobacco smoked in Britain that is counterfeit or contraband.

The methodology of the tobacco tax gap is pretty crude. It amounts to this:

The estimate of the illicit market for tobacco is produced using a top-down methodology; that is total consumption is estimated, from which legitimate consumption is subtracted, the remainder being the illicit market.

In other words, they estimate how many smokers there are and multiply it by the estimate of how many cigarettes they each smoke. They then subtract the number of recorded sales - plus an estimate of how much is bought legally abroad - from the total and the figure that emerges is the amount of non-duty paid tobacco.

It's a cheap way of doing it (the better way - collecting discarded cigarette packs - is left to the tobacco industry) and it has been coming to increasingly unbelievable conclusions. The latest edition finds no increase in non-duty paid cigarettes in 2014/15 and a slight decline in non-duty paid rolling tobacco.

Since 2006/07, HMRC thinks the picture looks like this (albeit with wide confidence intervals)...

This suggests that the illicit trade is bigger than it was five years ago but smaller than it was before that. But is this realistic? HMRC's tobacco bulletin shows that there was a 28 per cent decline in (duty paid) cigarette sales between 2010/11 and 2014/15 (from 45.7 billion sticks to 32.7 billion sticks). That is a massive decline over a four year period. During the same period, (duty paid) rolling tobacco sales rose by only a little - from 6.2 to 6.7 million kilograms, the equivalent of half a billion sticks.

So we have legal cigarette sales falling by more than a quarter in the course of four years. What happened to smoking prevalence in that time? We don't have data for 2014/15 yet, but the ONS says that...

'Nearly one in five adults (19 per cent) aged 16 and over were smokers in 2013, a rate that although slightly less than 2012, has remained largely unchanged in recent years'

The smoking rate was 20 per cent in 2010. By 2013, it had dropped to 19 per cent. In other words, it fell by five per cent (in relative terms). If you factor in population growth, the number of smokers has declined by even less than five per cent. And yet cigarette sales fell by 21 per cent. A slight anomaly, no?

Given that legal cigarette sales have been falling at a far faster rate than has the smoking rate, how have HMRC avoided the obvious conclusion that more tobacco is being sold on the black market?

I wish I could answer that question. HMRC publish a methodological annex and I challenge anyone to read it without concluding that the whole thing is basically guesswork. A great deal depends on HMRC's assumptions, but these are rarely spelt out. As far as I can see, there are only two possibilities that could help explain why legal cigarette sales are plummeting while the smoking rate is not...

1. Smokers are smoking far fewer cigarettes
2. Smokers are buying more cigarettes on the black market

I haven't seen any evidence that smokers are smoking fewer cigarettes than they did five years ago - though they may be - and it is far from clear that HMRC have seen any such evidence either. They say they use data from the Opinions and Lifestyle Survey to estimate how many cigarettes smokers consume but I can't see any such estimate in it.

So, it's over to you, faithful reader. The number of smokers has barely dropped since 2008 and yet the number of cigarettes sold legally has dropped precipitously and the black market is - supposedly- roughly the same size. How do we square this circle?

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