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Discount cigarettes and other cheap tobacco products

The issue: Until a couple of years ago, virtually all cigarette brands in Canada were sold at the same price. There were variations between provinces, but that was only because tax rates were different from province to province.

In the last couple of years, a large number of 'discount' or 'value-for-money' brands have been launched. At first, these were all brands manufactured by small, upstart companies - often cottage operations using second-hand equipment. By the end of 2002, these small companies had almost 8% of the Canadian market. In early 2003, major manufacturers decided to move into the discount sector, led by Rothmans, Benson & Hedges (brand: Number 7, Canadian Classics), followed quickly by Imperial Tobacco (brand: Peter Jackson). In May 2004, Imperial Tobacco slashed prices on its third-largest brand, Matinée, effectively making it a discount brand also.

As a result, a substantial part of the Canadian market (probably more than 20%) is now made up of discount brands, selling at $10-12 less per carton ($1.25-$1.50 per pack of 25) than premium brands. Product display 'power walls' across the country are now covered with price signs.

Related issues:

1) Discount cigarettes are taxed at the same rate as premium brands. However, two cigarette-like products are taxed at much lower rates than cigarettes: tobacco sticks (about 3.6% of the Canadian market in 2003) and roll-your-own tobacco (about 10.5% of the market). A tub of roll-your-own with enough tobacco to roll 200 cigarettes can cost less than $30, i.e. less than half the price of a carton of premium cigarettes.

2) Outside Canada, most countries have had different prices for different brands of cigarettes for many years. Canada's long-time single-price market was an international anomaly.

3) Extremely high profit margins for cigarette companies are another Canadian anomaly. British-American Tobacco, the parent company of Imperial Tobacco (which has about 2/3 of the Canadian market) sells roughly 10 times as many cigarettes in Europe as it does in Canada. But BAT generates almost as much profit from its Canadian sales as from all its European sales: profit margins are 8.8 times larger in Canada (in 2003).

Good news: The emergence of discount cigarettes is not all bad news. The main benefit for public health is that large manufacturers are losing their ability to raise prices. This leaves them with less money to throw around to try to recruit new customers, to lobby against regulations, or to take governments to court.

There is another benefit for governments that is strictly financial: because price competition makes manufacturers unable to raise prices, there is more room for tobacco taxes, which means more revenue to spend on health care, education and other priorities. Clearly it is preferable that money from tobacco sales go into public coffers than into the pockets of foreign shareholders in British-American Tobacco.

Bad news: Price competition is very visible at points of sale across the country, because in most provinces, there are no restrictions on the number or location of price signs that can be posted. This increases the visibility of tobacco products, which is clearly a bad thing for public health.

Also, if governments fail to raise taxes to occupy the price room left vacant by cuts in manufacturers' prices, the net result will be an increase in consumption.

Solutions:

1) In the short term, the priority should be to eliminate tax-based discounts on roll-your-
own and tobacco sticks, and to raise taxes on cigarettes so that the overall price does not decline because of discounting.

2) In the longer term, we can have the benefits of discounting (lower manufacturer profits) without the drawbacks (price signage etc.) by taking action to establish a ceiling on pre-tax prices - in short, make all brands of cigarettes into 'discount' brands, from the manufacturers' point of view, while ensuring higher taxes keep retail prices from coming down.

This may sound politically unrealistic at first glance, but price ceilings are in effect in Canada for a variety of products, and price ceilings for cigarettes exist in other countries. There are at least two methods of implementing a ceiling:

Governments (particularly at the provincial level) could simply legislate maximum prices, as is done for prescription drugs, funeral homes, telephone services etc. For example, the maximum price could be set at the cost of production + $2 per carton mark-up, which would effectively stop manufacturers from spending money on marketing.

Alternatively, the tobacco tax structure could be re-jigged so that 'greedy' manufacturers pay a steeply escalating tax as they raise their (pre-tax) price above the ceiling level. If the tax rates were set right, manufacturers would find it impossible to go much above the ceiling, though it would be legal to do so. (See ad valorem tax example below.)

False solution: In many US states, legislatures have adopted minimum retail price legislation for cigarettes. The original purpose of such laws was to protect small retailers from being undercut by large discount retailers. But obviously Canadian provinces could adopt similar laws, forcing all brands up to the same prices as 'premium' brands (du Maurier, Player's, Export 'A' etc.).

Minimum price laws, in the Canadian context, would amount to legislative protection for Imperial Tobacco's extraordinarily high profit margins. This would represent a $1-billion-per-year gift to the three big manufacturers.

A progressive ad valorem tax

According to Imperial Tobacco's own figures (in a November 2003 submission about reduced ignition propensity cigarettes), the price of a carton of cigarette breaks down as follows:

$56.66 = Total wholesale price, of which $42.89 is taxes.
$13.77 = Total wholesale price, before taxes, of which:

  • $6.36 - Operating costs
  • $0.53 - Net interests
  • $6.88 - Operating profits + income taxes (i.e. earnings before taxes).

Given that Imperial Tobacco's operating costs include many expenditures that are not, in fact, necessary for the production of cigarettes (promotional allowances to retailers, lawyers' fees to contest federal legislation, etc., $6 per carton is a reasonable price cap.

Under a progressive ad valorem tax system, the government would impose an extra tax for any manufacturer that went over $6 in pre-tax wholesale price. For example, the new tax could amount to:

  • 50% on any portion of price between $6 and $8.
  • 100% on any portion of price between $8 and $10.
  • 200% on any portion above $10.

So if a company attempted to charge $13.77 per carton, the extra tax would amount to $10.54 per carton, for a final retail price close to $20 higher than for a manufacturer who was willing to live with $6 per carton, which would effectively price that brand out of the market.

At the same time this system was introduced, the government could increase the 'normal', flat tobacco tax by $6-7 per carton, so that the new rules would not lead to a drop in retail prices.

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According to the latest results from the Canadian Tobacco Use Monitoring Survey (CTUMS), for data collected between February and December 2010, about 4.7 million people, representing 17% of the population aged 15 years and older, were current smokers, of which 13% reported smoking daily. Approximately 20% of men were current smokers, higher than the proportion of women (14%).
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