With  excise  duties  again  untouched  in  Budget  2013,  we  examine  what  the Government  should  do  to  efficiently  increase  tobacco  tax  revenues  and  reduce smoking  prevalence.  We  view  raising  excise  duties  at  the  current  conditions  as ineffective  in  both  trimming  cigarette  consumption  and  boosting  tax  collections. The  prevalence  of  illicit  cigarettes  (35%  of  total  cigarettes)  will  need  to  be addressed first, as a lack of accountability for incompetence and a compensation system not based on merit are barriers towards successfully executing strategies to combat it. Maintain NEUTRAL on Tobacco.
 
The  next  step.  With  Budget  2013  leaving  tobacco  excise  duties  untouched  for  the second consecutive year after eight successive years of excise duty increases, we look at  how  Malaysian  tobacco  regulations  should  be  implemented  to  best  meet  the Government's  goals.  A  typical  government  has  the  following  agenda  in  tobacco regulation:  i)  encourage  a  healthier  population,  ii)  maximize  excise  tax  revenues,  iii) reduce public medical costs, and iv) provide reasonable profit opportunities for tobacco companies, which in turn generate corporate income taxes and employment.

Not  that  effective.  Raising  excise  duties  without  stringent  controls  on  illicit  trade  has historically  been  an  inefficient  method  in  pursuing  these objectives. Malaysia's total cigarette  consumption  fell  just  2.6%  following  a  20%  excise  hike  in  2009,  and  illegal volumes surged by 30% as smokers diverted their consumption to smuggled cigarettes. Legal  volumes  plunged  by  10.9%  in  the  meantime,  significantly  reducing  the Government's taxable base.

Tightening  the  grip.  Thus,  the  most  immediate  task  is  to  implement  stricter  controls against illicit cigarettes when the Government raises tobacco excise duties in the future. Successfully  plugging  leakages  to  illicit  cigarettes  will  ensure  that  total  cigarette consumption falls and Government tax collections increase more efficiently.

Not  so  easy. Challenges exist in successfully executing an initiative to curb illicit trade. Malaysia's long  coastline  does  make  enforcing  more  difficult,  but  we  believe  the  equal civil  servant  compensation  system  that  is  not  purely  based  on  merit  and  a  lack  of accountability for incompetence are further barriers towards successfully clamping down on illicit cigarettes.

NEUTRAL.  We  expect  tobacco  excise  tax  hikes  to  resume  in  Budget  2014  as  excise taxes are easy targets to increase tax revenues, which should in turn drag legal volume growth  back  to  negative  territory.  We  are  of  the  opinion  that  the  Government  should raise excise taxes, but only during a time when illicit trade has been properly addressed. We  are  adjusting  our  FV  on  BAT  and  JTI  to  RM56.92  (WACC:  5.5%,  terminal  growth: 1.0%)  and  RM7.50  (WACC:  7.5%,  terminal  growth:  1.0%)  respectively  as  we  roll  over our FCFF valuations to FY13. Maintain NEUTRAL on Tobacco.

No excise duty increases for now. While the absence of tobacco excise duty hikes over the past two years very much stems from the Government's aim for an election-friendly  budget,  we  do  not  think  an  immediate resumption of tobacco excise tax hikes post-election will ultimately help it achieve its goal to reduce smoking prevalence and maximizing tobacco tax collections.

Prevalence of substitution. Cigarette demand is inelastic, so raising tobacco duties is generally an efficient method to increase Government revenues. Malaysian smokers, however, have an untaxed substitute product in  illicit  cigarettes  that  makes  duty-paid  cigarette  volumes  much  more  elastic  than  imagined.  This  in  turn makes Government's tax-raising and smoking-curbing measures much less effective. The prevalence of illicit cigarettes  remains  worryingly  high,  at  34.7%  of  total  cigarettes  consumed.  The  illicit  market  share  stood  at 36.1% in 2011, depriving the Government as much as RM2.1bn in tobacco-related tax collections.

Leakages  render  hikes  less  effective. When  the  Government  decided to  slap  a 20% increase  in  tobacco excise taxes during the Budget in late-Aug 2008, contraband cigarettes gained 11.8 ppt in market share from 25.7%  to  37.5%  in  2009.  That  was  an  estimated  30%  y-o-y  rise  in  illegal  cigarette  volumes,  indicating  that access  to  non-duty  paid  cigarettes  was  relatively  easy.  Legal  volumes  dropped  by  10.9%  that  year,  which implied that Government collections rose by just RM171.6m (+6.9%) following the 20% duty hike.

Not  effective  in  reducing  cigarette  consumption. As a result of the surge in contraband cigarette usage, total  cigarette  consumption  fell  by  just  2.6%.  Tobacco  corporate  earnings  (excluding  the  non-listed  Philip Morris  Malaysia  SB) fell 6.0%, trimming the Government's income tax proceeds by RM13.7m. Due to the ease of purchasing illicit cigarettes, raising excise duties has thus been less effective in i) reducing smoking prevalence, ii) maximizing tobacco tax revenues, and iii) increasing corporate tax collections.

Tightening the grip. The most immediate task is to implement stricter controls to prevent further leakages to illicit cigarettes when the Government raises tobacco excise duties. To do so, both vendors' and consumers' access to contraband cigarettes needs to be as limited as much as possible. Malaysia needs to have strong enforcement  at its  borders  to prevent  the entrance  of  non-duty  paid  cigarettes  from neighbouring  countries. Efforts should be stepped up so that there is an increased probability of nabbing vendors and consumers in possession of illegal cigarettes and once caught, the level of punishment meted out on them should be more severe.
 
A more effective tax hike. Should the authorities be able to substantially lower the prevalence of illicit trade by cutting off channels to obtain smuggled cigarettes, a rise in  tobacco excise duty will be more effective in fulfilling  the  Government's  aim  of  reducing  cigarette  consumption  and  boosting  tax  collections.  Given Malaysia's long coastline, it may not be easy, especially when compared to a city state like Singapore.

A  good  idea,  but  difficult  to  implement.  Non-geographical  challenges  also  exist  for  governments  that intend  to  clamp  down  on  illegal  trade.  An  across-the-board  civil  servant  compensation  system  that  is  not based  on  merit,  for  example,  does  not  incentivize  authorities  to  be  competent  since  compensation  or recognition  is  similar  regardless  of  the  amount  of  effort  put  in  or  accomplishments  achieved.  A  lack  of accountability  for  poor  performance  or  wrongdoings  further  serves  as  a  disincentive  for  authorities  to  be competent.

Explaining  incentives.  The  simple  model  below  intends  to  explain  the  rational  decision  authorities  make given the differing circumstances. This model makes a number of assumptions. Suppose the cost of being a hardworking  and competent  government  personnel is  5, due  to  the  hard  work needed.  The  reward of being promoted to a higher position is equal to 15 due to the higher salary, greater power and increased sense of personal accomplishment. The reward of not being promoted is equal to 7, which may include basic salary, power and so forth. Also suppose that the cost of being an incompetent government official is just 3 and the reward is 9 because there is an additional reward of 2 from corruption proceeds.

The  choice  of  rewarding  competency.  In  Figure  2,  the  more  competent  personnel  receive  the  same compensation and recognition and have identical chances of getting promoted. Given the lack of recognition for performance and additional income received from kickbacks, the personnel would not be inclined towards diligence and honesty. On the other hand, civil servants will make the rational decision to be as such, if they are more likely to see their hard work rewarded by a promotion (see Figure 3).

When  being  incompetent  pays  off.  Other considerations will also affect the decision. Suppose the reward from  corruption  proceeds  is  6  instead  of  2.  The  expected  payoff  of  being  incompetent  and  corrupt  will therefore  be  11.2.  Under  such  circumstances,  all personnel face the 'temptation' of being  incompetent  and corrupt even when chances of being promoted are higher.

Punishing  corruption.  Also,  we  assume  that  incompetent  workers  are  still  able  to  retain  their  positions,  a problem when there is a lack of accountability for poor performance or abuse of power. Now suppose that the government has the ability and the willingness to remove such civil servants from their positions. If the payoff after  being  ousted  is  0,  there  will  be  a  high  likelihood  of  being  ousted  will  incentivize  personnel  to  be competent and non-corrupt instead. The payoff after being removed can also be negative as the former civil servants will experience embarrassment and punishment as a result of their corrupt practices (see Figure 4).

Expect  a  duty  hike  in  Budget  2014. While the Malaysian Government has chosen to keep tobacco excise duties unchanged for two years in a row amid high illicit trade, many feel that this is due to the need to keep the population happy, in anticipation of an election. We expect tobacco excise tax hikes to resume in Budget 2014 as excise taxes are easy targets to increase tax revenues.

Volumes  to  shrink  as  a  result.  Although  1H12  legal cigarette shipments  rose  by  3.9% y-o-y,  much of  the growth came from an especially weak 1Q11 plagued by illegal cigarettes sold below the minimum retail price. With 2Q12's  industry  volume growing  by  a meager  0.4%  y-o-y,  a  continuation of  tobacco  duty  hikes  should pull  legal  volume  growth back  to  negative  territory. We are of  the opinion  that  the  Government  should raise excise  taxes,  but  only  during  a  time  when  illicit  trade  has  been  properly  addressed.  This  will  make  the Government's aim of reducing smoking prevalence and raising tax revenues much more effective.

Source: OSK