The Impact of E-Cigarette Regulation on the Illicit Trade in Tobacco Products in the European Union

Abstract

This appendices to this report can be found at: (https://ssrn.com/abstract=3435260). In regulating tobacco products, governments seek to promote public health by discouraging consumption. However, imposing regulatory costs and taxes on licit producers and consumers presents an economic opportunity to criminal actors to profit from skirting these laws. Illicit trade in tobacco products (ITTP) thus frustrates the goals of tobacco regulation. We estimate that a 10% increase in the price of licit cigarettes (which might result, for example, from a tax increase) leads to a 3.6 percentage-point increase in the illicit share of the market, which averages about 11% in the EU. However, e-cigarettes and their apparent health advantages over traditional tobacco products present regulators with an opportunity to increase taxes without swelling the flow of illicit goods: By allowing consumers a third choice as an alternative to either paying higher prices or buying illicit products, e-cigarettes could serve as a “safety-valve” allowing for higher taxes (and stricter regulations) on traditional tobacco products without encouraging the illicit market. This study tests and find support for that hypothesis and seeks to investigate the effects of law and policy on the extent of that substitution. We begin by analyzing the current policies of European Union Member States toward tobacco products and e-cigarettes and reviewing the literature on the factors that drive consumers to use illicit tobacco products and the evidence that e-cigarettes substitute for conventional cigarettes. We then assemble a dataset of volumes and prices for legally sold conventional cigarettes and e-cigarettes, and for illicit or smuggled products. An econometric analysis of those data generates a model relating the size of the ITTP market to e-cigarette policies and market penetration. The results show that higher taxes and prices for licit cigarettes are positively associated with higher ITTP shares and illicit-cigarette quantity. When the e-cigarette market is small, increases in cigarette prices have a positive and statistically significant effect on ITTP. The elasticity remains positive throughout the range of the data, although it decreases with the size of the e-cigarette market. However, the availability of e-cigarettes moderates the effect of conventional-cigarette prices on ITTP volumes: the more available e-cigarettes become, the less ITTP market share rises in response to tax-driven price increases for conventional cigarettes. In the presence of sufficiently robust e-cigarette markets, cigarette prices have no measured effect on ITTP volumes. Thus, as e-cigarettes become more available, the positive association between cigarette prices and taxes is attenuated. This suggests that e-cigarettes are substitutes for illicit cigarettes. Conversely, demand for e-cigarettes responds positively to cigarette prices while demand for conventional cigarettes responds positively to e-cigarette prices, thus indicating that the two goods are substitutes. However, while higher cigarette prices are strongly associated with larger e-cigarette markets, the same cannot be found for cigarette regulation here. Other important findings include that: • E-cigarette revenue responds positively to cigarette prices, negatively to product bans, and negatively to stricter regulation (although the evidence is mixed regarding the last point). • More stringent tobacco regulation, particularly health warnings on packaging, is associated with lower demand for cigarettes. • Demand for e-cigarettes responds negatively to its own price and to the stringency of regulation aimed at vaping. • No e-cigarette regulation at all is most conducive to e-cigarette sales; all the other regulatory coefficients are negative. • Strict limits on public use and pharma-only regimes are about equally detrimental to e-cigarette sales, and the apparent impacts are large. • The Tobacco Products Directive has been more favorable for e-cigarette sales than either of those regimes, but not as good as no regulation. Policy discussions and recommendations are presented. Optimal taxation would establish excise duties for combustible nicotine products at a rate that deters initiation and incentivizes switching to lower-risk products, while avoiding diversion to the black market. Non-combustible products should then be taxed at a low, zero, or even a negative level. Furthermore, the optimal tax on conventional cigarettes will be higher in the presence of low-priced reduced-risk substitutes than in their absence.