ANALYTICAL NOTE

In today’s environment, the need to increase tax revenues in order to adequately finance programs to strengthen the state’s defense capability is becoming more urgent. One of these areas is the further increase of excise tax rates on tobacco products. It should be noted that this measure is a classic tool for filling the state treasury in many countries, including those involved in military conflicts[1]. A full-scale invasion requires additional solutions from the state to cover at least part of the unprecedented fiscal gap. Increased excise tax revenues will strengthen the state’s ability to fulfill its tasks and functions.

At the same time, the increase in the excise tax should not only be aimed at ensuring the growth of budget revenues, but also be consistent with the goal of minimizing the volume of the illegal tobacco market, which continues to be a significant problem for the state. Despite the decline in its share to 14.6% in July 2024, the annual loss of tax revenues will amount to about UAH 23 billion, which is unacceptable in a period of acute financial shortages.

In 2022-2024, the budget shortfall from the illegal cigarette market is estimated at more than UAH 64 billion (EUR 1.4 billion). As the price of legal products increases, the benefits of participants in illegal schemes will grow and budget losses will increase. Obviously, demand for cheaper tobacco products creates supply.

The empirical experience of the EU member states and other developed G-7 countries shows that countering the growing illegal markets for excisable goods requires additional budgetary allocations, coordinated efforts of government agencies, and time.

So what should we do, given all this?

Let’s pay attention to another fundamental point. The excise policy should also take into account the fact that the cigarette market will gradually decline. Not only because the prevalence of smoking will decrease. This would be an ideal, but unfortunately difficult to implement scenario. The best thing is for young people not to start, and for smokers to stop. However, there is no perfect life; it is not easy to keep everyone from becoming addicted to nicotine, which in turn has fashionable trends. We live in a time when more and more consumers are opting for the latest nicotine consumption products: heat-not-burn or heated tobacco products (HTPs) and electronic cigarettes (also called vapes). The question is, how should they be taxed? And if this is a “promising pair” that will gradually replace CCs, are there any threats to tax revenues associated with the formation of their illegal markets?

We have tried to study all these aspects by examining the latest developments in world science, the practice of European and other countries, and the realities of the formation and implementation of excise policy in Ukraine, and we provide answers to the burning questions in this policy brief.

Plan to increase the excise tax on tobacco products in Ukraine by 2028

When forming the draft State Budget of Ukraine for 2025[2], the provisions of the Draft Law of Ukraine “On Amendments to the Tax Code of Ukraine on Revision of Excise Tax Rates on Tobacco Products” (the “Draft Law”)[3] adopted in the first reading, were taken into account. Its main innovations are as follows:

First, setting excise tax rates on tobacco products in euros. This is in line with the provisions of the National Revenue Strategy until 2030[4] approved by the Cabinet of Ministers of Ukraine and agreed with representatives of international financial organizations that act as financial donors during a full-scale invasion. Initially, the Draft Law envisaged that the excise tax would be introduced in euros on July 1, 2024. This has not been done, and the most realistic scenario for the change is now 2025.

Second, taking into account the approaches of EU countries to taxation of new nicotine products, differentiated excise tax rates for HTPs and cigarettes are envisaged. Effective January 1, 2025 The METL on cigarettes will increase to EUR 78 per thousand pcs., while the excise rate on HTPs is to increase to EUR 70.4. Taking into account the official exchange rate of hryvnia to euro set by the NBU as of 25.09.2024 (46.04 UAH/EUR), the current METL for cigarettes and the excise rate for HTPs are EUR 54.66 (UAH 2,516.54 per thousand pcs.). Thus, starting from 2025, the excise tax on cigarettes will increase by 42.77%, and the excise tax on HTPs will increase by 28.8%, assuming the euro remains unchanged.

At the same time, the Draft Law “On the State Budget for 2025” sets the average annual euro exchange rate for calculating tax revenues at UAH 48.60, which is 5.5% higher than the current rate.

The Draft Law also provides for a further increase in excise tax rates on tobacco products for 2026-2028. Thus, the minimum excise tax on cigarettes will increase by 5% annually, reaching EUR 90, and the excise tax rate on HTPs is to rise to EUR 72 in 3 years. This is roughly the level of the rate for HTPs that is expected to be provided for Ukraine in the successor to Council Directive 2011/64/EU. Instead, a new excise tax increase plan will have to be implemented for cigarettes after 2028.

Third, it is established that for the period of martial law, for three consecutive reporting months preceding the month in which the excise rates are increased, the average monthly sales volume of excise tax stamps to a tobacco producer and/or importer may not exceed 120% (previously 115%) of the average monthly sales volume of tobacco products by such producer and/or importer for the previous nine calendar months. 

If the Draft Law is adopted, the Government expects the state budget to receive additional revenues from the excise tax on tobacco products at the level of UAH 28.84 billion, including UAH 0.61 billion in 2025, UAH 5.0 billion in 2026, UAH 9.38 billion in 2027, and UAH 13.85 billion in 2028.

We will conduct our own calculations of the fiscal effect of the above plan to increase the excise tax on tobacco products in Ukraine.

General conclusion

The analyzed Draft Law on increasing excise tax rates on tobacco products is an optimal state fiscal solution. First, it is guaranteed to provide additional tax revenues to the budget, which is extremely important for strengthening the state’s defense capabilities. The direct fiscal effect is estimated at more than UAH 25 billion compared to the current schedule of annual excise tax increases on cigarettes, HTPs and other tobacco products by 20%. Second, it aims to bring the excise tax rate on cigarettes to its minimum EU level by 2028. Setting rates in euros offsets the impact of the national currency devaluation. Third, the Draft Law takes into account the established and effective EU practice of differentiating tax rates on tobacco products, which will prevent the expansion of illegal markets for tobacco and nicotine-containing products and budget losses of at least UAH 30 billion over 2025-2028.

In the coming years, when the purchasing power of the population is likely to continue to decline, a gradual increase in excise tax rates on cigarettes will serve to prevent new outbreaks of illicit trade in cigarettes and the expansion of the now almost entirely illegal market for e-liquids. The price of the latter can remain relatively stable because illegal players do not pay excise duty. At the same time, a slight differentiation in excise tax rates (prices) for cigarettes and HTPs may provide an additional “filter” effect that will limit the growth of new consumers of illegal conventional and electronic cigarettes. Since the HTP market is developing only in the legal segment, an increase in their consumption will ensure higher tax payments from each pack.

After 2028. Ukraine will have to continue to raise the excise tax on cigarettes quite substantially to meet the upcoming new EU standards, but will not have such obligations with regard to heat-not-burn products. In other words, there will be no requirement to abandon the differentiation of excise taxes on cigarettes and HTPs. This, in the context of a generational shift and the associated increase in the prevalence of the use of newer nicotine products, will ensure that the legal cigarette market does not become “grayer” and, most importantly, is not largely replaced by the “black” market for e-liquids. If the “white” market for HTPs grows, the budget will be protected from significant fiscal “failures”.

The fact that the Draft Law was developed by the Ministry of Finance of Ukraine, submitted to the Parliament by the Cabinet of Ministers of Ukraine and supported by many representatives of the expert community and leading business associations of Ukraine also proves the balance of its provisions. Such coherence of positions is not so common these days.

[1] Mehrotra, A. K. (2010). The Price of Conflict: War, Taxes, and the Politics of Fiscal Citizenship. Michigan Law Review, 108(6), 1053-1078

[2] Draft Law on the State Budget of Ukraine for 2025. URL: https://itd.rada.gov.ua/billInfo/Bills/Card/44888

[3] Draft Law on Amendments to the Tax Code of Ukraine on Revision of Excise Tax Rates on Tobacco Products URL: https://itd.rada.gov.ua/billInfo/Bills/Card/43855

[4] National Revenue Strategy until 2030. 2023. URL: https://mof.gov.ua/storage/files/National%20Revenue%20Strategy_2030_.pdf

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