Taxes on heated tobacco are trending below those on cigarettes

Last month the South Korean Parliament voted to apply the individual consumption tax on heated tobacco products at a rate equivalent to 89% of the tax levied on traditional cigarettes. The move by South Korean lawmakers preserves but significantly reduces the tax discount for lower risk vapor products compared to the rates applied to combustible cigarettes.

A fair question to consider is whether this move is part of a global trend. The answer is an emphatic no.

In sharp contrast to the Korean approach, policymakers in a dozen countries across Europe, nearly all are members of the European Union, have introduced new tax classifications in their excise legislation which recognize the distinct nature of tobacco intended for heating rather than smoking. In all cases, the levels of tax applied are considerably below the rates applied to regular cigarettes, a reflection of the perceived lower risk to health of vapor tobacco. In Italy, for example, the mechanism used by tax administrators for setting the rate on heated tobacco products incorporates a 50% discount to the tax on conventional cigarettes. Not all countries are as explicit in their tax policies but the sentiment is a shared one.

To demonstrate this pattern of lower taxation requires a look beyond the nominal rates of tax applied since the taxable bases of heated tobacco and cigarettes differ. Member States of the European Union must follow a framework for taxing cigarettes laid out in Council Directive 2011/64/EU on the structure and rates of excise duty applied to manufactured tobacco (the “Excise Directive”). While the Directive grants national governments substantial latitude to design their excise taxes as they consider appropriate, it requires that the tax consist of both a specific component expressed as a fixed amount per 1000 cigarettes and an ad valorem component expressed as a percentage of the maximum retail selling price. In addition, the overall excise rate must be at least 90 euros per 1000 cigarettes.

The Excise Directive does not currently apply to heated tobacco which is considered a novel tobacco product and Member States are not required to tax heated tobacco products. Many have chosen to subject these products to taxation with the majority opting to create new tax categories for “heated” or “novel” tobacco. A few have opted to classify heated tobacco in existing categories such as “other smoking tobacco” or “pipe” tobacco, generally those with the lowest tax burden, as a temporary measure until a new category is created. Most often the tax is based on the weight of the tobacco blend, usually a fixed monetary amount per kilogram. Occasionally, as in Portugal, an ad valorem portion is also applied and in Hungary a tax on novel products is based on the number of sticks.

Comparable tax bases

Given the diversity of structures and bases of the taxes applied to cigarettes and heated tobacco products it is possible to compare the degree of taxation on these products by expressing the tax on a common base. For example, we can compare the tax yield on a product to its retail price in order to determine its excise tax incidence (excluding VAT). This value is expressed as a percentage as shown in the table below.

To provide context we include a column showing the excise incidence of other tobacco products (“OTP”), a catch-all category containing other smoking tobacco such as pipe tobacco. This is generally the lowest taxed combustible tobacco product. The incidence calculation is based on the retail price of products in the most popular price category (“MPPC”). In the dozen European countries analyzed the excise tax incidence on heated tobacco was far less than the levels for OTP (pricing data for Serbia was not available).The data are based on the retail prices of Philip Morris International’s iQOS HEETS brand of heated tobacco sticks, which are available in all the markets shown, and the weighted average price (“WAP”) of cigarettes in EU countries (Marlboro in Serbia). Excise yields were calculated based on these prices and the applicable tax rates. In every instance the excise incidence for heated tobacco products is significantly less than for conventional cigarettes. This trend is driven by lower taxes and higher prices compared to cigarettes. Lower tax yields are the result of lower tax rates and more efficient usage of tobacco (heated tobacco products are “tobacco efficient” much like fuel efficient cars, thus less tobacco is consumed). Higher production costs for the heated tobacco units reflect the investment in innovation required to develop and manufacture the more efficient heated tobacco sticks.

Weight based taxation

Another means of comparing the tax burden on heated tobacco and cigarettes is to measure the tax per kilogram of consumable product. Taxes on manufactured cigarettes are based on units and retail prices while heated tobacco is generally taxed on weight and occasionally price or units. By knowing the weight per unit of heatstick and cigarette and the excise tax paid per pack of 20 units of each product category we can derive the tax generated per kilogram of each consumable product.

Here’s how. We assume the average weight of tobacco blend in a conventional cigarette is approximately 0.7 grams. We then multiply the tax yield per pack of 20 cigarettes by 50 to determine the total tax per 1000 cigarettes which weigh a combined 700 grams. By dividing this total tax by 0.7 we can determine the tax per kilo of cigarettes.

For example, the tax on 50 packs (1000 units) of cigarettes sold at the weighted average price in Slovenia is currently 111 euros. By simply dividing this amount by 0.7 we see that the tax yield on a kilogram of tobacco contained in manufactured cigarettes is 158.6 euros.

The task is somewhat easier in the case of heated tobacco since most countries apply a specific tax that is already expressed as a fixed monetary amount per kilo of tobacco blend (e.g. EUR 62 per kg in Latvia). For Hungary, where the tax is HUF 10,000 per 1000 sticks we divided that amount by the 0.305, which is the weight of an individual HEETS tobacco stick, and the result is HUF 32,787 per kilogram of tobacco (the weight of competing brands, such as BAT’s Neosticks for its Glo device, may be lower). For Portugal, which levies a mixed excise tax on heated tobacco, we multiplied the EUR 4.70 retail price per pack by 50 and then divided the resulting price per 1000 by the weight per stick of 0.305 grams to determine a retail price per kilogram of tobacco of EUR 770. The 16% ad valorem tax on this amount is EUR 123 which we then added to the EUR 80 specific tax per kg for a total excise of EUR 203.

A comparison of the tax yield per kilogram of consumable product is revealed in the table below. Once again, to provide context we include a column showing the excise tax yield per kilo of other tobacco products (“OTP”).

In all but one of the European markets analyzed the excise yield on heated tobacco is substantially below that of regular cigarettes.

Only in Portugal is the tax yield on heated tobacco slightly higher than the yield on cigarettes, a consequence of the ad valorem tax component on the higher priced heatsticks. The lower tax yields on heated tobacco products indicate that European markets employ a harm reduction approach to tobacco taxation. Contrary to the actions taken in South Korea to reduce the tax discount on tobacco for heating, most European governments apparently wish to maintain a substantial tax gap between heated tobacco products and conventional cigarettes.

There is less consistency in the relationship between the tax yields on heated tobacco and OTP. Tax parity is observed in half the markets while in others the yield on heated tobacco is higher and in others it is lower. Nevertheless, the pattern suggests that the tax yield on other tobacco products serves as an upper limit or boundary for the tax on heated tobacco. This may provide guidance to policymakers seeking to construct a balanced framework for taxation among traditional and novel tobacco products.

Speaking last month at the Bloomberg School of Public Health at the Johns Hopkins University on the Regulation of Nicotine, the U.S. FDA Commissioner Scott Gottlieb declared that his agency was challenging the tobacco industry to proceed more quickly with the movement out of combustible cigarettes through new innovation such as “heat not burn”. Tax parity between heated tobacco products and cigarettes would impose a major obstacle to the realization of that challenge.