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ASSESSING THE ECONOMIC CASE FOR AN EXCISE DUTY ON E-CIGARETTES A report prepared for British American Tobacco February 2017
Confidential
Frontier Economics Ltd is a member of the Frontier Economics network, which consists of two separate companies based in Europe (Frontier
Economics Ltd, with offices in Brussels, Cologne, Dublin, London & Madrid) and Australia (Frontier Economics Pty Ltd, with offices in Melbourne
& Sydney). Both companies are independently owned, and legal commitments entered into by one company do not impose any obligations on
the other company in the network. All views expressed in this document are the views of Frontier Economics Ltd.
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ASSESSING THE ECONOMIC CASE FOR AN EXCISE DUTY ON E-CIGARETTES
CONTENTS
Executive Summary 4
1 Introduction 6
1.1 Context of this report 6 1.2 Our approach 6
2 The market for e-cigarettes 8
3 Revenue-raising 10
3.1 Introduction 10 3.2 The economic arguments 10 3.3 Is demand for e-cigarettes price inelastic? 12 3.4 Conclusion 15
4 Externalities 16
4.1 Introduction 16 4.2 The negative externality rationale for taxation 16 4.3 Negative externalities and e-cigarettes 17 4.4 Conclusion 21
5 Internalities 22
5.1 Introduction 22 5.2 The rationale for taxing goods that have internalities 22 5.3 Are there internalities from e-cigarettes? 23 5.4 Conclusion 26
6 Administration and compliance 28
6.1 Introduction 28 6.2 Application to the e-cigarette market 29 6.3 Conclusions 31
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EXECUTIVE SUMMARY
British American Tobacco (BAT) asked Frontier Economics to provide an
independent assessment of the economic case for excise duties on e-cigarettes.
The scope of our assessment was limited to e-cigarettes, not new tobacco
products such as ‘heat not burn’. Our analysis was conducted independently and
the views expressed are those of the authors, based on the evidence analysed.
Economic theory identifies three main rationales for excise duties that could apply to e-cigarettes
Efficiency in revenue-raising: if the demand for e-cigarettes is not very
sensitive to their price, then revenue can be raised without significantly
distorting consumer behaviour and without eroding the tax base.
Correcting for externalities: if consumption of e-cigarettes causes costs to
society, excise taxes can help ensure these costs are fully reflected in price;
Correcting for internalities: if those using e-cigarettes are not fully informed
about the likely harms and risks of addiction, they may value taxes as a
mechanism to help them stop using them.
Tax theory also emphasises issues around the costs of administering and
complying with any new excise duty.
We find no compelling rationale to apply an excise duty to e-cigarettes in the current market
Demand for e-cigarettes is sensitive to price, suggesting no strong efficiency rationale to raise revenue from a new excise duty
The results of four empirical studies we
identified all suggested that the demand for
e-cigarettes is price sensitive. The single
most robust study from the US estimated
an own-price elasticity of –2.1.
The literature is limited by a lack of good quality data recording demand and
prices for e-cigarettes and conventional cigarettes. Demand may become less
sensitive to price as the e-cigarette market matures, or estimates may change as
more complete data become available; this needs to be validated with further
empirical evidence.
External costs from e-cigarette use are much lower than for traditional cigarettes, and substitution from traditional cigarettes to e-cigarettes generates external benefits. This would not rationalise an excise tax.
A growing literature has explored the relative harms from e-cigarettes and
conventional tobacco products. There is a consensus among health groups and
anti-smoking bodies that e-cigarettes are much less harmful, suggesting that any
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ASSESSING THE ECONOMIC CASE FOR AN EXCISE DUTY ON E-CIGARETTES
public health costs associated with e-
cigarette use would be low. Indeed, as most
e-cigarette users are current or former
smokers, switching from harmful to less
harmful products generates positive
externalities. The evidence relating to
passive harms from e-cigarette use is limited, but current studies point to the
risks being small compared with conventional tobacco.
In a world with limited or no use of conventional tobacco, the externalities
argument would give a rationale for an excise tax on e-cigarettes, at a much
lower rate than the optimal rate for traditional tobacco products. However, in the
current world with significant switching from traditional to e-cigarettes, the
externalities case for an excise duty is weak.
Most e-cigarette users are current or former smokers. There is no strong evidence of a ‘gateway’ effect or that users underestimate the harms from e-cigarettes. This gives no compelling internality rationale for excise duty.
The WHO find that few e-cigarette
users have never smoked conventional
cigarettes, and ASH highlight that e-
cigarettes are unlikely to be a gateway
into smoking. At present, most users of
e-cigarettes are likely to be well-informed about the risks of nicotine addiction.
Most evidence suggests that e-cigarette users, if anything, overestimate the
health risks relative to conventional cigarettes. Consumers are therefore unlikely
to regret using e-cigarettes and value higher prices as an aid to giving up. The
‘internality’ rationale for an excise is therefore weak.
In a world with limited use of conventional tobacco, the internality rationale could
be stronger: more e-cigarette users would never have smoked. However, an
excise tax would be a blunt instrument – proper information about the risks of e-
cigarettes and regulation around sale and promotion would be preferable.
The potential revenues from an e-cigarette excise are limited and the costs of administration and compliance could be high.
On current sales, an excise tax on e-
cigarettes in the EU at half the
minimum rate levied on conventional
tobacco could raise perhaps 0.3% to
0.7% as much revenue as tobacco
excise duties. There are reasons to
believe that an excise on e-cigarettes
would be costly to administer. The market is rapidly changing which would make
it hard to define the tax base in a stable way. The market is also much more
fragmented than that for conventional tobacco: there would be many more
taxpayers and a greater risk of sales leaking to illicit jurisdictions. This could
change as the market matures and consolidates.
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1 INTRODUCTION
1.1 Context of this report
Council Directive 2011/64/EU sets out the structure and minimum rates of excise
duty to be applied to tobacco products in EU member states.1 The most recent
report by the European Commission (EC) into the Directive identified, among
other issues, a need to provide clarity about the treatment of novel products such
as e-cigarettes, which are not currently covered by the Directive.2 Member States
are free to set their own tax structures and rates (if any) on these products,
leading to concerns about competition and the functioning of the single market.
British American Tobacco (BAT) asked Frontier Economics (Frontier) to provide
an independent assessment of the economic case for excise duties on e-
cigarettes. The scope of our assessment was limited to e-cigarettes, not new
tobacco products such as ‘heat not burn’. We were asked to set out the relevant
economic considerations for whether an excise duty should be introduced and
how these apply to e-cigarettes, but not to make any specific recommendations
on the level, structure or base for any excise duty.
This report sets out our conclusions and the evidence base underpinning them.
The analysis was conducted independently and all views expressed are those of
the authors based on the evidence analysed. BAT had the opportunity to
comment on earlier drafts of the report and provided initial input into evidence
sources, but did not constrain Frontier’s intellectual analysis or our ability to
consult a fuller range of evidence.
1.2 Our approach
We carried out desk research and evaluation of the relevant literature and
quantitative evidence on the e-cigarette market in Europe. Our empirical analysis
is set out in Chapter 2. We note that good empirical analysis of the issues around
e-cigarette taxation is hampered by a lack of timely, comprehensive and high
quality data on the market for e-cigarettes in Europe.
Our analytical framework was guided by the economic literature on optimal tax
theory, in particular for the taxation of goods and services. We drew heavily on
the recent, influential Mirrlees Review of the characteristics of a good tax system,
in particular the work of experts in indirect tax policy Professors Ian Crawford
(University of Oxford), Michael Keen (IMF) and Stephen Smith (UCL).3
1 http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2011:176:0024:0036:EN:PDF
2 http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=COM:2015:621:FIN&rid=1
3 We drew on the overall report Tax By Design (Mirrlees, J. et al. (2011), available at
https://www.ifs.org.uk/publications/mirrleesreview/) and the specific supporting chapter on VAT and excise duties (Crawford, I., M. Keen and S. Smith (2010), ‘VAT and excises’, in J. Mirrlees et al., Dimensions of Tax Design, Oxford: Oxford University Press (https://www.ifs.org.uk/uploads/mirrleesreview/dimensions/ch4.pdf)).
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In terms of economic rationales for excise taxes, we identified three key
arguments which are the subject of separate Chapters of this analysis:
1. To raise revenue in the least economically distorting way (Chapter 3);
2. To account for external costs associated with consuming goods and services
(Chapter 4); and
3. To account for ‘internalities’ associated with difficulties people have in
making optimal decisions about what to consume, particularly for addictive or
unhealthy products (Chapter 5).
In Chapter 6, we also consider issues around administration and compliance of
excise taxes: would a tax on e-cigarettes would be cheap to collect and enforce?
Terminology
We define three key terms of interest that are used frequently in this report:
E-cigarettes: Electronic cigarettes are hand-held devices including an atomiser,
battery and liquid-filled cartridge. The liquid is heated to release vapour, usually (not
always) containing nicotine which is inhaled by the user. There are many types of e-
cigarette and we use the term as a shorthand for them all, including (not limited to):
□ Disposable e-cigarettes or ‘cig-a-likes’ which are disposed of once the battery runs out or the
pre-filled liquid cartridge is emptied;
□ Rechargeable e-cigarettes and vape pens where the battery can be re-charged and liquid
cartridges replaced; and
□ Vaping devices / tank systems where a liquid tank is refilled manually by the consumer using e-
liquids, purchased separately from the base system.
Conventional tobacco products: Refers to combustible cigarettes in the main but
also used as a shorthand to cover e.g. hand-rolling tobacco, cigars and pipe tobacco.
Excise duty: Any tax levied per unit sold (‘specific’ duty) or as a proportion of the
retail price (‘ad valorem’ duty) for a defined group of products. The terms ‘excise tax’
and ‘excise duty’ are used interchangeably.
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2 THE MARKET FOR E-CIGARETTES
The market for e-cigarettes is relatively new but rapidly-growing. The first
products were introduced to the market in 2006. By 2015, sales of e-cigarettes in
Europe were just over €2.8 billion, with sales roughly doubling year on year to
2013, and rising at around 30% per year since then (see Figure 1). In 2015, the
largest market for e-cigarette sales in the EU by far was the UK, with sales of
€911 million. Poland, Italy, France and Germany were the four other largest
markets, with sales in each around €200 million to €400 million.
Figure 1 Value of e-cigarette sales in the EU, 2010 to 2015, real-terms
Source: Euromonitor International
While sales of e-cigarettes in Europe have been rising rapidly, they remain very
small compared with sales of conventional tobacco products. In 2015,
combustible cigarette sales in the EU were €125 billion, 44 times larger in cash
terms than the e-cigarette market. Between 2010 and 2015, e-cigarette sales as
a fraction of conventional cigarette sales rose from 0.1% to 2.4% (see Figure 2).
The significant size of the conventional cigarette market is also reflected in their
importance as a source of tax revenue. In 2015, excise duties on tobacco
products raised around €83.6 billion in the EU (see Figure 3). This amounted to
around 1.4% of all tax revenues in the EU that year.4
4 Eurostat estimates of total EU tax receipts in 2015 were €5.88 trillion, including compulsory social insurance.
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Figure 2 E-cigarette sales in the EU compared with combustible, 2010 to 2015, real-terms
Source: Euromonitor International, Frontier calculations
Figure 3 EU Excise duty receipts from tobacco products, 2014 and 2015
Source: European Commission DG-TAXUD
(http://ec.europa.eu/taxation_customs/sites/taxation/files/resources/documents/taxation/excise_duties/tobacco_products/rates/excise_duties_tobacco_en.pdf); Frontier calculations
Note: Data unavailable on a consistent basis for all countries before 2014. Figures not adjusted for inflation.
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3 REVENUE-RAISING
3.1 Introduction
Excise taxes represent a significant source of revenue in many EU member
states. Alcohol and tobacco excises together, for example, raised more than
€118 billion in the EU-28 in 2014, or 2.2% of all tax revenues. At the national
level, alcohol and tobacco excises are a more significant source of revenue in
many member states, accounting for 8.8% of receipts in Hungary in 2014, 6.3%
in Estonia and 5.5% in Romania.5 For finance ministries, the potential to raise
revenue from excise taxes is often a compelling political rationale for increasing
existing excises or introducing new excise duties on other commodities.
The key economic rationale, however, focuses on raising tax revenue in the
most efficient way possible. Here, efficiency has a particular meaning: taxes
should be raised to minimise the distortion to people’s decisions about what to
buy or what to produce. The idea is that, given a certain amount of money to
spend, people will buy the goods and services that make them as well-off as
possible. When there are taxes, people must be less well-off – either because
their income is taxed so they have less to spend; or because goods and services
are taxed meaning that prices increase. The less that decisions can be distorted,
the less is the impact on people’s well-being.
In Chapters 4 and 5 we explore evidence for two arguments that suggest that
taxes can sometimes improve overall well-being: either because what people
choose to buy and consume has a negative effect on others (externalities,
Chapter 4); or because people may not make fully-informed decisions about what
to buy in terms of their own well-being (internalities, Chapter 5). We examine
whether these economic arguments apply to e-cigarettes.
In this Chapter, we ignore those issues and focus instead on the question of
whether there would be a case for an excise tax on e-cigarettes on the grounds
of it helping to raise tax revenue in a more efficient (less distorting) way than
other forms of taxation.
3.2 The economic arguments
Economists have been studying so-called ‘optimal commodity taxation’ for
decades, and the most influential analysis was written by Frank Ramsey ninety
years ago.6 Ramsey outlined that when the government was limited to raising
revenue from taxing goods and services, the economic distortions would be
minimised if tax rates were higher on goods and services that are price inelastic
(see box). That is – when the demand for a product is not very sensitive to its
price, then the tax rate should be high; when demand is very sensitive to price,
the tax rate should be low.
5 Data from Table 42 of Taxation Trends in the European Union 2016 Edition
(http://ec.europa.eu/taxation_customs/sites/taxation/files/resources/documents/taxation/gen_info/economic_analysis/tax_structures/2016/econ_analysis_report_2016.pdf)
6 Ramsey, F. (1927), ‘A contribution to the theory of taxation’, Economic Journal, 37, 47–61.
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Price elasticities
Price elasticity measures how responsive the demand for a good or service is to price. A
key measure is the own-price elasticity of demand, defined as:
Since demand tends to fall when prices rise, the own price elasticity is negative. For
example, an own-price elasticity of –2.0 means that a 10% increase in price would lead to
a 20% reduction in demand, all else equal; an own-price elasticity of –0.5 means that a
10% increase in price would lead to a 5% reduction in demand, all else equal. When the
own-price elasticity is between 0 and –1, the product is said to be price inelastic
(demand is relatively unresponsive to price). When the own-price elasticity is below –1,
the product is said to be price elastic (demand is relatively responsive to price).
Another important measure is the cross-price elasticity of demand, defined as:
The cross-price elasticity shows how the demand for a product responds to changes in
the price of a different product, all else being equal. If the cross-price elasticity is positive,
the products are said to be substitutes (for example, an increase in the price of tobacco
could increase the demand for e-cigarettes). If the cross-price elasticity is negative, the
products are said to be complements (for example, an increase in the price of e-
cigarette cartridges could reduce the demand for liquid refills).
In general, the price elasticity is not independent of the price. Elasticities tend to be larger
(that is, more price sensitive) at higher prices. This is intuitive – a 10% increase from a
high base price is a larger increase in cash terms than a 10% increase from a low price.
The intuition is clear: if demand does not respond much to price, then a higher
tax (leading to a higher price) will not change decisions about what to buy very
much, and so the distortion to behaviour is limited. There is also another way to
look at this focused on the sustainability of tax revenues: if a product is very price
elastic, then a higher tax could feasibly reduce demand so much that overall tax
revenues fall rather than rise.
Taken at face value, the ‘Ramsey Rule’ gives a clear economic hypothesis: there
would be a more compelling case for an excise on e-cigarettes if they are
price inelastic. We explore the evidence in Section 3.3.
More recently, the economic theory around how best to tax different goods and
services has developed to highlight two key points:7
Even if a product is price inelastic, higher taxes on that product could distort
the demand for other goods and services unless there are no cross-price
effects. Cross-price elasticities cannot, therefore, be ignored.
When governments have the option to tax income as well as goods and
services (as is the case in all developed economies), these taxes cause
distortions to how much people are willing to work. The economic case for
varying tax rates on goods and services then rests more on whether these
7 Summarised in Crawford, I., M. Keen and S. Smith (2010), ‘VAT and excises’, in J. Mirrlees et al., Dimensions
of Tax Design, Oxford: Oxford University Press (https://www.ifs.org.uk/uploads/mirrleesreview/dimensions/ch4.pdf)
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distortions to work incentives can be mitigated. In particular, tax rates should
be lower on goods and services which are associated with working
(such as formal clothes or uniforms) and higher on good and services
which are associated with leisure time (such as casual clothes).
On the former point, we therefore develop a second hypothesis: purely on
revenue-raising grounds, there would be a more compelling case for an
excise on e-cigarettes if they are substitutes for other highly-taxed
products. This is because taxing e-cigarettes would increase the demand for
these products, and so raise revenue. However, as we discuss below, there
would clearly be negative consequences in terms of health from this substitution.
On the latter point, it is important to be clear that no practical examples exist of
taxes on products being introduced or raised on the basis of them being
associated with leisure time, and there is little reliable evidence on how far
individual products are particularly associated with work or with leisure that could
be used as the basis for designing tax policy. Some studies have looked at the
extent to which, for example, tobacco is associated with work or with leisure, but
as summarised in Crawford et al. (2010) in the influential Mirrlees Review:8
“… in the current state of knowledge, it is unlikely that cigarette
consumption is sufficiently complementary with leisure to warrant high
taxation on those grounds alone.” (p. 319)
Given the lack of evidence on this for e-cigarettes, we do not consider it further.
3.3 Is demand for e-cigarettes price inelastic?
Perhaps unsurprisingly, given that e-cigarettes have not been available for very
long, there is limited evidence on own- and cross-price elasticities of demand for
these products. This is certainly true compared against the quite voluminous
literature on elasticities for traditional cigarettes.9 We reviewed the literature with
a detailed keyword search using search engines for academic publications and a
general search of the so-called ‘grey’ literature (policy reports and non-academic
publications). In total, we identified only five studies, summarised in Figure 4,
which attempted to estimate own- or cross-price elasticities of demand for e-
cigarettes. In terms of our main hypotheses:
Almost all studies find that e-cigarettes are price elastic, which would not
rationalise a new excise tax on them. The one exception (Stoklosa et al,
2016) finds that e-cigarettes are price inelastic in the short-term, but price
elastic in the long-term once the addictive nature of demand is accounted for.
All studies find that e-cigarettes and traditional cigarettes are substitutes.
This suggests that an excise tax on e-cigarettes would raise demand for
traditional cigarettes, which are highly taxed, which could raise tax revenues
overall. However, this completely ignores the health and addiction issues in
encouraging e-cigarette users to switch back to traditional tobacco which we
address in Chapters 4 and 5.
8 Crawford, I., M. Keen and S. Smith (2010), ‘VAT and excises’, in J. Mirrlees et al., Dimensions of Tax Design,
Oxford: Oxford University Press (https://www.ifs.org.uk/uploads/mirrleesreview/dimensions/ch4.pdf) 9 Gallet and List (2003), for example, identified more than 80 studies on tobacco price elasticities (Gallet, C. and
J. List (2003), ‘Cigarette demand: a meta-analysis of elasticities’, Health Economics, 12(10), 821–35.
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Figure 4 Evidence on the price elasticity of demand for e-cigarettes
Study Method Own-price elasticity Cross-price elasticity Comments
Zheng, Y. et al. (2016)
Analysis of scanner data sales, tobacco and e-cigarette products. Uses systems approach to demand estimation. The e-
cigarette category includes disposables, starter kits and replacement cartridges.
-2.1
(price elastic)
Cross-price elasticity of e-cigarettes with respect to
cigarette prices is +1.9.
(substitutes)
Good theoretical foundation but relies on scanner data so does not fully capture e-cigarette market. However, e-
cigarette prices do account for quality changes.
Pesko, M. et al. (2016)
Online hypothetical purchase experiment. 1,200 smokers in US
-1.8
(price elastic)
Hypothetical choice experiment may lack real-world validity. Representative sample of smokers, not e-cigarette users.
Stoklosa, M. et al. (2016)
Panel data of monthly e-cigarette and conventional cigarette sales in 6 EU
countries, Dec 2011 to Oct 2014. Time series analysis of impact of prices on e-
cigarette demand, controlling for country fixed effects, time trends and various other
variables.
Static models: -0.8 (price
inelastic)
Dynamic models, allowing for addictive nature: short-
run elasticity -0.3 (price
inelastic); long-run elasticity -1.1 to -1.2 (price elastic).
Cross price elasticity of e-cigarettes with respect to
price of conventional cigarettes estimated at +3.6 to +4.6 in static model, and
+6.5 in dynamic model (substitutes)
Model passes statistical tests for panel data validity. Data do not provide good coverage of e-cigarette sales and exclude
e-liquids. Prices may not account for quality changes. “Long-run” elasticities measured over short time period.
High cross price elasticity could reflect relative immaturity of e-cigarette market (rapid time series growth) not fully
captured in time trends in specification. Also finds substitution between snus and e-cigarettes in Sweden.
Grace, R. et al. (2015)
Experimental approach with sample of 210 smokers in New Zealand; and asked
hypothetical purchase questions at higher and higher conventional cigarette prices.
Not estimated; interest was in cross-price elasticities.
Average cross price elasticity of e-cigarettes with
respect to conventional cigarette price +0.2
(substitutes).
Hypothetical choice approach so not clear how valid to real-world decisions. Only included those who had never used e-
cigarettes so not applicable to whole population.
Huang, J. et al. (2014)
US scanner data, quarterly, 59 geographic areas, 2009 to 2012. Panel data
estimation to identify elasticities, including market, time and store effects. Analyse
disposable and reusable e-cigarettes separately as quite distinct products.
Disposable e-cigarettes: -1.2 (price elastic);
reusable: -1.9 (price elastic).
Cross price elasticities of e-cigarettes (disposable and
reusable) with respect to conventional cigarette
prices positive (substitutes); not statistically significant.
Data limited to sales in the stores captured by the scanner company, so does not account for online sales, and does not cover vaping products. High own-price elasticity could partly
reflect substitution to vaping.
Sources: Zheng, Y., C. Zhen, D. Dench and J. Nonnemaker (2016), ‘US demand for tobacco products in a system framework’, Health Economics; Pesko, M., D. Kenkel, H. Wang and J. Hughes (2016), ‘The effect of potential electronic nicotine delivery system regulations on nicotine product selection’, Addiction, 111(4), 734–44; Stoklosa, M., J. Drope and F. Chaloupka (2016), ‘Prices and e-cigarette demand: evidence from the European Union’, Nicotine and Tobacco Research, 18(10), 1973–80; Grace, R., B. Kivell and M. Laugesen (2015), ‘Estimating cross-price elasticity of e-cigarettes using a simulated demand procedure’, Nicotine and Tobacco Research, 592–98; Huang, J., J. Tauras and F. Chaloupka (2014), ‘The impact of price and tobacco control policies on the demand for electronic nicotine delivery systems’, Tobacco Control, 23(3), 41–7.
Note: Elasticity estimates rounded to nearest 0.1 to avoid spurious precision.
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The evidence on the own-price elasticity of demand for e-cigarettes suggests that
a small increase in price could lead to a significant fall in demand. There are a
number of potential explanations for this finding:
The market for e-cigarettes is relatively immature. Consumer preferences for
e-cigarettes may not be well entrenched and so susceptible price changes.
The introduction of e-cigarettes means that smokers now have a greater
range of substitutes than before. High e-cigarette own price elasticities may
be picking up the ability to substitute to combustible tobacco, refill products,
heat not burn products, and so on. When there are more substitutes for a
product, own-price elasticities are more elastic.
The relatively low base in e-cigarette demand means that small changes in
quantity resulting from substitution from conventional tobacco products
translates into large percentage changes, which may be correlated with
movements in e-cigarette prices.
Current modelling of elasticities may not be able to fully account for other
drivers of demand which are also correlated with price (such as changes in
the quality of e-cigarettes).
The latter explanation also reflects difficulties in modelling price elasticities for e-
cigarettes given a lack of high quality data. Most of the non-experimental studies
cited in Figure 4 use a short time series of sales data from different ‘markets’
(regions or countries) and construct prices for e-cigarettes based on observed
volume and values of sales. The models estimated may not fully capture changes
in the quality of e-cigarettes, and typically do not capture online sales which, as
we saw in Chapter 2, are a significant source of e-cigarette sales.10
Ideally, estimation of e-cigarette elasticities would be based on a long time series
of data with prices varying across time and location, fully observing the market for
e-cigarettes (types of product and online/offline sales) and including similar data
for close substitutes such as combustible tobacco. This would allow a ‘demand
system’ to be estimated, consistent with economic theory.
While none of the studies cited fully achieve this, the one that comes closest
(Zheng et al, 2016) still finds that the own-price elasticity of demand for e-
cigarettes is price elastic; indeed, at –2.1 it is the most elastic of all estimates in
the literature. Their study does estimate a demand system, including combustible
tobacco, and all types of e-cigarettes including refillables. However, the data do
not account for the online market. It is not clear what impact this has on the
estimated own-price elasticity for e-cigarettes. If the estimate is partly capturing
(unobserved) substitution from retail to online purchases, then the market-level
demand for e-cigarette products would be less price sensitive. However, if retail
purchasers are less price sensitive than online purchasers (who can more readily
compare prices and switch retailers) then the market-level demand for e-
cigarettes could be more price sensitive.
10 High elasticities could also therefore reflect an unobserved substitution to online sales of e-cigarettes.
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3.4 Conclusion
Economic theory suggests that there would be a stronger case for an excise tax
on e-cigarettes if demand for them is not very sensitive to their price. While the
evidence base on this question is fairly limited, the best available evidence from
both experimental and observed data suggests that, if anything, the demand for
e-cigarettes is price sensitive. Own-price elasticities of demand for e-cigarettes
range between –1.1 and –2.1.
On this basis, there is no strong rationale for a new excise tax.
The literature does point to combustible cigarettes and e-cigarettes as being
closely substitutable. Purely from a revenue-raising perspective, therefore, an
excise tax on e-cigarettes would increase demand for combustible cigarettes
which are already highly taxed, and therefore raise additional revenue. However,
this ignores the health and addiction issues raised by encouraging current users
of e-cigarettes to switch to combustible tobacco. We turn to these in the next
Chapters.
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4 EXTERNALITIES
4.1 Introduction
In this section we set out the economic principles of externality based
consumption taxes and their potential application to e-cigarettes. On the basis of
current evidence, we find:
No clear rationale in the current market for significant excise taxes on e-
cigarettes on the basis of externalities:
□ E-cigarettes are substantially less harmful than smoking conventional
tobacco products and the evidence suggests that the vast majority of e-
cigarette users are already smokers;
□ switching to e-cigarettes reduces the harm to health for these smokers,
and reduces the associated costs to wider society.
In a world without conventional cigarettes there would be some residual case
for an externality-based tax driven by potential health harms from nicotine
intake – but the best current evidence suggests these would be much lower
than any taxes on conventional tobacco products.
4.2 The negative externality rationale for taxation
There is a longstanding literature on negative externalities as a rationale for
taxation.11 Negative externalities occur where the consumption of a good or
service leads to costs to wider society. These costs are not fully reflected in the
price of the product, and so not taken into account by individuals making private
decisions about how much of the product to consume. As a result, there is too
much consumption of these goods and services when looked at from a societal
perspective. Goods that cause environmental costs are a classic example.
Taxation can be used to adjust for this. In particular, economic theory is clear that
an optimal externality-correcting tax should be set such that the external cost to
society of consuming one more unit of the product is exactly equal to the tax on
that unit.12 Assuming the tax is reflected in the price of the product, demand will
fall to the socially desirable level.
These negative externality arguments have been increasingly given as a
rationale for taxation of conventional tobacco products over recent decades.13
There are two main types of negative externalities from smoking conventional
tobacco, both relating to health impacts:
Costs to society from the health impacts on the smoker: these relate to
publicly funded healthcare costs of treating smokers for the harm caused by
11 The economic theory discussed here was first set out in Pigou (1962). Such taxes are often referred to as a
‘Pigouvian tax’. 12
This is what economists mean by taxes set at the marginal external cost. This is not the same as saying that the total revenue raised from the tax should be equal to the total social harms done by the product in question. An optimal externality-correcting tax could raise more, or less, than the social harms.
13 See, for example, Chaloupka and Warner (2000), ‘The economics of smoking’; and, for a summary of the
evidence on the magnitude negative externalities, see Crawford et al (2010), ‘Value added tax and excises’.
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their own smoking (note that this is separate from the costs to the smokers
themselves, which we discuss in Chapter 5).
Costs resulting from the health impacts on others: these relate to the
costs from passive smoking, both in terms of the individual costs to passive
smokers and the costs relating to public funding of their healthcare.
An optimal tax would therefore be set equal to the marginal increase in these
costs from smoking an additional unit of tobacco.
4.3 Negative externalities and e-cigarettes
We now consider the extent to which the negative externalities rationale outlined
above applies to taxation of e-cigarettes. This depends upon: the health impacts
for e-cigarette users, the health impacts for bystanders from passive inhalation,
and interactions with the use of conventional tobacco products.
4.3.1 Health impacts for e-cigarette users
There is a growing literature assessing the potential health impacts from the use
of e-cigarettes. The evidence base is not as mature as that for conventional
tobacco products, particularly in terms of any long-term impacts from nicotine
exposure. Nonetheless, the current evidence base points to e-cigarettes being
substantially less harmful than conventional tobacco products.
Public Health England (PHE) have commissioned three expert reviews on the
health impacts of e-cigarettes. The latest review, in 201514, updates and expands
on the evidence from the previous reviews. The review concludes that a
reasonable estimate is that e-cigarettes are around 95% safer than smoking. This
estimate draws principally on Nutt et al (2014)15, which used an international
expert panel to estimate the relative harm of e-cigarettes.
Subsequent UK publications have been consistent with these findings. In 2016,
PHE published a joint statement on e-cigarettes with 12 leading UK public health
organisations. This concludes that,
“All the evidence suggests that the health risks posed by e-cigarettes are
relatively small by comparison [with conventional cigarettes] but we must
continue to study the long-term effects”.16
West et al (2015)17 provides a review of e-cigarette evidence presented to the UK
All Party Parliamentary Group on Smoking and Health. This also finds that e-
cigarettes are much less harmful than smoking, but not 100% safe.
14 McNeill, Brose, Calder, Hitchman, Hajek and McRobbie (2015), E-cigarettes: an evidence update. A report
commissioned by Public Health England’ 15
Nutt, Phillips, Balfour, Curran, Dockrell, Foulds, Fagerstrom, Letlape, Milton, Polosa, Ramsey, Sweanor (2014), ‘Estimating the harms of nicotine-containing products using the MCDA approach’
16 PHE (2016), ‘E-cigarettes: a developing public health consensus’. The organisations on the joint statement
are: Public Health England, Action on Smoking and Health, Association of Directors of Public Health, British Lung Foundation, Cancer Research UK, Faculty of Public Health, Fresh North East, Healthier Futures, Public Health Action, Royal College of Physicians, Royal Society for Public Health, UK Centre for Tobacco and Alcohol Studies, and UK Health Forum.
17 West, Hajek, McNeill, Brown, and Arnott (2015) ‘Electronic cigarettes: what we know so far. A report to UK
All Party Parliamentary Groups.’
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Glasser et al (2017)18 provides a systematic review of evidence on e-cigarettes.
The review included 687 articles, with the majority assessing patterns of e-
cigarette use and consumer perceptions, followed by studies examining health
effects and product features. The authors find that the evidence suggests e-
cigarettes pose substantially less harm to smokers than cigarettes, while further
research is needed to assess long-term health effects.
Shahab et al (2017)19 provide an assessment of the nicotine, carcinogen and
toxin exposure in long-term e-cigarette users relative to nicotine replacement
therapies and conventional cigarettes. The authors find that e-cigarette only
users, and nicotine replacement therapy only users, obtain roughly similar levels
of nicotine compared with smokers of conventional cigarettes. Long-term e-
cigarette only use is associated with substantially reduced levels of measured
carcinogens and toxins relative to smoking. NNAL levels20 in e-cigarette only
users were significantly lower than all other groups studied, with levels reduced
by 97% compared to smoking. E-cigarette only users also had significantly lower
levels of all major metabolites of selected toxic and carcinogenic volatile organic
compounds than smokers. However, dual users of conventional cigarettes with e-
cigarettes or nicotine replacement therapies had largely comparable results to
users of conventional cigarettes only. The results suggest fully replacing
conventional cigarette use with e-cigarettes may reduce health risks significantly.
Some studies have suggested risks for specific sub-groups from nicotine
exposure. The World Health Organisation (WHO) (2014) examines emerging
evidence on the health impacts of e-cigarettes. The report identifies specific risks
for children, adolescents and pregnant women, because of a potential for foetal
and adolescent nicotine exposure to have long-term consequences for brain
development. Similarly, England et al (2015)21 finds evidence of risks from
nicotine exposure for foetal brain and lung development, and altered
development of cerebral cortex and hippocampus in adolescents.
Overall the evidence in the current literature suggests e-cigarettes are
substantially less harmful to users than smoking conventional tobacco products.
Potential risks are identified for specific groups, or from long-term effects from
nicotine exposure, but further research is needed to understand the extent of any
risks to health. The literature has not so far tied e-cigarette use to public costs of
health service provision, but the low health risks of e-cigarettes and (as
discussed below) the fact that e-cigarettes substitute for consumption of
combustible tobacco suggests that the public health costs at present are likely to
be negative, as a result of discouraged consumption of tobacco products.
18 Glasser, Collins, Pearson, Abudayyeh, Niaura, Abrams and Villanti (2017), ‘Overview of Electronic Nicotine
Delivery Systems: A Systematic Review’ 19
Shahab, Goniewicz, Blount, Brown, McNeil, Udeni Alwis, Feng, Wang and West (2017), ‘Nicotine, Carcinogen, and Toxin Exposure in Long-Term E-Cigarette and Nicotine Replacement Therapy Users: a cross-sectional study’
20 The carcinogenic metabolite 4-(methylnitrosamino)-1-(3-pyridyl)-1-butanol.
21 England, Bunnell, Pechacek, Tong and McAfee(2015), ‘Nicotine and the Developing Human: A Neglected
Element in the Electronic Cigarette Debate’
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4.3.2 Health impacts from passive use of e-cigarettes
There have been a number of recent studies into the potential for e-cigarettes to
cause social costs through passive ‘smoking’. The evidence is limited. Most
studies suggest that the release of nicotine and other chemicals into
surroundings is low; some nonetheless identify potential health risks, but the risks
appear small compared to passive smoking of conventional tobacco products.
Long (2014)22 examined the composition of exhaled air from the use of two
leading e-cigarette brands in the United States. The composition was found to be
over 99.9% water and glycerine, and less than 0.06% nicotine. Bertholon et al
(2013)23 estimated the ‘half-life’ of particles exhaled by users at 11 seconds from
e-cigarettes, compared to 19-20 minutes from tobacco smoke.
Maloney et al (2016)24 outlined results from two studies to measure indoor air
concentrations of chemicals from e-cigarettes. A validated industrial hygiene
sampling methodology was used to test concentrations of nicotine, menthol,
propylene, glycol, clycerol, formaldehyde and total particles. The studies found
that the use of e-cigarettes does not produce chemical constituents at
quantifiable levels.
As outlined in Section 4.3.2 above, Shahab et al (2017) assesses the nicotine,
carcinogen and toxin exposure in long-term e-cigarette users. The authors find
that those switching entirely from conventional cigarettes to e-cigarettes have
substantially reduced levels of measured carcinogens and toxins relative to
smoking. This suggests any related risks from passive intake of e-cigarettes may
also be much lower than conventional cigarettes.
Two recent systematic reviews of the literature have reached slightly different
conclusions on the potential health risks. Hess et al (2016) undertakes a
systematic review of the literature on passive use of e-cigarettes, identifying 16
relevant studies (including Long (2014) above). Limitations were identified in all
of the studies, such as a focus only on short-term effects, issues translating
animal studies to humans, and very small sample sizes. The authors conclude
that current evidence shows the potential for health impacts from passive
exposure to vapours from e-cigarettes, but that the risk is likely to be lower than
from conventional cigarettes. McNeill et al (2015) undertakes a review identifying
25 studies regarding nicotine content of ambient air, e-liquid and vapour. The
authors conclude that e-cigarettes release negligible levels of nicotine into
ambient air and that there are no identified health risks to bystanders.
Overall the evidence in the literature suggests that health risks from the passive
use of e-cigarettes are significantly lower than passive smoking of conventional
tobacco products. There are mixed findings on the extent of the remaining risk,
reflecting limitations in the current evidence base.
22 Long (2014), ‘Comparison of Select Analytes in Exhaled Aerosol from E-Cigarettes with Exhaled Smoke
from a Conventional Cigarette and Exhaled Breaths’ 23
Bertholon, Becquemin, Roy M, Roy F, Ledur, Annesi Maesano and Dautzenberg (2013), ‘Comparison of the aerosol produced by electronic cigarettes with conventional cigarettes and the shisha’
24 Maloney, Thompson, Oldham, Stiff, Lilly, Patskan, Shafer and Sarkar (2016), ‘Insights from two industrial
hygiene pilot e-cigarette passive vaping studies’
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4.3.3 Prevalence of e-cigarettes
The overall health impacts of e-cigarettes can only be understood when
considering their place in the market alongside conventional tobacco products.
The impacts depend critically on the extent to which e-cigarette use is the result
of switching away from conventional tobacco products, or take-up by those that
did not previously smoke.
European survey data on ‘current use’ shows low prevalence throughout Europe
in 2014, as show in Figure 5 below.25 Average prevalence is 2% across the EU,
with the highest being 4% in the UK and France, and the lowest being 0%,
reported in Hungary, Romania, Slovenia and Sweden.
Figure 5 Prevalence of e-cigarette users in EU countries 2014 (%)
Source: Eurobarometer 2014 data
Using the same dataset, Filippidis et al (2016)26 estimate changes in e-cigarette
use in EU countries from 2012 to 2014. Prevalence of ever having used e-
cigarettes across 27 EU member states is found to have increased from 7.2% in
2012 to 11.6% in 2014. However, only around 1 in 7 ‘ever users’ describe
themselves as ‘current users’. Current smokers are found to be around 23 times
more likely to have ever used e-cigarettes than those who have never smoked,
and former smokers are around 7 times more likely.
ASH (2016a)27 outlines recent survey evidence on e-cigarette use in Great
Britain. Among adults, 51% of e-cigarette users are found to be current smokers
and 47% are ex-smokers. E-cigarette use by those who have never smoked is
found to be very rare, and has been stable since 2012. Evidence for e-cigarette
25 European Commission (2015), ‘Attitudes of Europeans towards tobacco and electronic cigarettes’
26 Filippidis, Anthony, Laverty, Vasiliki, Gerovasili, Constantine and Vardavas (2016), ‘Two-year trends and
predictors of e-cigarette use in 27 European Union member states’ 27
ASH (2016), ‘Use of electronic cigarettes (vapourisers) among adults in Great Britain’
0.0
0.5
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use among children gives similar results. ASH (2016b)28 surveys use of e-
cigarettes among 11-18 year olds. Use is again almost exclusively among current
or ex-smokers. Just 4% of never smokers are found to have ever tried e-
cigarettes, and 0% use them once a month or above. This compares to 38% of
current smokers and 28% of ex-smokers who have tried e-cigarettes.
A review of international evidence on e-cigarette use is provided in McNeill et al
(2015). Current use of e-cigarettes is found to be associated with being a smoker
or ex-smoker, similar to findings for the UK. However, McNeill et al (2015) notes
a number of difficulties in making international comparisons, notably
inconsistencies around terminology and measures. The authors highlight this as
an area in need of further research.
The evidence shows that the vast majority of e-cigarette use is from current or
former smokers, while use among those that have never smoked is relatively
rare. This is the case both for adults and children.
4.4 Conclusion
The available evidence suggests there is not a clear externalities rationale for
taxing e-cigarettes in the current market.
We have found that e-cigarettes are substantially less harmful than conventional
tobacco products. The evidence suggests this is the case both for users of e-
cigarettes and passive intake. It is possible that a residual risk to health remains
for both groups, but evidence on the scale of this risk is an area in need of
additional research.
To the extent that there is a residual health risk from e-cigarettes, this could in
theory provide a rationale for a tax if considering the e-cigarette market in a world
without conventional tobacco products. The optimal level for such a tax would
need to be proportionate to the social costs, which is very difficult to determine
precisely on the basis of the current evidence. However, it would be a much
lower rate than the equivalent optimal tax rate on conventional cigarettes.
More importantly, the e-cigarette market does not operate in isolation. It is
essential to take into account interactions between e-cigarette use and
conventional tobacco smoking to determine the marginal impact of e-cigarette
use. The evidence shows that the vast majority of e-cigarette use is from current
or former smokers. E-cigarettes reduce the health risks for these individuals and
for passive smokers, and therefore reduce the social costs. Meanwhile, take-up
of e-cigarettes by those that have never smoked is relatively rare. This suggests
there may be positive externalities from e-cigarettes as a substitute for
conventional tobacco.
This conclusion could change in a future world in which consumption of
conventional cigarettes is relatively low and the market is dominated by e-
cigarettes or other nicotine delivery services. In that world, an externality-
correcting excise tax at a rate commensurate with the marginal external costs
would be more strongly justified.
28 ASH (2016), Use of electronic cigarettes (vapourisers) among children in Great Britain’
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5 INTERNALITIES
5.1 Introduction
In this section we outline the economic principles around ‘internality’ effects, and
their potential application as a rationale for taxation of e-cigarettes. Negative
internalities relate to inconsistencies between a consumer’s long-term wellbeing
and the decisions they make in the short-term. These are especially relevant to
addictive products.
We find that:
whilst in principle this argument could be applied to e-cigarettes (given the
addictive nature of nicotine), there is not a clear rationale for excise taxation in
the current market because of the role that they play in reducing consumption
of conventional tobacco products;
consumers tend to overestimate the relevant health risks of e-cigarettes
compared with tobacco;
low current take-up of e-cigarettes among non-smokers suggests any
internality from addiction to e-cigarettes for this group are currently very
limited, though the evidence base here is limited; and
an excise tax would be a blunt instrument compared with effective information
provision and regulation to ensure people make informed decisions about
using e-cigarettes.
5.2 The rationale for taxing goods that have internalities
The rationale for taxation on the basis of internality effects is very similar to that
of externalities. Indeed, internalities are sometimes defined as “externalities to a
future self” – the idea being that rather than consumption of a product causing
costs to other people, it causes a cost to the individual consuming it by going
against what he or she “truly” wants to do.
The internality argument builds on a growing literature influenced by behavioural
economics that demonstrates so-called ‘time inconsistencies’ in consumer
decision-making.29 The basic insight is that, for some products, consumers have
a ‘rational’ side that understands that consumption could be harmful, but a short-
term side that craves it. These different ‘selves’ can conflict. For example, if you
ask someone on a diet in the morning whether they plan to eat fatty food for
dinner in a restaurant, they may say no; but then when choosing from the menu
they succumb to the temptation to pick the fatty dish – which they may then later
regret. In such cases, a consumer’s long-term wellbeing can sometimes be
enhanced by influencing or restricting their choices in the short-term: for
example, not going to a restaurant with unhealthy options on the menu.
29 For a review, see Frederick, S., G. Loewenstein and T. O’Donoghue (2002), ‘Time discounting and time
preference: a critical review’, Journal of Economic Literature, 40(2), 351–401.
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Internalities have been given as an additional rationale for taxes on conventional
tobacco products. This reflects that consumers may underestimate the future
harm to their health at the point of deciding to smoke a cigarette; or addiction
may mean that they continue to smoke despite wanting to quit. Gruber and
Koszegi (2004)30 develop a model accounting for time-inconsistency in cigarette
consumption. They find taxation can provide a ‘self-control’ function valued by
consumers who would like to quit but cannot. Mullainathan and Gruber (2005)31
assess empirical evidence with subjective well-being data in the US and Canada.
Cigarette taxes are found to improve the subjective wellbeing of those with a
propensity to smoke. Leicester and Levell (2016)32 repeat this finding with British
data, finding a positive impact of cigarette taxes on the wellbeing of those with a
high propensity to smoke, but no impact of other tobacco control policies such as
bans on smoking in public places.
Internalities may give a stronger economic rationale for traditional ‘paternalistic’
reasons for excise taxation: where it is believed that public authorities are better
informed about the harms associated with consuming particular goods and
services than individuals, and so wish to deter their consumption even if there is
no externality. While a theoretical case has been made for an ‘internality’ tax on
cigarettes, it is hard in practice to estimate what the ‘optimal’ tax would be.33
There are also no concrete examples of ‘internalities’ having been used to justify
the introduction of a new excise, or increases in existing excise duties.
5.3 Are there internalities from e-cigarettes?
We now consider whether the internalities rationale for taxation applies to e-
cigarettes. Such a tax would be motivated by:
the addictive nature of nicotine, and;
any future health risks that users of e-cigarettes overlook.
Given our findings that e-cigarettes are substantially less harmful to users than
conventional tobacco products, the internalities rationale depends critically on
interactions between the e-cigarette and tobacco markets. We explore this below
through evidence on motivations for e-cigarette use, and take-up among non-
smokers. This gives us an understanding of whether those starting to use e-
cigarettes fully understand the addictive nature of nicotine.
5.3.1 Motivations for e-cigarette use
We have seen that the vast majority of e-cigarette users are current or ex-
smokers. Any potential internalities effects will therefore be strongly influenced by
interactions between e-cigarette use and smoking.
Stopping or recuing smoking is an important motivation for people using e-
cigarettes. European survey data for 2014 shows 67% of respondents listed
30 Gruber and Koszegi (2004), ‘Tax incidence when individuals are time-inconsistent: the case of cigarette
excise taxes’ 31
Mullainathan and Gruber (2005), ‘Do Cigarette Taxes Make Smokers Happier?’ 32
Leicester and Levell (2016) ‘Anti-smoking policies and smoker well-being: evidence from Britain’ 33
Marron (2015), ‘Should we tax internalities like externalities?’
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stopping or reducing smoking as an important reason for starting to use e-
cigarettes.34 This compares to 44% motivated by using e-cigarettes in places
where tobacco smoking is not allowed and 24% who considered them attractive,
cool or fashionable. Filippidis et al (2016)35 provides analysis of the motivations
for e-cigarette use in the European survey data for 2012 and 2014. The authors
find that those using e-cigarettes as a cessation aid were much more likely to
become ‘current users’, whereas those who tried e-cigarettes because they
considered it attractive were not more likely to become ‘current users’.
There is evidence that e-cigarettes help some, but not all, users to reduce or stop
smoking. The European survey data shows 14% of e-cigarette users stopped
smoking entirely and 21% reduced their smoking but did not stop (Figure 6). 36
Figure 6 Success in smoking reduction or quitting for e-cigarette users in EU 2014
Source: Eurobarometer 2014 data
West et al (2017)37 provides survey evidence of e-cigarette use in England. E-
cigarettes are now the most popular quitting aid in England. The latest data from
2016 finds that e-cigarettes are used by over 40% of smokers trying to stop in
their most recent quitting attempt. Ash (2016a) assesses the reasons why people
use e-cigarettes in Britain. The top reason for ex-smokers use of e-cigarettes is
“to help me stop smoking entirely” (67%) and for current smokers it is “to help me
reduce the amount of tobacco I smoke, but not stop completely” (41%). Saving
money compared with tobacco is also among the top three reasons for both
34 European Commission (2015), ‘Attitudes of Europeans towards tobacco and electronic cigarettes’
35 Filippidis et al (2016), ‘Two-year trends and predictors of e-cigarette use in 27 European Union member
states’ 36
European Commission (2015), ‘Attitudes of Europeans towards tobacco and electronic cigarettes’ 37
West, Beard and Brown (2017), ‘Trends in electronic cigarette use in England’
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
stopped smokingcompletely
stopped for awhile but started
again
reduced but didnot stop
did not reduce atall
increased don't know
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groups.38 This again suggests e-cigarettes have a potentially important role in
reducing use of conventional tobacco products.
McNeil et al (2015) review the literature on the effectiveness of e-cigarettes as a
quitting and reduction aid. A number of random-control trials are assessed as
well as evidence from UK and international population studies. The authors find
evidence that e-cigarettes can help people to quit and reduce their cigarette
consumption.
While the majority of e-cigarette users are current or former smokers, and so
presumably aware of the addiction issues around nicotine consumption, there
may be an internality-based rationale for excise taxes on e-cigarettes if those
using them underestimate the health or addiction risks of e-cigarettes relative to
conventional tobacco products. However, if anything the evidence points the
other way. Ash (2016a) find that only 15% of surveyed adults in Britain correctly
identified e-cigarettes as a lot less harmful than smoking, down from 21% in
2013. Tan and Bigman (2014)39 find a similar trend in US data, with the
proportion of current smokers believing that e-cigarettes are less harmful than
smoking declining between 2010 and 2013.
Evidence on motivations for e-cigarette use does not appear consistent with the
internalities argument. Those using e-cigarettes appear to be primarily motivated
by a desire to reduce or stop smoking conventional cigarettes. There is also a
recent growing trend of consumers tending to overestimate the health risks of e-
cigarettes compared to smoking.
5.3.2 Use of e-cigarettes by non-smokers
Whilst most e-cigarette users are current or former smokers, take-up by those
that have never smoked could potentially lead to internality effects if there are
future risks to health for these individuals. This could result from non-smokers
becoming addicted to e-cigarettes, and the costs would be highest if e-cigarettes
provide a ‘gateway’ into smoking.
European survey data for 2014 shows which products individuals use first (Figure
7).40 Boxed cigarettes are by far the most frequent product smoked first (83%),
followed by hand-rolled (6%) and water-pipe (5%); e-cigarettes are essentially
never the first product used. Whilst this will be influenced by the relatively recent
availability of e-cigarettes, there is no evidence to date of a gateway effect from
e-cigarettes to tobacco products in the data.
38 This is consistent with the findings in Section Error! Reference source not found. that consumers see e-
igarettes and conventional tobacco as substitutes, and their relative prices influence consumer choices between them.
39 Tan and Bigman (2014), ‘E-Cigarette Awareness and Perceived Harmfulness: Prevalence and Associations
with Smoking-Cessation’ 40
European Commission (2015), ‘Attitudes of Europeans towards tobacco and electronic cigarettes’
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Figure 7 Tobacco-related products first tried, EU, 2014
Source: Eurobarometer 2014 data.
Note: the remaining 3% were listed as “other (spontaneous)” and “don’t know”.
McNeil et al (2015) highlight flaws and misconceptions in the gateway argument,
suggesting that the terminology is abandoned until there is clarity over how it
could be tested. WHO (2014) review international studies on e-cigarette use
among adolescents. They find rapid increases in experimentation among
adolescents, but there are very few e-cigarette users who have never smoked
(mostly around 1% of the population). Friedman (2015) studies the causal
impacts of e-cigarette access for adolescents based on variations in policies
between US states. It is found that recent smoking is higher in states with bans
on e-cigarettes. Friedman concludes that this result is consistent with e-cigarette
access reducing smoking in adolescents.
Overall, e-cigarette use is rare among non-smokers and there does not appear to
be any evidence to date of a gateway effect into smoking. Whilst there could be a
potential internalities rationale for taxation to deter uptake up-take of e-cigarettes
by non-smokers in the future, this would be a poorly targeted measure in the
current market where the majority of use is by current or former smokers.
5.4 Conclusion
As with externalities, in theory there could be an internalities rationale for taxation
of e-cigarettes in a world without conventional tobacco products. Such a tax
would be based on the future costs that are overlooked when an individual
decides to use e-cigarettes, in particular if consumers are not fully aware of the
health or addiction risks from consuming them. However, there is little evidence
on the scale of any such internality.
83%
6% 5%
1% 1% 1% 0% 0% 0% 0%
Boxedcigarettes
Hand-rolledcigarettes
Water pipe Pipe Oraltobacco
Cigars Cigarilos Nasal snuff Chewingtobacco
Total e-cigarettes
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In reality, the vast majority of e-cigarette consumption is from current or ex-
smokers. The evidence suggests that motivations for e-cigarette use are driven
primarily by a desire to quit or reduce smoking of conventional tobacco products.
E-cigarettes are now the most popular quitting aid in England. These interactions
with smoking are very important, as e-cigarettes would likely reduce future costs
where they help users to reduce or quite smoking. Consumers also tend to
overestimate the relative health risks of e-cigarettes, making it less likely that any
future costs are overlooked. Both points suggest that most current users of e-
cigarettes are not underestimating the risks associated with their use, and so do
not point to a compelling internality-based rationale for an excise tax.
The potential for uptake of e-cigarettes non-smokers could be an area of
particular relevance if those that would not otherwise have smoked become
addicted to e-cigarettes. However, e-cigarette use is rare among non-smokers
and there does not appear to be any evidence to date of a gateway effect into
smoking. Even if there are future concerns about whether non-smokers are
making fully-informed decisions about whether to start and continue using e-
cigarettes, this need not imply that a new excise tax is the ideal policy response,
since it would also affect other users for whom there are benefits from switching
to e-cigarettes from conventional smoking. Better provision of information and
regulation of advertising would be more sensible interventions.
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6 ADMINISTRATION AND COMPLIANCE
6.1 Introduction
Chapters 3, 4 and 5 have focused on the ‘efficiency’ costs of excise taxes: aiming
to minimise or correct distortions to ensure that the tax system is as effective as
possible. There are, however, other costs associated with taxation:
Administration costs to public authorities to design the tax and put
processes in place to collect it, including enforcing the tax rules; and
Compliance costs for those who have to remit taxes to the authorities.
These costs can largely be thought of in monetary terms, but (particularly for
compliance and enforcement) there can also be significant opportunity costs for
those involved – time spent enforcing tax rules or complying with legal tax
obligations could perhaps be put to more productive use.
All else equal, taxes which generate lower administration and compliance costs
are clearly preferable: they leave more net revenue to spend, and cause less
financial and hassle costs to people remitting taxes. Where the potential yield
from a tax is low, issues around administration and compliance become more
acute. There is a degree of ‘economies of scale’ in tax compliance: there are
some fixed costs of setting up a structure to administer and comply with a new
tax. For very low yield taxes, there may be a risk that administration and
compliance costs could even exceed tax revenues.
A recent analysis of these issues in tax design highlighted a number of factors
which could be associated with lower administration and compliance costs for
excise duties:41
the tax is simple – with few rates, exemptions and ‘borderlines’ of what is
taxable, meaning reporting requirements are relatively straightforward and the
potential for legal dispute is minimised (this has been highlighted as the key
cost relating to excise duties on tobacco in the EU)42;
the tax is stable and ‘future-proofed’ – the scope of the tax is not subject to
frequent change meaning that authorities must alter collection processes and
those remitting the tax their compliance processes;
there are a small number of large remitters of the tax, given likely
economies of scale in tax compliance;
the product being taxed is fairly immobile – that is, it is hard to separate
where the product is taxed from where it is consumed.
41 Shaw, J., J. Slemrod and J. Whiting (2010), ‘Administration and compliance’, in J. Mirrlees et al., Dimensions
of Tax Design, Oxford: Oxford University Press (https://www.ifs.org.uk/uploads/mirrleesreview/dimensions/ch12.pdf)
42 Pedersen, H. et al (2012), Study on the measuring and reducing of administrative costs for economic
operators and tax authorities and obtaining in parallel a higher level of compliance and security in imposing excise duties on tobacco products, report for TAXUD prepared by Ramboll, The Evaluation Partnership and Europe Economics (http://publications.europa.eu/en/publication-detail/-/publication/a5d22256-3d16-4c7f-bb9e-3209447e517e/language-en)
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We assess each of these points in terms of a potential excise duty on e-
cigarettes to come to a view on the likely scale of administration and compliance
costs and the potential revenue yield.
6.2 Application to the e-cigarette market
6.2.1 The scale of potential revenues
The revenue available from any new excise tax on e-cigarettes will clearly
depend on the specific design and rates. However, whatever the design, the
scale of revenues is likely to be small given the current market size, and certainly
much lower than the revenues from excise on traditional tobacco products.
As shown in Chapter 2, in 2015, e-cigarette sales in the EU were around €2.8
billion, compared with (licit) sales of traditional cigarettes of €125.1 billion.
Estimates of the total EU-wide yield from excise taxes on traditional tobacco
products were some €83.6 billion that year.
EC Directive 2011/64/EU stipulates that at least 60% of the average retail selling
price for cigarettes must come from excise duty. Assuming that an excise were
levied on e-cigarettes at half this level (reflecting a view that they are less harmful
than traditional tobacco products) and fully passed through to prices, even
without any impact on e-cigarette demand the revenue from e-cigarette duty
would be only around €0.8 billion. Given our estimates from Chapter 2 that the
own-price elasticity of demand for e-cigarettes is fairly high (between –1.1 and –
2.1), we would also expect a 30% increase in retail prices to see a very large fall
in e-cigarette demand (between –33% and –63%), suggesting that overall
revenues after behavioural response could be as little as €0.3 billion to €0.6
billion from a new e-cigarette excise duty. This would be something between
0.4% and 0.7% of the revenue from traditional cigarettes.
Given the very low current potential yield, administration and compliance issues
would need to be very seriously considered to ensure that the net impact on
exchequer revenues was not, in fact, negative.
6.2.2 Simplicity and stability
The way that any new excise tax on e-cigarette was implemented would clearly
determine how simple the tax was to administer and comply with. Decisions
around what was taxed (the tax base), whether there were multiple rates and
exemptions and so on would have to be taken at the tax design phase.
There is a clear link between issues of simplicity of any excise tax on e-cigarettes
and the need for the tax to be ‘future proofed’ against future innovation in the
market. When the market is dynamic and the nature of products changes rapidly,
it is much harder to design a simple system that encompasses current and future
products without needing to be rewritten regularly. A new excise tax designed in
2012, for example, may have been a unit tax on ‘cig-a-likes’ but would rapidly
have been rendered inadequate by the arrival of refillable e-liquid tanks with the
tax rules having to be rewritten to determine how to accommodate them,
generating additional compliance and administration costs. This compares with
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conventional cigarettes – while there has been innovation in their design, the
core product as a taxable unit (the ‘stick’) has essentially been unchanged for a
long period. It could also be challenging to define the tax base for e-cigarettes in
a way that distinguishes them sufficiently from nicotine reduction therapies, with a
potential ‘grey area’ between nicotine products that are taxed and those that are
promoted by health authorities as quitting aids for smokers.
This suggests that for a nascent, continually-evolving product like e-cigarettes it
would be somewhat more challenging to devise a simple, stable tax regime that
would be easy to administer and comply with. This could change as the market
for e-cigarettes matures and consolidates in future years.
6.2.3 Market fragmentation
Excise duties are formally levied on manufacturers and importers of the products
being taxed, rather than on end consumers (though in practice the tax is passed
on in whole or in part to consumer prices).43 This reduces the number of people
who have to comply with the tax.
Figure 8 Market share of top four refill liquid brands, by market, 2015
Source: Euromonitor estimates
For tobacco excises, the number of companies remitting the tax in Europe is
relatively low. There are four major companies with a combined market share in
excess of 90% for combustible cigarettes (Philip Morris International, JTI,
Imperial Tobacco and British American Tobacco). The EU market for combustible
cigarettes has become more concentrated over time, with the market share for
these four companies rising from more than 60% to more than 90% since 2001.
43 In the UK, the tax authority (HM Revenue and Customs) assumes one-to-one pass through of excise taxes to
consumer prices for tobacco products in determining the impact of tax reform on demand. Much of the empirical literature has found one-to-one pass through or close to this (DeCicca et al., 2010; Espinosa and Evans, 2012; Pesko et al., 2013), sometimes with variation by product type (Xu et al, 2014; Chiou and Muehlegger, 2014).
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For other traditional tobacco products, the market is still relatively concentrated
among the four leading firms, though somewhat less than for cigarettes (around
70% for hand-rolling tobacco, and 40% for cigars).44
For e-cigarettes, the situation is somewhat different. The market is dominated by
distributors rather than producers and many more small companies. Estimates for
2015 for the market share of the top four brands of refillable liquids (only a subset
of the overall e-cigarette market) in key EU markets range between 21% and
70% (see Figure 8), with a large number of smaller brands. This suggests there
would be many more taxpayers in the current market for a new e-cigarette
excise, potentially increasing administration and compliance costs. This could
change with market consolidation and maturity, but it seems clear that the costs
involved for a new excise on e-cigarettes would be somewhat larger than costs
for duties on tobacco products.
6.2.4 Mobility
A significant cost of administration and compliance for excise duties relates to
dealing with fraud and evasion. The UK government estimates that in 2015-16,
for example, around £2.4 billion of expected tobacco duty was lost to ‘illicit’
tobacco products where the duty was not paid.45 Smuggled and illegal dutiable
products also bring social costs associated with crime. Although regular
estimates of the costs incurred by tax authorities to deal with this are not
published, estimates suggest that in 2011-12, for example, the UK government
spent almost £69 million on its strategy to reduce tobacco smuggling.46
One driver of these costs is the ease with which consumers can purchase
products from locations where duty is not levied and those can enter the country
without having duty added. For e-cigarettes, where the market is fragmented and
products are regularly sold online, the costs of imposing and enforcing an excise
duty could be very large. Evidence from IFF Research (2016) for HMRC in the
UK suggests that among those who buy e-cigarettes, around 38% of users make
most or all of their purchases online, compared with around 59% who buy most
or all in retail outlets (and 3% using both equally).47 An excise duty on e-
cigarettes could lead consumers to switch online purchases to non-taxed
jurisdictions, and costly enforcement mechanisms would need to be put in place
to ensure that these were subject to duty at the point of import.
6.3 Conclusions
Relative to conventional tobacco, the fragmented and mobile nature of the e-
cigarette market suggests that the administration and compliance costs of an
excise duty would be large, both in terms of the number of taxpayers being larger
and the potential ease with which consumers could purchase from other, non-
44 Matrix Insight (2013), Economic analysis of the EU market of tobacco, nicotine and related products,
Executive Agency for Health and Consumers (http://ec.europa.eu/health//sites/health/files/tobacco/docs/tobacco_matrix_report_eu_market_en.pdf)
45 See https://www.gov.uk/government/statistics/tobacco-tax-gap-estimates.
46 See p.8 of https://www.publications.parliament.uk/pa/cm201415/cmselect/cmhaff/200/200.pdf.
47 IFF Research (2016), Understanding the online e-cigarette market
(https://www.gov.uk/government/publications/understanding-the-online-e-cigarette-market)
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taxed jurisdictions. Given the relatively small potential revenue from a new e-
cigarette excise at present, these costs could be significant.
As the e-cigarette market matures and consolidates, it is likely that there will be
fewer market actors and greater scope to more easily co-ordinate tax approaches
across physical and electronic borders. These could reduce the administration
costs associated with a new excise duty.
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