With excise duties again untouched in Budget 2013, we examine what the Government should do to efficiently increase tobacco tax revenues and reduce smoking prevalence. We view raising excise duties at the current conditions as ineffective in both trimming cigarette consumption and boosting tax collections. The prevalence of illicit cigarettes (35% of total cigarettes) will need to be addressed first, as a lack of accountability for incompetence and a compensation system not based on merit are barriers towards successfully executing strategies to combat it. Maintain NEUTRAL on Tobacco.
The next step. With Budget 2013 leaving tobacco excise duties untouched for the second consecutive year after eight successive years of excise duty increases, we look at how Malaysian tobacco regulations should be implemented to best meet the Government’s goals. A typical government has the following agenda in tobacco regulation: i) encourage a healthier population, ii) maximize excise tax revenues, iii) reduce public medical costs, and iv) provide reasonable profit opportunities for tobacco companies, which in turn generate corporate income taxes and employment.
Not that effective. Raising excise duties without stringent controls on illicit trade has historically been an inefficient method in pursuing these objectives. Malaysia’s total cigarette consumption fell just 2.6% following a 20% excise hike in 2009, and illegal volumes surged by 30% as smokers diverted their consumption to smuggled cigarettes. Legal volumes plunged by 10.9% in the meantime, significantly reducing the Government’s taxable base.
Tightening the grip. Thus, the most immediate task is to implement stricter controls against illicit cigarettes when the Government raises tobacco excise duties in the future. Successfully plugging leakages to illicit cigarettes will ensure that total cigarette consumption falls and Government tax collections increase more efficiently.
Not so easy. Challenges exist in successfully executing an initiative to curb illicit trade. Malaysia’s long coastline does make enforcing more difficult, but we believe the equal civil servant compensation system that is not purely based on merit and a lack of accountability for incompetence are further barriers towards successfully clamping down on illicit cigarettes.
NEUTRAL. We expect tobacco excise tax hikes to resume in Budget 2014 as excise taxes are easy targets to increase tax revenues, which should in turn drag legal volume growth back to negative territory. We are of the opinion that the Government should raise excise taxes, but only during a time when illicit trade has been properly addressed. We are adjusting our FV on BAT and JTI to RM56.92 (WACC: 5.5%, terminal growth: 1.0%) and RM7.50 (WACC: 7.5%, terminal growth: 1.0%) respectively as we roll over our FCFF valuations to FY13. Maintain NEUTRAL on Tobacco.
The next step. With Budget 2013 leaving tobacco excise duties untouched for the second consecutive year after eight successive years of excise duty increases, we look at how Malaysian tobacco regulations should be implemented to best meet the Government’s goals. A typical government has the following agenda in tobacco regulation: i) encourage a healthier population, ii) maximize excise tax revenues, iii) reduce public medical costs, and iv) provide reasonable profit opportunities for tobacco companies, which in turn generate corporate income taxes and employment.
Not that effective. Raising excise duties without stringent controls on illicit trade has historically been an inefficient method in pursuing these objectives. Malaysia’s total cigarette consumption fell just 2.6% following a 20% excise hike in 2009, and illegal volumes surged by 30% as smokers diverted their consumption to smuggled cigarettes. Legal volumes plunged by 10.9% in the meantime, significantly reducing the Government’s taxable base.
Tightening the grip. Thus, the most immediate task is to implement stricter controls against illicit cigarettes when the Government raises tobacco excise duties in the future. Successfully plugging leakages to illicit cigarettes will ensure that total cigarette consumption falls and Government tax collections increase more efficiently.
Not so easy. Challenges exist in successfully executing an initiative to curb illicit trade. Malaysia’s long coastline does make enforcing more difficult, but we believe the equal civil servant compensation system that is not purely based on merit and a lack of accountability for incompetence are further barriers towards successfully clamping down on illicit cigarettes.
NEUTRAL. We expect tobacco excise tax hikes to resume in Budget 2014 as excise taxes are easy targets to increase tax revenues, which should in turn drag legal volume growth back to negative territory. We are of the opinion that the Government should raise excise taxes, but only during a time when illicit trade has been properly addressed. We are adjusting our FV on BAT and JTI to RM56.92 (WACC: 5.5%, terminal growth: 1.0%) and RM7.50 (WACC: 7.5%, terminal growth: 1.0%) respectively as we roll over our FCFF valuations to FY13. Maintain NEUTRAL on Tobacco.
A Richer Government and a Healthier Population
No excise duty increases for now. While the absence of tobacco excise duty hikes over the past two years very much stems from the Government’s aim for an election-friendly budget, we do not think an immediate resumption of tobacco excise tax hikes post-election will ultimately help it achieve its goal to reduce smoking prevalence and maximizing tobacco tax collections.
Prevalence of substitution. Cigarette demand is inelastic, so raising tobacco duties is generally an efficient method to increase Government revenues. Malaysian smokers, however, have an untaxed substitute product in illicit cigarettes that makes duty-paid cigarette volumes much more elastic than imagined. This in turn makes Government’s tax-raising and smoking-curbing measures much less effective. The prevalence of illicit cigarettes remains worryingly high, at 34.7% of total cigarettes consumed. The illicit market share stood at 36.1% in 2011, depriving the Government as much as RM2.1bn in tobacco-related tax collections.
Leakages render hikes less effective. When the Government decided to slap a 20% increase in tobacco excise taxes during the Budget in late-Aug 2008, contraband cigarettes gained 11.8 ppt in market share from 25.7% to 37.5% in 2009. That was an estimated 30% y-o-y rise in illegal cigarette volumes, indicating that access to non-duty paid cigarettes was relatively easy. Legal volumes dropped by 10.9% that year, which implied that Government collections rose by just RM171.6m (+6.9%) following the 20% duty hike.
Not effective in reducing cigarette consumption. As a result of the surge in contraband cigarette usage, total cigarette consumption fell by just 2.6%. Tobacco corporate earnings (excluding the non-listed Philip Morris Malaysia SB) fell 6.0%, trimming the Government’s income tax proceeds by RM13.7m. Due to the ease of purchasing illicit cigarettes, raising excise duties has thus been less effective in i) reducing smoking prevalence, ii) maximizing tobacco tax revenues, and iii) increasing corporate tax collections.
Tightening the grip. The most immediate task is to implement stricter controls to prevent further leakages to illicit cigarettes when the Government raises tobacco excise duties. To do so, both vendors’ and consumers’ access to contraband cigarettes needs to be as limited as much as possible. Malaysia needs to have strong enforcement at its borders to prevent the entrance of non-duty paid cigarettes from neighbouring countries. Efforts should be stepped up so that there is an increased probability of nabbing vendors and consumers in possession of illegal cigarettes and once caught, the level of punishment meted out on them should be more severe.
A more effective tax hike. Should the authorities be able to substantially lower the prevalence of illicit trade by cutting off channels to obtain smuggled cigarettes, a rise in tobacco excise duty will be more effective in fulfilling the Government’s aim of reducing cigarette consumption and boosting tax collections. Given Malaysia’s long coastline, it may not be easy, especially when compared to a city state like Singapore.
A good idea, but difficult to implement. Non-geographical challenges also exist for governments that intend to clamp down on illegal trade. An across-the-board civil servant compensation system that is not based on merit, for example, does not incentivize authorities to be competent since compensation or recognition is similar regardless of the amount of effort put in or accomplishments achieved. A lack of accountability for poor performance or wrongdoings further serves as a disincentive for authorities to be competent.
Explaining incentives. The simple model below intends to explain the rational decision authorities make given the differing circumstances. This model makes a number of assumptions. Suppose the cost of being a hardworking and competent government personnel is 5, due to the hard work needed. The reward of being promoted to a higher position is equal to 15 due to the higher salary, greater power and increased sense of personal accomplishment. The reward of not being promoted is equal to 7, which may include basic salary, power and so forth. Also suppose that the cost of being an incompetent government official is just 3 and the reward is 9 because there is an additional reward of 2 from corruption proceeds.
Explaining incentives. The simple model below intends to explain the rational decision authorities make given the differing circumstances. This model makes a number of assumptions. Suppose the cost of being a hardworking and competent government personnel is 5, due to the hard work needed. The reward of being promoted to a higher position is equal to 15 due to the higher salary, greater power and increased sense of personal accomplishment. The reward of not being promoted is equal to 7, which may include basic salary, power and so forth. Also suppose that the cost of being an incompetent government official is just 3 and the reward is 9 because there is an additional reward of 2 from corruption proceeds.
The choice of rewarding competency. In Figure 2, the more competent personnel receive the same compensation and recognition and have identical chances of getting promoted. Given the lack of recognition for performance and additional income received from kickbacks, the personnel would not be inclined towards diligence and honesty. On the other hand, civil servants will make the rational decision to be as such, if they are more likely to see their hard work rewarded by a promotion (see Figure 3).
When being incompetent pays off. Other considerations will also affect the decision. Suppose the reward from corruption proceeds is 6 instead of 2. The expected payoff of being incompetent and corrupt will therefore be 11.2. Under such circumstances, all personnel face the ‘temptation’ of being incompetent and corrupt even when chances of being promoted are higher.
Punishing corruption. Also, we assume that incompetent workers are still able to retain their positions, a problem when there is a lack of accountability for poor performance or abuse of power. Now suppose that the government has the ability and the willingness to remove such civil servants from their positions. If the payoff after being ousted is 0, there will be a high likelihood of being ousted will incentivize personnel to be competent and non-corrupt instead. The payoff after being removed can also be negative as the former civil servants will experience embarrassment and punishment as a result of their corrupt practices (see Figure 4).
Punishing corruption. Also, we assume that incompetent workers are still able to retain their positions, a problem when there is a lack of accountability for poor performance or abuse of power. Now suppose that the government has the ability and the willingness to remove such civil servants from their positions. If the payoff after being ousted is 0, there will be a high likelihood of being ousted will incentivize personnel to be competent and non-corrupt instead. The payoff after being removed can also be negative as the former civil servants will experience embarrassment and punishment as a result of their corrupt practices (see Figure 4).
Expect a duty hike in Budget 2014. While the Malaysian Government has chosen to keep tobacco excise duties unchanged for two years in a row amid high illicit trade, many feel that this is due to the need to keep the population happy, in anticipation of an election. We expect tobacco excise tax hikes to resume in Budget 2014 as excise taxes are easy targets to increase tax revenues.
Volumes to shrink as a result. Although 1H12 legal cigarette shipments rose by 3.9% y-o-y, much of the growth came from an especially weak 1Q11 plagued by illegal cigarettes sold below the minimum retail price. With 2Q12’s industry volume growing by a meager 0.4% y-o-y, a continuation of tobacco duty hikes should pull legal volume growth back to negative territory. We are of the opinion that the Government should raise excise taxes, but only during a time when illicit trade has been properly addressed. This will make the Government’s aim of reducing smoking prevalence and raising tax revenues much more effective.
Volumes to shrink as a result. Although 1H12 legal cigarette shipments rose by 3.9% y-o-y, much of the growth came from an especially weak 1Q11 plagued by illegal cigarettes sold below the minimum retail price. With 2Q12’s industry volume growing by a meager 0.4% y-o-y, a continuation of tobacco duty hikes should pull legal volume growth back to negative territory. We are of the opinion that the Government should raise excise taxes, but only during a time when illicit trade has been properly addressed. This will make the Government’s aim of reducing smoking prevalence and raising tax revenues much more effective.
Source: OSK
No comments:
Post a Comment