Differential taxation and heated tobacco products: Do lower excise taxes guarantee higher profits?

The increasing growth of heated tobacco and other vapor products in global markets has focused attention on the appropriate level of taxation for such novel products in fiscal policy discussions.

This increased attention is driven by the increasing body of evidence that vapor products present a substantially reduced risk profile when compared to conventional tobacco products that are smoked, (i.e. cigarettes). The publication in 2016 of “Nicotine without Smoke: Tobacco Harm Reduction” by the UK Royal College of Physicians which found that “the hazard to health arising from long-term vapour inhalation from the e-cigarettes available today is unlikely to exceed 5% of the harm from smoking tobacco” was a pivotal moment in the growing awareness by health and regulatory authorities of the harm reduction potential of vapor products. Also, an evidence review commissioned by Public Health England in 2018, concluded that “the available evidence suggests that heated tobacco products may be considerably less harmful than tobacco cigarettes and more harmful than e-cigarettes.”

In 2020 the U.S. Food and Drug Administration (FDA) authorized the marketing of IQOS, Philip Morris International’s (PMI) electrically heated tobacco system, as a modified risk tobacco product (MRTP), concluding that the iQOS exposure modification order is appropriate to promote public health, and is expected to benefit the health of the population as a whole, taking into account both users and nonusers of tobacco products. The agency also noted that “because the IQOS Tobacco Heating System heats tobacco and does not burn it, it significantly reduces the production of harmful and potentially harmful chemicals compared to cigarette smoke.”

As a result of these and subsequent reports with similar findings most informed observers of the issue eventually concluded that the appropriate health and fiscal policies to adopt were those which supported differentiated taxation of vapor and combusted tobacco products. In this article we address the impact of different cost structures among competing categories of tobacco products. This analysis suggests the appropriate level of excise tax for novel heated tobacco products is one that takes into account the higher research & development and commercial costs required to convince smokers to move to a less harmful yet satisfying alternative.

Differential taxation

Differential taxation has emerged in the literature and public policy debate as a tool to reflect the varying degrees of harm caused by different tobacco products and to promote switching by smokers from more hazardous cigarettes to products with lower risk profiles such as electronic cigarettes, heated tobacco and smokeless tobacco products such as Swedish snus.

The consumable liquid product that is heated electronically in e-cigarettes in order to generate a vapor that is inhaled by the user, contains no tobacco but is generally derived from tobacco. As a liquid, however, with physical properties distinct from leaf tobacco products, e-liquid has not been subject to traditional excise taxes based on weight or units. Beginning about a dozen years ago, early taxes on e-cigarettes were based on the volume of the consumable liquid and were initially imposed at modest rates, if at all. This permitted the sector to establish a market among smokers wishing to quit or find less harmful alternatives at prices that encouraged smokers to test the product.

Later on, a few jurisdictions expanded the taxable base to include devices and applied higher ad valorem excise taxes. Such an approach discouraged switching and as documented in the case of Minnesota, USA (Cotti et al, 2020), resulted in increased consumption of cigarettes.

Heated tobacco products are sticks or pods of specially prepared tobacco that is electronically heated to create a vapor which the consumer inhales without burning. These products were launched commercially more recently starting in 2016 following many years of costly research and development.

Because these products contain tobacco, they were subject to taxation immediately upon their introduction into the commercial market in many countries. The challenge for fiscal authorities was to determine which excise tax to apply. They uniformly concluded that since these products were not suitable to be smoked as cigarettes there was no justification to tax them at the same rate as cigarettes. Since these products are potentially less harmful than cigarettes and can play a role in reducing the harm caused by smoking, policy makers generally agreed that heated tobacco products should be taxed at rates lower than those applied to cigarettes.

Thus, several markets took steps to tax heated tobacco products at the lowest rate applied to smoking tobacco, such as pipe tobacco. Such taxes can still be found today in markets such as France, Germany and the Netherlands.

Some thirty-five countries in Europe and Asia have created new tax categories for heated tobacco products. Most apply a flat rate of tax based on the weight of the tobacco, which is explained by the presence of different types/forms of heated tobacco in the market. Examples of markets taking this approach include the UK, Poland, Denmark, Austria, Russia and Kazakhstan among others.

Evidence from the field indicates that heated tobacco products are generally taxed at levels 60–70% less than cigarettes. Only a handful of countries fully apply cigarette excise tax rates on heated tobacco such as Israel, Colombia and Georgia.

Taxation of heated tobacco products

Our analysis of the the different levels of tax applied to vapor products and combusted cigarettes from this point forward will focus primarily on the heated tobacco category. Taxation of these products has received less attention in the literature than the fiscal policies applied to the more mature e-cigarette sector. Additionally, since the production and marketing of HTPs is led by some well-established large publicly traded companies, business related data are easily accessible.

Successful commercialization of novel heated tobacco products requires manufacturers to persuade smokers to change a well-established habit which they know (smoking) to one that is new and unknown. The harm reduction potential of this shift is a key motivation, of course, one that is lodged in the mind of the smoker himself based on his/her awareness of the health benefits of cessation. Manufacturers face numerous regulatory limitations on making health related claims. Thus, they must focus on 1) offering an attractive satisfying alternative to smoking at 2) a reasonable price, and 3) communicating the offer to smokers in an environment where consumer communication is highly restricted.

Taxation plays a key role in this process. Manufacturers will typically pass a high rate of tobacco excise tax on to consumers in the form of higher prices. For a novel product, such as heated tobacco, there is a risk that this would reduce the attractiveness of the offering for consumers and thus diminish the likelihood of trial. A low rate of tax does not guarantee a lower price to consumers than cigarettes however, but it does provide the manufacturer a needed flexibility to set a price that will encourage consumers to switch. This is especially important during the initial phase of the novel product life cycle when development and switching costs are at their highest.

We have observed that in practice manufacturers tend to price their novel products below or at parity to the mid-point of the price spectrum of a similar offering of cigarettes that the smoker currently purchases. Not too long ago a pack of Marlboro branded heatsticks for Philip Morris International’s iQOS device would have been launched at a similar retail price to a pack of Marlboro cigarettes. However, due to rising excise taxes for cigarettes, as well as increasing economies of scale for the company’s heated tobacco products, a retail price gap has emerged.

Cigarettes versus heated tobacco products

The scientific evidence indicates a strong case for applying a lower rate of tax to a non-combustible product with a higher potential for reduced risk to health. Indeed, lower tax rates are often seen as a means to incentivize manufacturers to reallocate R&D, manufacturing, sales and marketing resources towards the production of less harmful alternatives with at least similar profit margins. However, even with lower rates of taxation there are formidable technical and financial challenges facing manufacturers of heated tobacco products which are not present in the production and distribution of cigarettes.

1) Production – The manufacture of cigarettes has changed relatively little in the past several decades. Some flavor enhancements to filters have been introduced along with a few innovations in packaging but these have largely been limited to selected brands. While production methods have not changed radically, streamlining of the supply chain, computerization and more efficient machinery have helped manufacturers to massively control and optimize costs.

In contrast, the launch of heated tobacco as a new product category has required a complete re-engineering of production processes. Both the electronics of the heating devices and the consumable portion of the products in the form of blended tobacco in rods and pods have been designed from the bottom up over several years through a complex process of testing and consumer trial. New factories have been built and new manufacturing processes developed, all involving new suppliers, materials and technologies, not only for tobacco and nicotine products but also electronic devices.

For electronic devices we also foresee new costs related to warranties, repairs and returns which are not thinkable for traditional tobacco products. Statements from most manufacturers indicate that the devices are a loss-making activity, exacerbated by permanent big price promotions.

2) Marketing, administration and research – For decades cigarettes have typically been sold in distribution channels such as c-stores, tobacco shops and other traditional retail outlets along with other fast moving consumer goods. Heated tobacco products are new and have higher switching costs requiring smokers to adopt an entirely new system of nicotine delivery. The traditional approach to cigarette sales will not suffice to promote switching.

Knowledgeable sales staff and other field resources must be developed and deployed to engage with adult smokers and the trade. Specialized retail spaces including dedicated boutiques have been created to display and sell the products as well as serve as venues for educating consumers in the nuances of the novel products. Digital platforms will be created for outreach to potential customers and after-sales support must be established to service customers’ devices.

R&D costs to design, test and refine novel heated tobacco products have been extensive, well above any similar spending for cigarettes. There are also additional costs related to scientific studies and regulatory approval processes such as FDA, PMTA and MRTPA as well as EU Tobacco Product Directive Notification to substantiate the different risk profile of these products. Philip Morris International reports having invested cumulative $8.1 billion in Reduced Risk Products since 2008 while British American Tobacco has doubled its R&D spending in New Categories in the last three years. Japan Tobacco, which has trailed both PMI and BAT in developing heated tobacco products, recently announced that during 2021 it will launch a new heated tobacco sticks (“HTS”) device in Japan and prioritize management resources and future investments for HTS.

Device costs should be considered here as well. They are sold at a loss as manufacturers typically provide large discounts in their device offers to smokers.

All these additional costs related to production and distribution of heated tobacco products will be reflected in higher cost of goods sold (“COGS”) and marketing expenses, respectively, in the income statement. To put into perspective and compare these costs with those of cigarettes, we have analyzed the annual reports and 10Ks of PMI, the company whose heated tobacco products (iQOS) has the widest distribution globally.^[1]

Comparison of cost of goods sold (HTPs vs cigarettes)

PMI’s financial statements and Investor Relations disclosures reveal the total cost of goods for all its product categories during an annual reporting period. Total sales volume of cigarettes is also disclosed in millions of units. For the five years from 2012 to 2016 nearly all cost of goods sold data correspond to cigarettes as only a de minimis number of heated tobacco units (“sticks”) were released into the market. Using these data, we can determine the cost of goods sold per 1000 cigarettes in each year and then calculate the arithmetic average of USD 11.58 per 1000 cigarettes over the five-year period.

Because the process of manufacturing cigarettes has changed little in recent decades, we assume the same arithmetic average cost of goods sold applies during the following four-year period between 2017 and 2020. If we multiply the average COGS (USD 11.58 per 1000) by the total volume of 628.5 billion cigarettes reported in the company’s 2020 10-K, we estimate a total cost of goods sold for cigarettes of USD 7,267 million in 2020. Subtracting this amount from the combined total COGS of USD 9,569 million reported in 2020 leaves a balance of USD 2,315 million which corresponds to the heated tobacco sticks category (both the iQOS device and the consumable tobacco sticks). Dividing this figure by the total reported 76.1 billion units of heated tobacco sold in the year reveals an average cost of sales of USD 30.42 per 1000 units of heated tobacco. To summarize, this analysis implies that PMI has a USD 18.88 higher cost of goods sold for 1000 units of heated tobacco product compared to the COGS for 1000 cigarettes.

Table 1 – Cost of goods sold

Comparison of marketing, administration and research costs (HTPs vs cigarettes)

PMI states in its 2020 10K report that its marketing, administrative and research costs “include the costs of marketing and selling our products, other costs generally not related to the manufacture of our products (including general corporate expenses), and costs incurred to develop new products. The most significant components of our marketing, administration and research costs are marketing and sales expenses and general and administrative expenses.”

We have calculated the average marketing, administrative and research costs for the five years prior to the widespread launch of PMI’s iQOS heated tobacco products as USD 7.84 per 1000 cigarettes. This amount is assumed to be constant during the 2017-2020 period. We can estimate the marketing, administrative and research expenses for cigarettes in 2020 by multiplying the reported unit sales of 628.5 billion by the average cost per 1000 from 2012-2016, which comes to USD 4,925 million. Subtracting this amount from the total costs in 2020 reveals a marketing, administrative & research expense of USD 2,459 million related to heated tobacco products. Dividing this amount by the total HTP sales of 76,111 million units produces an average marketing, administrative and research cost of USD 32.31 per 1000 units in 2020.

The analysis indicates that on average PMI’s marketing, administrative and research expenses for heated tobacco products is USD 24.48 per 1000 units higher than similar expenses for cigarettes. In fact, this number appears to be lower than might have been expected possibly due to the slight pullback in marketing and sales expenses due to the COVID-19 pandemic in 2020.

Table 2 – Marketing, administrative and research

Combined costs

The combined estimated costs of production, marketing and research for PMI’s iQOS system in 2018/19 stood at approximately USD 92 per 1000 units, while in 2020 totaled USD 62.73 per 1000 units, placing such expenses between 3 and 5 times the total for similar costs corresponding to cigarettes (USD 19.38 per 1000). The 2020 drop in costs needs to be analyzed further to understand if it is attributable to economies of scale or to COVID related reductions in marketing activities.

Table 3 – Combined costs Cigs vs HTPs

These higher costs reflect the challenges to producing and selling an innovative product which embodies a completely new consumer eco-system. Only with rates of excise tax substantially lower than those applied to cigarettes could heated tobacco products sustainably absorb its higher cost structure and still be sold at an attractive price to consumers.

Potential impact of higher taxes

During the initial phase of building a new product category such as heated tobacco expenses are high and income is low in relation to cigarettes. Any attempt to close the excise tax gap between heated tobacco and cigarettes would lead to two possible outcomes. Manufacturers of HTPs could retain the near consumer price parity with cigarettes, which would lead to much lower net revenue and greatly reduced operating income and, consequently, lower their ability to channel investments and marketing efforts in the new categories. This scenario would favor manufacturers focused on cigarettes which today still have higher net profit margins.

A second choice would be to pass on the higher tax to consumers and raise the price. This would definitely lead to substantially less consumer switching, while prompting HTP users to move partly to e-cigarettes, as both categories include smokers seeking alternatives to cigarettes. These responses would also lead to much lower volumes and lower operating income from heated tobacco products.

In either event, the income erosion would present additional important challenges to growing the heated tobacco category, where operating profit margins are below those of cigarettes. This would fall especially hard on newer entrants to the category which face high investment hurdles in R&D, marketing and sales.

^[1] According to the CEO’s presentation at PMI’s virtual investor Day on February 10, 2021, as of December 2020, iQOS has been launched in 64 markets. See: https://philipmorrisinternational.gcs-web.com/static-files/d301e75f-04b6-49e4-a280-600a0765d2b2

References

“Nicotine without smoke, Tobacco harm reduction”, Royal College of Physicians, 28 April 2016 https://www.rcplondon.ac.uk/projects/outputs/nicotine-without-smoke-tobacco-harm-reduction
“Evidence review of e-cigarettes and heated tobacco products 2018”, A report commissioned by Public Health England, https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/684963/Evidence_review_of_e-cigarettes_and_heated_tobacco_products_2018.pdf
“FDA Authorizes Marketing of IQOS Tobacco Heating System with ‘Reduced Exposure’ Information” FDA News Release 7 July 2020, https://www.fda.gov/news-events/press-announcements/fda-authorizes-marketing-iqos-tobacco-heating-system-reduced-exposure-information
PMI 2020 10K: https://philipmorrisinternational.gcs-web.com/static-files/7c50495d-a88e-4e2a-b108-0c5c5ff7cf4d
The Effects of E-Cigarette Taxes on E-Cigarette Prices and Tobacco Product Sales: Evidence from Retail Panel Data, Chad D. Cotti, Charles J. Courtemanche, Johanna Catherine Maclean, Erik T. Nesson, Michael F. Pesko, and Nathan Tefft, NBER Working Paper No. 26724 January 2020, Revised August 2020
BAT CEO Jack Bowles CAGNY Presentation 18 February 2021 https://www.bat.com/group/sites/uk__9d9kcy.nsf/vwPagesWebLive/DO6FKEVZ/$FILE/medMDBYCMVH.pdf?openelement
Japan Tobacco CEO Masamichi Terabatake Investor Presentation, Business Plan 2021, https://www.jt.com/investors/results/forecast/pdf/2020/Full_Year/20210209_08.pdf

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