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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.
‘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.
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.
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.
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.