Policy and the smuggling bonanza

AS THERE are only three more (cross-border) shopping days to Christmas, it is a good moment to reflect on this great new British pastime. Ever since customs border controls were dismantled in January 1993, people have not been obliged to buy taxed cigarettes and alcohol, as the untaxed alternative has been available in large quantities across the Channel. This poses a long-term threat to the tax base and to the rule of law, and threatens to turn the conventional wisdom on tobacco taxation on its head. Let me explain.

In the past, consumption of alcohol and cigarettes in Britain was almost entirely from taxed goods bought on the high street. This gradually changed as duty-free consumption became an increasingly significant source of supply. But the abolition of border controls has added an entirely new source of tax-avoiding supply - smuggled goods.

Whenever two identical products are available in different jurisdictions at different prices, you must expect people to buy in the cheap country for resale or consumption in the expensive country.

Usually this is called trade, and the activity tends to equalise the prices in the two countries. But when the authorities outlaw trade, and/or impose a tax on it, it is driven underground and becomes smuggling.

The economics of smuggling are just like the economics of trade. It is only worthwhile if the price difference more than covers the transport costs - plus, in the case of smuggling, a premium to induce the smuggler to run the risk of being caught. Tobacco is an attractive good from the smuggler's point of view because the price gap between the UK and Europe is large, and cigarettes are small and light. A van filled to the brim with cigarettes generates many thousands of pounds of revenue to the successful smuggler.

However, when the ports and airports were closely policed the chances of getting caught were too great to make smuggling attractive. It is only since the border controls were abolished that smuggling has grown up on any scale. This reflects a sharp fall in the expected costs of smuggling - the penalty for being caught multiplied by the probability of apprehension. The rewards of smuggling are now well in excess of the costs.

Historically, most smuggling has been amateur - goods brought in for the smuggler's own use. There is a natural limit to the damage done by amateur smuggling, set by the number of journeys people make, their personal needs and the physical capacity of their means of transport. Professional smuggling, which is all about resale to third parties, has no such natural limits. If one van-load generates thousands of pounds of income, many vans will cross the Channel.

We can think of smugglers as entering a market where they have an identical product at a fraction of the existing market price. If they price at the existing level, they are hugely profitable. The profits enjoyed by the first entrants will attract others and competition for the contraband market will tend to drive down the price of contraband. As a result, contraband will tend to increase its share of the total market, and contraband suppliers will enjoy increasing economies of scale.

Thus professional smuggling, once established, tends to grow. It quickly dwarfs legitimate cross-border shopping. The UK authorities, who launched a pre-Christmas crackdown on smuggling last month, believe that contraband is costing the taxpayer pounds 1bn of tobacco tax revenue out of a total of pounds 10bn. This compares with only pounds 60m of revenue lost to cross-border shopping. These figures show that smuggling is now a firmly established form of organised crime. It has become a business with a turnover measured in hundreds of millions and thousands of retail outlets.

Despite the crackdown, this business is bound to grow. For example, industry experts believe that one cigarette in three smoked in Canada during the high tax regime of the early 1990s was smuggled. Canada provides a fascinating case study because data is available by province, and the incidence of contraband across provinces varies with the distance from the border with the US - the source of cheaper cigarettes.

The UK is moving rapidly in this direction. The official estimates on smuggling suggest that it is doubling every three years. This has profound implications both for tax revenue and for health policy.

The usual assumption made by the authorities is that when they put up tax, the fall in sales is always much less than the rise in price. Smokers, for whom cigarettes are a necessity, are simply not very price-sensitive. They pay the extra tax and go on puffing.

However, if the hardened smoker has the option of buying cheaper duty- free or contraband cigarettes, the effect of a tax hike is to make him switch. The more widely available are cigarettes that avoid duty, the greater the chances that a tax hike will simply cause the smoker to switch to them when the duty goes up.

The implications for tax policy, if you think about it for a minute, are pretty drastic. Every increase in cigarette duty will drive more smokers into the arms of the smugglers. This is bad for the rule of law and it is obviously bad for revenue. A less obvious implication, but a very disturbing one, is that it is also bad for the health of the nation.

One oft-proclaimed purpose of having high tobacco taxation is the paternalist one of discouraging people, for their own good, from smoking. When the only available cigarettes were taxed cigarettes this policy worked - although it always conflicted with the government's real objective in taxing smoking, which was to raise money. However, now that smokers have access to cheaper smuggled cigarettes, the effect of each duty increase is to make more of them switch to contraband.

Smoking is an activity which has become increasingly concentrated among the poor - the middle classes have all but given it up. And it is the poor who are targeted by the purveyors of contraband, who "push" smuggled cigarettes in many of the same outlets as illegal drugs. Raising duty rates does not affect the smoking behaviour of those who already depend on contraband. But it does make contraband more profitable for the seller and more attractive for the buyer. It thus increases the supply-push of illegal cigarettes to new users.

Two conclusions follow. First, the Government is entirely right to crack down on smuggling. It is good for public health and good for tax revenue. No other policy meets both objectives, which usually conflict.

Second, the time is fast approaching when it will be necessary to attack the smugglers by destroying the source of their profits. That means cutting duty, as the Canadians did in 1994. It is politically unthinkable at present but, as the Canadians found, the logic is irresistible. A tax cut brings so many smokers back into the legitimate market that it boosts revenue. And because these smokers are paying the full price, not the contraband price, they smoke less. Good for health, good for revenue.

Bill Robinson is director of the Strategy and Policy practice at London Economics.