APPENDIX I
STRUCTURF OF TAXATION
The t%vo main structures are explored in some
detail in this appendix viz
A) End Product Excise
B) Specific by Weight
A. END PRODUCT EXERCISE
This method of taxing cigarettes has been in
existence for a long time. nere
are many examples where the three sub systems
apply viz :
Specific A fixed tax per 000 cigarettes, eg. Hong
Kong
Ad Valorem A variable tax expressed as a
percentage of the retail
price eg. Venezuela or the ex factory price, eg.
Nigeria.
Mixed A combination of the two eg. the European
Community.
The principle features, advantages and
disadvantages of these type of end
product excise are :
SPECIFIC A specific excise structure is most
suited to a company
whose brands have high levels of added value or
image
and are positioned in the high and premium price
segments. Because a specific structure results in
only a
narrow price range between the cheapest and the
most
expensive, there is little opportunity to compete
on the
basis of price. A specific structure is the global
policy
of Philip Morris \,.hose brands are normally
positioned
at the top end of the market. Indeed, they lobby
hard
to change structures to specific and in some
instances
have succeeded, eg. Hong Kong.
A specific excise structure is closely associated
with
high levels of profitability and product quality.
Although many factors determine profitability, a
key
one is the nature and extent of price competition,
the
opportunities for which are limited with a
specific
structure. For example
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A B C
Retail price 100 89 111
Specific Excise 70 70 70
Trade Margin - 10% 10 9 11
Net Manufacturer Price 20 10 30
This example demonstrates two features of a
specific
structure based upon base case A :
B A reduction of 50% in the manufacturer's net
price from 20 to 10 results in an 11 % fall in the
retail price thereby demonstrating the limited
opportunity for price competition.
C. An increase of 50% in the manufacturer's net
price from 20 to 30 results in only an I I%
increase in the retail price thereby demonstrating
how simple it is for a manufacturer to increase
profitability provided freedom to raise prices
exists.
For the same reasons as it discourages price
competition, a specific structure tends to
encourage
high quality products.
A specific structure requires a positive act by
Government to raise the level of taxation which
may be
difficult to achieve in a political coalition
situation or
where the opposition is strong.
There are excise structures whose features are
essentially specific but whose impact is the same
;is an
ad valorem structure. This occurs when Government
has different specific taxes according to a
particular
price level with a lower specific the lower the
price and
vice versa (a 'slab' specific structure). A
specific slab
structure is to be preferred to an ad valorem slab
structure.
It may be difficult to achieve a wholly specific
structure
in some developing markets because of the
resultant
limited price range which Governments may consider
necessary to meet the divergent needs of smokers.
In
such instances. a predominantly specific structure
should be the target.
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AD VALOREM The impact of ad valorem excise
structure will vary
according to the local circumstances of a
particular
company. In a highly competitive market it may
result
in a significant degree of price competition and a
resultant low level of profitability. However, in
a
Monopoly or near Monopoly market, it may not have
the same results unless a new small compefitor
starts a
price war. It will also depend upon many factors
such
as the recognition by Competitors and Government
of
the need for a profitable price structure to
ensure the
financial health of the manufacturers and the
Ministry
of Finance.
An ad valorem excise structure creates or is best
suited
to a company whose brands are mainly located in
the
lower price segments, or a company whose costs of
manufacture are significantly lower than the
competition by virtue of a dominant market share.
Such a structure enables low added value and low
image brands to survive with a significant price
advantage over the higher image brands whilst
giving
no protection at the bottom of the market in terms
of a
lower minimum price. It also enables the advantage
of
lower costs to be passed on to the consumer with a
'mulLiplier' effect on the retail price.
An ad valorem excise structure is frequendy linked
with lower levels of profitability because it
creates the
circumstances where price competition can
flourish.
However, there are many exceptions to this which
demonstrates that many other factors need to be
taken
into account before such a general statement can
be
made.
An ad valorem structure has a multiplier effect
upon ex
factory price differences which enables
manufacturers
to reduce prices at the 'expense' of the
Government
instead of by reducing their own profit margins
for
example.
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A B C
Retail Price 100 50 150
Ad Valorem Excise
(70% of retail price) .70 35 105
Trade Margin
(10% of retail price) 10 5 15
Net Manufacturers Price 20 10 30
-17his example demonstrates two features of an ad
valorem structure based upon a base case A :
B. A reduction in the manufacturer's net price by
10
units from 20 to 10 results in a decrease in the
retail
price of 50 units thereby showing the multiplier
effect of an ad valorem excise structure.
C. Similarly an increase in the manufacturer's net
price
by 10 units from 20 to 30 results in an increase
in
the retail price of 50 units, thereby showing the
multiplier effect in the context of an increase.
The MULTIPLIER concept occurs directly from an ad
valorem structure. In the above case the
multiplier has
a value of 5 which means a net pnce change of 10
results in a retail price change of 50. It is
calculated as
follows :
M = 100
100 - x
where x = the sum of the proportional elements
expressed as percentages of the retail price.
M = 100 = 100 = 100 = 100
100-(ad 100-(70+10) 100-80 20
valorem
+ trade
margins)
For the same reason as it encourages price
competition,
an ad valorem structure can often lead to lower
quality
products whose lower costs can be passed on to the
consumer in the form of lower prices where the
reduction is multiplied through the tax structure.
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An ad valorem structure automatically increases
the
amount of excise when a manufacturer increases its
prices- It therefore has an appeal to Government
who
may not therefore need to take any action to
increase
their revenues. On the other hand, because revenue
yield depends on retail prices, them is a greater
danger
of Government interference in retail price
determination than there is when the excise is
specific.
In some markets ad valorem excise is expressed as
a
percentage of the ex factory price and not the
retail
price. In such situations, it may be appropriate
to
consider transferring some of the elements
normally
included int he ex factory price to beyond the
point
where the ad valorem is applied and so saving the
multiplier effect impacting upon them. One means
of
achieving this is to transfer some of the
marketing
expenses. However, one should appreciate that this
might be a short lived tactic which may give rise
to
problems with Government over the longer term and
may enhance the power of the trade, particularly
if
their margin were increased to absorb the transfer
of
marketing expenses.
MIXED A mixed excise structure contains elements
of both
specific and ad valorem. Its effect clearly
depends
upon the relative size of the two elements. Such a
system applies throughout the European Community
although different countries have different
relativities
between the two.
A mixed structure can be particularly beneficial
to a
company whose brand mix includes both higher
priced
brands and mid priced brands which are normally
local
or national.
'ne exact balance or relatively between the two
will
depend very much upon the cost structure of a
market
and the retail price structure required.
B. SPECMC BY WEIGliT
This method of taxing cigarettes originated in the
United Kingdom which
discontinued it when it joined the European
Community. However, many
countries still apply such a structure, the most
notable being Australia. The
principle features of such a system are
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because excise varies in line with the quantity of
tobacco used, the
tendency is for products to be launched with lower
specifications and
hence lower prices. Such an excise system
therefore can lead to intense
price competition and the significant reduction in
levels of profitabWty.
For example, in Australia, the cigarette market
has progressively moved
through various phases commencing with 20's king
size full density
products (260 mg) to 25's, 30's 35's 40's and now
50's packings with
densities at the level of 200 mg and lower. As a
result, levels of
profitability in this market has fallen
significantly. Although an
intensely competitive market, the excise system
has created a situation
in which price competition can flourish at the
expense of industry
profitability.
The method of applying such a structure is
important because of the
opportunities to agree specifications with
Government for excise
purposes which may offer scope for paying a lower
level of excise than
the competition.
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