It’s the season to consider taxes on so-called sin products such as cigarettes and alcoholic drinks.

There is no better evidence for this than the full-page advertisements that came out during the past weeks in the major dailies paid by concerned manufacturers.

British American Tobacco logo

The first blast was fired by a company (obviously British American Tobacco Philippines through its public relations company) seeking entry into the cigarette industry with the proviso that the tax regime should not be discriminatory.  Under the current regime, cigarettes were classified  and taxed using a four-tiered schemeHowever, cigarette brands introduced after 1997 were taxed at a higher rate relative to older brands. BAT Philippines, which manufactures Lucky Strike among others,  wants the discrimination against new brands to be done away with.  It adds that it will bring in $200 million in fresh investments if a level playing field will ensue after the tax reform.

Philip Morris Fortune Tobacco Corp. logo

The Philip Morris Fortune Tobacco Corp. (PMFTC) opposed the abolition of four-tiered scheme as well the higher tax rates on newer brands.  This is understandable since PMFTC benefits from the existing tax regime and is willing only for minimal tax increases over five years.

Rep. Joseph Abaya

Authored by Rep. Joseph Abaya, House Bill No. 5727 incorporates features, such as a unitary tax regime, that are to BAT Philippines’ liking and is opposed by PMFTC. 

However, HB 5727 contains a feature that finds favor with both corporations.  The excise tax on cigarettes (of packs of 10s and packs of 20s) are specific rather than ad valorem or percentage taxes.

An ad valorem tax is a percentage levy imposed on the monetary value (i.e., the manufacturers’ price) of a product.  For example, if the tax rate is 10% and the manufacturers’ price of a 20-stick pack of ciga­rettes is P30.00, then the excise would amount to 3 pesos (or P3.00).  If all cigarettes regardless of retail price were slapped with a uniform tax rate, more expensive cigarette brands would pay a higher amount on a per unit basis compared to cheaper brands.    On the other hand, a spe­cific tax is a monetary levy on the quantity (or specified unit) of the product in question.  To illustrate, if the tax base is the cigarette pack (of 20 cigarette sticks), then a specific tax of P3.00 can be collected on each pack produced.

The ad valorem tax is regarded as superior to the specific tax since it is inflation-proof.  When manufacturers’ costs go up and retail prices would consequently increase, the revenue to be collected would increase in a like manner without any change in the ad valorem tax rate.  Sup­pose the manufacturers’ price of the cigarette pack increased from P30.00 to P35.00, the cor­responding excise would now be 3 pesos and 50 centavos (or P3.50).  To remedy its inferiority, tax technicians advise indexation of the specific tax rate; that is, the specific tax should automatically increase as an agreed-upon indicator, say the consumer price index, increases.

The supposed advantage of the specific tax over the ad valorem lies in its simplicity.  As wags would put it, tax bureaucrats must understand a company’s financial statements in or­der to impose an ad valorem tax.   With a specific tax, the tax bureaucrat needed only to know how to count how many of the product in question was produced during a taxable period.  With the ad valorem, the tax official must not only know how to count but also how to ac­count, that is, to understand complicated accounting and financial statements.   A further disadvantage of the ad valorem system is that it invites transfer pricing and other schemes at tax evasion.  The tax must necessarily be levied on the manufacturer; if it were imposed on the retailers, the administration of the tax would be more complicated.  There are obviously many more re­tailers than manufacturers and there would a great number of retail prices to reflect differing market conditions.  If the ad valorem was levied on the retail price of a product, then there would as many effective tax rates as the number of retail prices for a given product.  Of course, the situation is complicated by the existence of many brands of a given generic sin product since cigarettes of Brand A would sell at a retail price different from cigarettes of Brand B or Brand C.  In addition, Brand A cigarettes would sell at different retail prices in different parts of the country.

Sin product manufacturers would thus face the incentive of under-declaring their manufacturers’ price so that their ad valorem tax bites would be lower.  They would then sell their output to affiliated marketing arms that would sell the products at retail price levels that were many degrees removed from the declared tax base.  In this manner, they deprive the public treasury of revenues the amount of which is determined by the difference between the retail and the manufacturers’ price.   Tax evaders would face this incentive if there was a great differen­tial between the ad valorem and the VAT rates (where the ad valorem is greater than the VAT rate).  Furthermore, if the tax base for the VAT is the manufacturer’s net price plus the ad valorem excise tax, then the incentive to under-declare costs at the manufacturer’s level be­come more robust.  The under-declaration would have a cascading effect; under-declaring manufacturing costs would lower the VAT base, which it would lower the income tax base.  If the tax code provides different ad valorem rates for differently priced generic products, then the manufacturer also faces the incentive to mis-classify his product in order to be taxed at a lower rate.  The corporate group can cheat the public treasury many times over.  For this to happen, the marketing arms must also cheat on their value-added tax (VAT).  They can avoid paying the VAT altogether.  If they were scrupulous in paying this tax, what the manufacturer avoided paying by under-declaring his price would be captured by the internal revenue service from the marketing firms.  Then all of these companies (manufacturer and marketing arm) would doctor their profit-and-loss statements to be assessed lower income taxes.


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