Adriana Mladenova
Research Economist
Institute for Market Economics

One of the various aspects of Bulgaria joining the EU is the need for harmonisation of excise duties in Bulgaria with the tax regime of the European Union.

This means that Bulgaria will have to introduce the minimum excise duties on certain goods by 2013 -  tobacco products, alcoholic beverages, energy and petrol. This article reviews the impacts on the Bulgarian economy of the introduction of only one of the duties - excises on tobacco. The experience of the 10 countries that joined the EU in 2004 serves as an example because many of the difficulties that these countries are facing coincide with the problems that Bulgaria is encountering and will have to solve in the process of integration.

The Derivatives of the Council of the European Union, most recently amended in 2002, prescribe the following parameters of tobacco tax structure:

• Member states impose a cigarette excise duty consisting of a specific and an ad valorem component. The minimum total excise duty must be 64 euro on 1000 cigarettes (1.28 euro on a pack of 20).

• The minimum total level of excise taxation on the Most Popular Price Category (MPPC) of cigarettes in each member state should be 57 per cent of the retail sale price (including VAT).

• States are exempt from this requirement if the total excise duty on MPPC cigarettes is 101 euro on more than 1000 cigarettes (2.02 euro a pack).

• The specific element of the tax should be no less than five per cent and no more than 55 per cent of the total tax on the MPPC, including VAT.

There are four general aims of the EU policy in the sphere of tobacco taxation.

To achieve tax harmonisation and uniformity - the EU requirement has not achieved harmonistion of tax burdens so far, nor any significant convergence of retail selling prices in the EU.

To discourage consumption of tobacco products. To raise revenues for the government. To correct negative externalities from smoking.

At present all the long-standing EU members (EU15) meet the minimum requirement of 64 euro tax a 1000 cigarettes. Relative total tax burdens, which are on average 75 per cent of retail price, do not vary greatly between most old member states. However, there are substantial differences in the absolute amounts of total tax burdens and retail prices of MPPC cigarettes. The most striking and self-evident example is the gap between the UK and Spain - the price for a packet in the UK is 7.69 euro with an overall tax of 3.05 euro while the price of a packet of cigarettes in Spain is 2.25 euro with a tax of "only" 1.76 euro.

Currently, only Cyprus and Malta comply with the EU cigarette tax regime from all new member states (EU-10).

Bulgaria has already begun harmonising its excise duty regime on cigarettes since 2002. In 2006 it increased the excise taxes from 6.1 euro a 1000 cigarettes plus 31.8 per cent on sale price to 7.7 euro a 1000 cigarettes plus 48 per cent on sale price. As a result, the hike in retail prices of cigarettes in 2006 was 62 per cent. The next (and last) tobacco price adjustment is scheduled for 2010 when specific and ad valorem taxes will increase by more than 40 per cent. These are preliminary projections set in the negotiation program between Bulgaria and EU that says that Bulgaria has to adopt the acquis communautaire for cigarettes by 2010.

Excise duties on cigarettes were increased earlier than required by the EU because Bulgarian Government aims to have higher inflation in 2006 and thus, to avoid it in 2007-2009 when the macroeconomic indicators of the Bulgarian economy will, most likely, be scrutinised against the Maastricht criteria for the introduction of the euro in Bulgaria in 2009 or 2010.

The analysis of the components of tax incidence (as of September 2006) shows that the relative share of specific taxes to the overall tax burden in Bulgaria is lower than the EU averages, while the share of the ad valorem exceeds the EU averages. Although Bulgaria meets the requirements of the EU Directive concerning the relative sizes of the tax components, economic theory suggests that there are differences in the economic impact that different types of taxes have on the industry and the market as a whole. According to Professor Cnossen of Maastricht University, ad valorem taxes increase absolute price differences, discourage investments in quality, promote cheap tobaccos and favour cheap homegrown tobaccos.

The production of cigarettes in Bulgaria is still under the monopoly of the state-owned Bulgartabac Holding, which has a market share of more than 90 per cent of the cigarettes sold legally on the market. Domestically produced cigarettes have been protected by high import duties and all cigarettes have been subject to price regulations imposed by the Government. Tobacco producers have been heavily subsidised in comparison with other entrepreneurs and as a result, the tobacco production in the country is not efficient and a lot of farmers will not receive direct payments under CAP as they fail to meet the requirement of minimum of one hectare a farm. Control on customs has proven weak and corruption is still common.

However, the future of the tobacco business in Bulgaria is not that dismal. Bulgartabac Holding has already begun restructuring its subsidiaries and will privatise several of its plants in the coming months. Abolition of fixed prices on cigarettes is due in October 2006 and thus the market will be liberalised. Import duties on cigarettes imported from the EU will be abolished due to EU accession of the country. New market players have recently entered the market such as Philip Morris and British American Tobacco, which is a clear sign that competition on the market has begun its first steps towards intensifying.

The smoking prevalence in Bulgaria is very high, about 50 per cent in 2005 of the population between 18 and 69. Still, there is a trend towards decreasing of smoking in the country, as in 2002 the prevalence was 59.5 per cent. This tendency, however, is not induced by tax changes. Also, Bulgarians are among the heaviest smokers in Europe according to recent research. Smokers in Bulgaria tend to smoke, on average, more than 20 cigarettes a day. Only Greeks, Cypriots and Romanians can compete with Bulgarians in this regard.

Also, Bulgaria ranks first in the EU by the percentage of total agricultural land devoted to growing tobacco. In absolute figures, the country is surpassed only by Greece by the indicator "hectares of land devoted to growing tobacco".

There are several findings for Bulgaria

Retail cigarette prices in Bulgaria are lower than in most of the EU members, but in real terms (cigarette prices relative to personal disposable income) they are much higher compared to the EU benchmark.  The increase of cigarette prices will be considerably greater than the expected growth in disposable income per capita in Bulgaria. Given the great percentage of smokers in the country, the high tax rates will have a negative impact on overall consumption and savings of people, which means less economic growth for the economy.

Because of the hike in excise duties at the beginning of the year, Bulgaria is experiencing an influx of smuggled cigarettes, which the industry suggests account for more than 15 per cent of the market. The retail prices of cigarettes are already higher than in its neighbours Romania, Serbia, Macedonia and Turkey. Also, legal purchases of cigarettes in duty-free shops rose by 24 per cent in the first six months of 2006.

Bulgartabac's sales fell by 24 per cent on an annual basis in the first half of 2006, while revenues from core operations fell by 48 per cent. The IME observes substitution from Bulgarian brands to imported brands - Serbian and Turkish brands are the main substitutes in the "cheap" category, and many also prefer to buy duty-free "expensive" brands.

The increase of smuggling and sales in duty-free shops means less VAT and excise taxes paid to the Government. In the first half of the year, revenues from excise duties account for 45 per cent of the expected annual excise revenue  for 2006. In comparison, all other tax revenues account for more than 50 per cent of their annual expected levels. That means that revenues from excise duties are lagging behind all other taxes. In addition, less consumption of legal cigarettes means a forgone amount of VAT payments, while losses in tobacco industry means less corporate tax payments.

Taxes hurt the poor much harder than the rich - cigarette excise duties are discriminatory and highly regressive.

Privatisation of the state-owned cigarette companies will be even harder in such an environment - tax harmonisation impedes competition in the sector and set rules that are not in the interest of all market players. Higher taxes increase incentives for fraud, bribery and corruption practices.

The IME's general recommendations are for tax cuts and abolition of the requirement for minimum tax burdens on tobacco products within the EU. The tobacco excise duty harmonisation in EU fails to meet the stated purposes, and at the same time the costs that are imposed on the economy are not taken into full account by policy-makers. Tax competition, not tax harmonisation is the right way to fight the black market and to encourage investments in research and development of healthier products. The EC should review its tax policy and launch an EU-wide debate on the abolition of the minimum level of excise duties in the member states.

This article is based on a speech delivered at an international conference on "Economic, social and security impacts of tobacco excise duty harmonisation in the EU", held on Sept 20 2006 in Prague, organised by the Liberalni institut. For more texts and presentations of the participants please go to: http://libinst.cz/data/Tabak_Aj_final.doc