In Defence of Liberty

A Libertarian Conservative's Perspective

OfSmoke

Researchers of the University of Bath have proposed a price capping system for tobacco companies, enforced by taxation. Professor Anna Gilmore and Dr Robert Branston have authored a paper, entitled The Case for Ofsmoke: the potential for price cap regulation of tobacco to raise £500m per year in the UK, which has received widespread media coverage.

The proposal is for the creation of a new regulator, dubbed OfSmoke, which would have two functions: institute RPI-X price-cap regulation and determine the maximum profitability rates of the regulated companies; funded by a charge on all tobacco companies. This would mean tobacco companies would only be able to “charge a price high enough to cover their legitimate costs and still make a small rate of return”. Prices would only be able to increase by RPI minus X, where RPI is the Retail Price Index and ‘X’ is the expected efficiency savings. The OfSmoke regulator would determine the “appropriate level of profitability”, defined as the adjusted operating profits as a percentage of net revenue in the UK. For example, Imperial Tobacco had net UK revenue of £911m in 2010, whilst its adjusted operating profits for that year were £614m, so its profit margin was 67%. When the tobacco companies step over OfSmoke’s “appropriate level of profitability”, OfSmoke will deem their profits ‘excessive’, and the government is then empowered to confiscate all profits over this limit. Such a tax would be similar in form and favour to former Chancellor Gordon Brown’s windfall tax on utilities in 1997, but Professor Gilmore and Dr Branston believe their proposed tax could be extracted annually.

Are tobacco manufacturers making 'excess' profits? (Photo thanks to bsterling: found here: http://www.flickr.com/photos/bsterling/4882548436/sizes/l/in/photostream/)

Are tobacco manufacturers making ‘excess’ profits? (Photo thanks to bsterling: found here: http://www.flickr.com/photos/bsterling/4882548436/sizes/l/in/photostream/)

‘Massive Profits’ and ‘Extreme Profitability’

Dr Branston, Deputy Direction of the University of Bath’s Centre for Governance and Regulation, said:

A handful of companies dominate the market and cream off massive profits. With such a deadly product, competition isn’t attractive, so we’ve identified regulation as an attractive alternative that stands to benefit government and public health. The market has failed to curb cigarette manufacturers in terms of pricing power and profit, and tobacco control policies have unintentionally exacerbated the problem. Clamping down on the extreme profitability of cigarettes would reduce the incentive for tobacco companies to fight public health measures and mean they have fewer funds at their disposal.

The paper claims numerous benefits, including that the expected £500m tax revenue would fund, twice over, the current operations against tobacco smuggling across the UK and smoking cessation services in England. The authors claim that the new regulation would put tobacco companies under close scrutiny, and would curb smokers from switching to cheaper products, as price differentials would be based on production costs.

Dr Branston does acknowledge that the current regulation of tobacco companies, including the complete ban on advertising, has the unintended consequence of restraining competition between present companies, whilst erecting a massive barrier to new tobacco manufacturers. Whilst much furore surrounds the estimated extra tax revenue, £500m, it would only fund present UK government annual spending for about 6 hours and 19 minutes. Professor Gilmore made the argument that:

If it came to a choice between increasing income tax or capping excess profits of companies whose products kill one in two users, I could hazard a guess which one the public would prefer.

Income tax revenues are about £153.3bn, so £500m, that is £0.5bn, really represents a rounding error on our current income tax receipts. Tobacco duty alone raises £9.5bn for the Exchequer; enough to fund the paper’s highlighted expenditures of approximately £250m for smoker cessation and against tobacco smuggling 38 times over. This figure excludes the present corporation tax that tobacco companies already submit to the Treasury. To utilise Dr Branston’s phrase, the “extreme profitability of cigarettes” should mean the amount of corporation tax mined from tobacco companies would be quite high.

Would placing tobacco makers under a single regulator like Ofcom or OfGem be a good idea? (Photo thanks to 38 Degrees, found here: http://www.flickr.com/photos/38degrees/5189561252/sizes/l/in/photostream/)

Would placing tobacco makers under a single regulator like Ofcom or OfGem be a good idea? (Photo thanks to 38 Degrees, found here: http://www.flickr.com/photos/38degrees/5189561252/sizes/l/in/photostream/)

The Genesis of Profit

The proposals fundamentally misunderstand profits. A company spends money on hiring employees and producing their good or service, and then receives money from people voluntarily purchasing their product. When the revenue exceeds the expenditure, a profit is made. There is no ‘excess’. A profit may be transformed into a loss if expenditures rise or revenues fall. Prices do not directly determine revenue – the volume of sales matter too. The issue with noncompetitive markets is that consumer purchases will only move glacially between different companies or out of the industry completely. Thus, if expenditures are driven down through such means as technological advancement, an noncompetitive market would have ‘high’, ‘extreme’ or ‘excessive’ profits compared to more competitive markets, where consumer purchases fluctuate rapidly. There is no assurance of profit, unless one is guaranteed by government regulators. Unfortunately, Professor Gilmore’s and Dr Branston’s proposal does exactly that: the price-capping regulation encourages companies to make a ‘reasonable’ rate of return, and so would have their revenue galvanised and protected. Indeed, Dr Branston accepts this point: “A move to regulation would make it easier to expand tobacco control policies as companies would be partially insulated against their impact on revenue and, therefore, less able to argue against them.”

Price-capping would actively entrench the present tobacco manufacturers, rendering the tobacco industry even more rigid. Despite Dr Branston’s protestations that this regulation could be a way of preventing tobacco companies from using price as a marketing strategy, companies do not compete on price in only one direction. Unless the authors wish to suggest a minimum price for the sale of tobacco directly from the manufacturer, only the sclerosis of competition will stop direct sale prices from creeping downwards. According to the University of Bath press release for the paper, “Retail mark-up would not be affected, or the price that consumers pay, but the excess profit currently accrued by cigarette manufacturers would be transferred to the Treasury through increased tax.” Ultimately, the price that consumers pay for tobacco is determined by the level of tobacco duty applied. In theory, this duty could escalate to compensate for any drop in pre-tax sale prices, either through the tobacco manufacturers or retail distributors.

Waterfall Taxes

There are two ways that a company’s profit may be reduced: declining revenue or increased business spending. If tobacco companies have the incentive to do either of these two things, as their profits must be ‘reasonable’ and not ‘excessive’ to avoid extra tax, then increasing business spending is the only one directly under their control. Revenues may be expected, but are not certain. The problem is that the paper’s authors suggest if the industry has less money, then it cannot continue lobbying and fighting public health proposals. However, putting an industry under a direct regulator increases its incentives to lobby that regulator. If a company has already spent money on lobbying, then that money, by definition, cannot be taken away in tax. The proposal seems to apply the logic behind a ‘windfall tax’, which are unexpected, to annual profits, which are expected: a ‘waterfall tax’.

Lastly, the authors suggest that the new regulator would “expose companies to much tighter than ever before, and so curb activities, such as smuggling and marketing to the young”. These two activities are already illegal, and there does not need to be a direct regulator in place to prosecute these crimes.  Also, this hypothetical regulator is already suffering from mission creep, as it was originally supposed to only have the power to cap prices and determine the ‘reasonable’ profit margins.

£500m is not a lot of money for the UK government - it is fool's gold. (Photo thanks to reillybutler, found here: http://www.flickr.com/photos/r-butler/4744838850/sizes/l/in/photostream/)

£500m is not a lot of money for the UK government – it is fool’s gold. (Photo thanks to reillybutler, found here: http://www.flickr.com/photos/r-butler/4744838850/sizes/l/in/photostream/)

Fool’s Gold

The series of previous tobacco control measures, such as the complete ban on advertising, have accumulated and rotted the competition between tobacco makers. The absence of competition has meant tobacco corporations are showing healthy profits, as revenue from customers becomes congealed and coagulated. The proposed regulator would have the effect of nearly guaranteeing a level of profit for tobacco corporations, which is intended, as those companies will supposedly be acquiescent to other tobacco control policies, once their revenues are fortified. The trumpeted bounty of £500m from cigarette manufacturers is actually a fool’s gold, when compared to £9.5bn annually from tobacco duty. A direct regulator would also swell the desire of tobacco companies to lobby and fight tobacco control crusades, rather than dulling and pacifying it. If we truly want to reduce the number of people smoking, without hectoring or societal whinging, then we should allow smokers access to all the available treatments, including e-cigarettes, to help them in their quest. If such a reduction were achieved, this would automatically erode the revenues for tobacco manufacture. Undoubtedly, the case for OfSmoke has already gone up in smoke.

6 comments on “OfSmoke

  1. Jonathan Bagley
    January 17, 2013

    “If we truly want to reduce the number of people smoking, without hectoring or societal whinging, then we should allow smokers access to all the available treatments, including e-cigarettes, to help them in their quest.”

    I agree with that. Sadly your friends at Bath University don’t. They used taxpayers’ money in an attempt to cut off the mail-order supply of Swedish snus to the UK.

    http://www.bath.ac.uk/news/2012/01/24/snus/

    Yet one more illustration of their bizarre “Quit or Die” approach to reducing tobacco harm. Sweden has both the lowest male smoking prevalence and lung cancer incidence in the developed world. Oral cancer rates are among the lowest in the EU.

    • anthonymasters
      January 17, 2013

      It is strange that snus is currently kept illegal for sale outside of Sweden. I think the concern shown by the Tobacco Control Research Group and others to snus and e-cigarettes is thanks to the fallacy that such products present a ‘gateway’ to tobacco, rather than a safer alternative.

  2. michaeljmcfadden
    January 20, 2013

    “With such a deadly product, competition isn’t attractive, so we’ve identified regulation as an attractive alternative”

    Actually, the main force against price competition in tobacco has nothing to do with “such a deadly product.” Price competition doesn’t exist because the government has artificially jacked up the base price so much with criminally high levels of taxation. Reduce the taxation to normal goods levels and the price regulation of the market forces would then come into play. Problem solved — along with the problem of smuggling and the funneling of smuggling profits to organized crime and terrorism while promoting a general atmosphere of anarchy and providing easy access to No-ID-Necessary tobacco sales to teens.

    Of course that solution will not be satisfactory to Antismokers, but it *IS* the solution.

    Michael J. McFadden
    Author of “Dissecting Antismokers’ Brains”

    • Anthony Masters
      January 20, 2013

      That’s absolutely correct. I expect you’ve already read it, but if not, do read Christopher Snowdon’s ASI paper “The Wages of Sin Taxes”. http://www.adamsmith.org/sites/default/files/research/files/The%20Wages%20of%20Sin%20Taxes%20CJ%20Snowdon%20ASI_0.pdf
      The paper details how current levels of tobacco duty are having no perceptible effects on smoking rates, and how tobacco duty is an inefficient manner of getting people to not smoke. Tobacco is addictive, and so the product has a low price elasticity, which means that people who buy tobacco are generally not sensitive to price increases – they are just left poorer.
      This is the danger of ignoring trade-offs: there is a goal, stopping people smoking, and that goal has to be achieved, even by methods which are clearly deleterious to the whole society.

  3. Junican
    January 21, 2013

    Some of the ideas which Tobacco Control Rent-seekers are coming up with these days are so silly that it amazes me that the MSM don’t kick them into touch with barely a glance rather than actually publish them. It seems clear to me that Gilmore and friends are simply thrashing about concocting reasons to keep the loot rolling in.

    I wonder when it is going to click into the brains of politicians that academics are about the worst people to take advice from. The reason for that is the limited nature of their expertise, which is due to the necessity for academics to specialise. How much does Gilmore know about economics, and, especially, about the economics of taxation? What is the justification for using taxation to control lifestyles?

    It is a clear as daylight that if the Government want to help people who want to stop smoking, then it should RECOMMEND e-cigs. That the EU want them banned is scandalous. Is the EU decision based upon the opinion of academics? If not, upon whose opinion is it based? We should remember that almost all studies are academic in nature and academically driven.

    • Anthony Masters
      January 21, 2013

      I believe that the silliness of these tobacco control ideas is a direct result of campaigners ignoring trade-offs: the goal of a society without tobacco must be achieved, regardless of the damage done by any policy proposed to achieve it.
      It is very true that academics have specialisms, and when you step outside that area of expertise, it can be like walking off an intellectual cliff. To quote Will Rogers, “everybody is ignorant, only on different subjects.” Professor Gilmore and her TCRG colleagues do not seem to understand the economics of taxation, or price elasticity.
      I would say that the government should not be recommending certain lifestyle choices, but I think more people would be able to make the judgement that e-cigarettes are safer than tobacco cigarettes. I’m currently unaware of how the EU came to its decision on snus, and the potential restrictions on e-cigarettes.

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This entry was posted on January 16, 2013 by in National Politics and tagged , , , .
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