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ASSESSING THE ECONOMIC CASE FOR AN EXCISE DUTY ON E-CIGARETTES A report prepared for British American Tobacco February 2017

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ASSESSING THE ECONOMIC CASE FOR AN EXCISE DUTY ON E-CIGARETTES

CONTENTS

Executive Summary 4

1 Introduction 6

1.1 Context of this report 6 1.2 Our approach 6

2 The market for e-cigarettes 8

3 Revenue-raising 10

3.1 Introduction 10 3.2 The economic arguments 10 3.3 Is demand for e-cigarettes price inelastic? 12 3.4 Conclusion 15

4 Externalities 16

4.1 Introduction 16 4.2 The negative externality rationale for taxation 16 4.3 Negative externalities and e-cigarettes 17 4.4 Conclusion 21

5 Internalities 22

5.1 Introduction 22 5.2 The rationale for taxing goods that have internalities 22 5.3 Are there internalities from e-cigarettes? 23 5.4 Conclusion 26

6 Administration and compliance 28

6.1 Introduction 28 6.2 Application to the e-cigarette market 29 6.3 Conclusions 31

frontier economics │ Confidential 4


EXECUTIVE SUMMARY

British American Tobacco (BAT) asked Frontier Economics to provide an

independent assessment of the economic case for excise duties on e-cigarettes.

The scope of our assessment was limited to e-cigarettes, not new tobacco

products such as ‘heat not burn’. Our analysis was conducted independently and

the views expressed are those of the authors, based on the evidence analysed.

Economic theory identifies three main rationales for excise duties that could apply to e-cigarettes

Efficiency in revenue-raising: if the demand for e-cigarettes is not very

sensitive to their price, then revenue can be raised without significantly

distorting consumer behaviour and without eroding the tax base.

Correcting for externalities: if consumption of e-cigarettes causes costs to

society, excise taxes can help ensure these costs are fully reflected in price;

Correcting for internalities: if those using e-cigarettes are not fully informed

about the likely harms and risks of addiction, they may value taxes as a

mechanism to help them stop using them.

Tax theory also emphasises issues around the costs of administering and

complying with any new excise duty.

We find no compelling rationale to apply an excise duty to e-cigarettes in the current market

Demand for e-cigarettes is sensitive to price, suggesting no strong efficiency rationale to raise revenue from a new excise duty

The results of four empirical studies we

identified all suggested that the demand for

e-cigarettes is price sensitive. The single

most robust study from the US estimated

an own-price elasticity of –2.1.

The literature is limited by a lack of good quality data recording demand and

prices for e-cigarettes and conventional cigarettes. Demand may become less

sensitive to price as the e-cigarette market matures, or estimates may change as

more complete data become available; this needs to be validated with further

empirical evidence.

External costs from e-cigarette use are much lower than for traditional cigarettes, and substitution from traditional cigarettes to e-cigarettes generates external benefits. This would not rationalise an excise tax.

A growing literature has explored the relative harms from e-cigarettes and

conventional tobacco products. There is a consensus among health groups and

anti-smoking bodies that e-cigarettes are much less harmful, suggesting that any



public health costs associated with e-

cigarette use would be low. Indeed, as most

e-cigarette users are current or former

smokers, switching from harmful to less

harmful products generates positive

externalities. The evidence relating to

passive harms from e-cigarette use is limited, but current studies point to the

risks being small compared with conventional tobacco.

In a world with limited or no use of conventional tobacco, the externalities

argument would give a rationale for an excise tax on e-cigarettes, at a much

lower rate than the optimal rate for traditional tobacco products. However, in the

current world with significant switching from traditional to e-cigarettes, the

externalities case for an excise duty is weak.

Most e-cigarette users are current or former smokers. There is no strong evidence of a ‘gateway’ effect or that users underestimate the harms from e-cigarettes. This gives no compelling internality rationale for excise duty.

The WHO find that few e-cigarette

users have never smoked conventional

cigarettes, and ASH highlight that e-

cigarettes are unlikely to be a gateway

into smoking. At present, most users of

e-cigarettes are likely to be well-informed about the risks of nicotine addiction.

Most evidence suggests that e-cigarette users, if anything, overestimate the

health risks relative to conventional cigarettes. Consumers are therefore unlikely

to regret using e-cigarettes and value higher prices as an aid to giving up. The

‘internality’ rationale for an excise is therefore weak.

In a world with limited use of conventional tobacco, the internality rationale could

be stronger: more e-cigarette users would never have smoked. However, an

excise tax would be a blunt instrument – proper information about the risks of e-

cigarettes and regulation around sale and promotion would be preferable.

The potential revenues from an e-cigarette excise are limited and the costs of administration and compliance could be high.

On current sales, an excise tax on e-

cigarettes in the EU at half the

minimum rate levied on conventional

tobacco could raise perhaps 0.3% to

0.7% as much revenue as tobacco

excise duties. There are reasons to

believe that an excise on e-cigarettes

would be costly to administer. The market is rapidly changing which would make

it hard to define the tax base in a stable way. The market is also much more

fragmented than that for conventional tobacco: there would be many more

taxpayers and a greater risk of sales leaking to illicit jurisdictions. This could

change as the market matures and consolidates.



1 INTRODUCTION

1.1 Context of this report

Council Directive 2011/64/EU sets out the structure and minimum rates of excise

duty to be applied to tobacco products in EU member states.1 The most recent

report by the European Commission (EC) into the Directive identified, among

other issues, a need to provide clarity about the treatment of novel products such

as e-cigarettes, which are not currently covered by the Directive.2 Member States

are free to set their own tax structures and rates (if any) on these products,

leading to concerns about competition and the functioning of the single market.

British American Tobacco (BAT) asked Frontier Economics (Frontier) to provide

an independent assessment of the economic case for excise duties on e-

cigarettes. The scope of our assessment was limited to e-cigarettes, not new

tobacco products such as ‘heat not burn’. We were asked to set out the relevant

economic considerations for whether an excise duty should be introduced and

how these apply to e-cigarettes, but not to make any specific recommendations

on the level, structure or base for any excise duty.

This report sets out our conclusions and the evidence base underpinning them.

The analysis was conducted independently and all views expressed are those of

the authors based on the evidence analysed. BAT had the opportunity to

comment on earlier drafts of the report and provided initial input into evidence

sources, but did not constrain Frontier’s intellectual analysis or our ability to

consult a fuller range of evidence.

1.2 Our approach

We carried out desk research and evaluation of the relevant literature and

quantitative evidence on the e-cigarette market in Europe. Our empirical analysis

is set out in Chapter 2. We note that good empirical analysis of the issues around

e-cigarette taxation is hampered by a lack of timely, comprehensive and high

quality data on the market for e-cigarettes in Europe.

Our analytical framework was guided by the economic literature on optimal tax

theory, in particular for the taxation of goods and services. We drew heavily on

the recent, influential Mirrlees Review of the characteristics of a good tax system,

in particular the work of experts in indirect tax policy Professors Ian Crawford

(University of Oxford), Michael Keen (IMF) and Stephen Smith (UCL).3

1 http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2011:176:0024:0036:EN:PDF

2 http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=COM:2015:621:FIN&rid=1

3 We drew on the overall report Tax By Design (Mirrlees, J. et al. (2011), available at

https://www.ifs.org.uk/publications/mirrleesreview/) and the specific supporting chapter on VAT and excise duties (Crawford, I., M. Keen and S. Smith (2010), ‘VAT and excises’, in J. Mirrlees et al., Dimensions of Tax Design, Oxford: Oxford University Press (https://www.ifs.org.uk/uploads/mirrleesreview/dimensions/ch4.pdf)).

http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2011:176:0024:0036:EN:PDF

http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=COM:2015:621:FIN&rid=1

https://www.ifs.org.uk/publications/mirrleesreview/

https://www.ifs.org.uk/uploads/mirrleesreview/dimensions/ch4.pdf



In terms of economic rationales for excise taxes, we identified three key

arguments which are the subject of separate Chapters of this analysis:

1. To raise revenue in the least economically distorting way (Chapter 3);

2. To account for external costs associated with consuming goods and services

(Chapter 4); and

3. To account for ‘internalities’ associated with difficulties people have in

making optimal decisions about what to consume, particularly for addictive or

unhealthy products (Chapter 5).

In Chapter 6, we also consider issues around administration and compliance of

excise taxes: would a tax on e-cigarettes would be cheap to collect and enforce?

Terminology

We define three key terms of interest that are used frequently in this report:

E-cigarettes: Electronic cigarettes are hand-held devices including an atomiser,

battery and liquid-filled cartridge. The liquid is heated to release vapour, usually (not

always) containing nicotine which is inhaled by the user. There are many types of e-

cigarette and we use the term as a shorthand for them all, including (not limited to):

□ Disposable e-cigarettes or ‘cig-a-likes’ which are disposed of once the battery runs out or the

pre-filled liquid cartridge is emptied;

□ Rechargeable e-cigarettes and vape pens where the battery can be re-charged and liquid

cartridges replaced; and

□ Vaping devices / tank systems where a liquid tank is refilled manually by the consumer using e-

liquids, purchased separately from the base system.

Conventional tobacco products: Refers to combustible cigarettes in the main but

also used as a shorthand to cover e.g. hand-rolling tobacco, cigars and pipe tobacco.

Excise duty: Any tax levied per unit sold (‘specific’ duty) or as a proportion of the

retail price (‘ad valorem’ duty) for a defined group of products. The terms ‘excise tax’

and ‘excise duty’ are used interchangeably.



2 THE MARKET FOR E-CIGARETTES

The market for e-cigarettes is relatively new but rapidly-growing. The first

products were introduced to the market in 2006. By 2015, sales of e-cigarettes in

Europe were just over €2.8 billion, with sales roughly doubling year on year to

2013, and rising at around 30% per year since then (see Figure 1). In 2015, the

largest market for e-cigarette sales in the EU by far was the UK, with sales of

€911 million. Poland, Italy, France and Germany were the four other largest

markets, with sales in each around €200 million to €400 million.

Figure 1 Value of e-cigarette sales in the EU, 2010 to 2015, real-terms

Source: Euromonitor International

While sales of e-cigarettes in Europe have been rising rapidly, they remain very

small compared with sales of conventional tobacco products. In 2015,

combustible cigarette sales in the EU were €125 billion, 44 times larger in cash

terms than the e-cigarette market. Between 2010 and 2015, e-cigarette sales as

a fraction of conventional cigarette sales rose from 0.1% to 2.4% (see Figure 2).

The significant size of the conventional cigarette market is also reflected in their

importance as a source of tax revenue. In 2015, excise duties on tobacco

products raised around €83.6 billion in the EU (see Figure 3). This amounted to

around 1.4% of all tax revenues in the EU that year.4

4 Eurostat estimates of total EU tax receipts in 2015 were €5.88 trillion, including compulsory social insurance.



Figure 2 E-cigarette sales in the EU compared with combustible, 2010 to 2015, real-terms

Source: Euromonitor International, Frontier calculations

Figure 3 EU Excise duty receipts from tobacco products, 2014 and 2015

Source: European Commission DG-TAXUD

(http://ec.europa.eu/taxation_customs/sites/taxation/files/resources/documents/taxation/excise_duties/tobacco_products/rates/excise_duties_tobacco_en.pdf); Frontier calculations

Note: Data unavailable on a consistent basis for all countries before 2014. Figures not adjusted for inflation.

http://ec.europa.eu/taxation_customs/sites/taxation/files/resources/documents/taxation/excise_duties/tobacco_products/rates/excise_duties_tobacco_en.pdf

http://ec.europa.eu/taxation_customs/sites/taxation/files/resources/documents/taxation/excise_duties/tobacco_products/rates/excise_duties_tobacco_en.pdf



3 REVENUE-RAISING

3.1 Introduction

Excise taxes represent a significant source of revenue in many EU member

states. Alcohol and tobacco excises together, for example, raised more than

€118 billion in the EU-28 in 2014, or 2.2% of all tax revenues. At the national

level, alcohol and tobacco excises are a more significant source of revenue in

many member states, accounting for 8.8% of receipts in Hungary in 2014, 6.3%

in Estonia and 5.5% in Romania.5 For finance ministries, the potential to raise

revenue from excise taxes is often a compelling political rationale for increasing

existing excises or introducing new excise duties on other commodities.

The key economic rationale, however, focuses on raising tax revenue in the

most efficient way possible. Here, efficiency has a particular meaning: taxes

should be raised to minimise the distortion to people’s decisions about what to

buy or what to produce. The idea is that, given a certain amount of money to

spend, people will buy the goods and services that make them as well-off as

possible. When there are taxes, people must be less well-off – either because

their income is taxed so they have less to spend; or because goods and services

are taxed meaning that prices increase. The less that decisions can be distorted,

the less is the impact on people’s well-being.

In Chapters 4 and 5 we explore evidence for two arguments that suggest that

taxes can sometimes improve overall well-being: either because what people

choose to buy and consume has a negative effect on others (externalities,

Chapter 4); or because people may not make fully-informed decisions about what

to buy in terms of their own well-being (internalities, Chapter 5). We examine

whether these economic arguments apply to e-cigarettes.

In this Chapter, we ignore those issues and focus instead on the question of

whether there would be a case for an excise tax on e-cigarettes on the grounds

of it helping to raise tax revenue in a more efficient (less distorting) way than

other forms of taxation.

3.2 The economic arguments

Economists have been studying so-called ‘optimal commodity taxation’ for

decades, and the most influential analysis was written by Frank Ramsey ninety

years ago.6 Ramsey outlined that when the government was limited to raising

revenue from taxing goods and services, the economic distortions would be

minimised if tax rates were higher on goods and services that are price inelastic

(see box). That is – when the demand for a product is not very sensitive to its

price, then the tax rate should be high; when demand is very sensitive to price,

the tax rate should be low.

5 Data from Table 42 of Taxation Trends in the European Union 2016 Edition

(http://ec.europa.eu/taxation_customs/sites/taxation/files/resources/documents/taxation/gen_info/economic_analysis/tax_structures/2016/econ_analysis_report_2016.pdf)

6 Ramsey, F. (1927), ‘A contribution to the theory of taxation’, Economic Journal, 37, 47–61.

http://ec.europa.eu/taxation_customs/sites/taxation/files/resources/documents/taxation/gen_info/economic_analysis/tax_structures/2016/econ_analysis_report_2016.pdf

http://ec.europa.eu/taxation_customs/sites/taxation/files/resources/documents/taxation/gen_info/economic_analysis/tax_structures/2016/econ_analysis_report_2016.pdf



Price elasticities

Price elasticity measures how responsive the demand for a good or service is to price. A

key measure is the own-price elasticity of demand, defined as:

Since demand tends to fall when prices rise, the own price elasticity is negative. For

example, an own-price elasticity of –2.0 means that a 10% increase in price would lead to

a 20% reduction in demand, all else equal; an own-price elasticity of –0.5 means that a

10% increase in price would lead to a 5% reduction in demand, all else equal. When the

own-price elasticity is between 0 and –1, the product is said to be price inelastic

(demand is relatively unresponsive to price). When the own-price elasticity is below –1,

the product is said to be price elastic (demand is relatively responsive to price).

Another important measure is the cross-price elasticity of demand, defined as:

The cross-price elasticity shows how the demand for a product responds to changes in

the price of a different product, all else being equal. If the cross-price elasticity is positive,

the products are said to be substitutes (for example, an increase in the price of tobacco

could increase the demand for e-cigarettes). If the cross-price elasticity is negative, the

products are said to be complements (for example, an increase in the price of e-

cigarette cartridges could reduce the demand for liquid refills).

In general, the price elasticity is not independent of the price. Elasticities tend to be larger

(that is, more price sensitive) at higher prices. This is intuitive – a 10% increase from a

high base price is a larger increase in cash terms than a 10% increase from a low price.

The intuition is clear: if demand does not respond much to price, then a higher

tax (leading to a higher price) will not change decisions about what to buy very

much, and so the distortion to behaviour is limited. There is also another way to

look at this focused on the sustainability of tax revenues: if a product is very price

elastic, then a higher tax could feasibly reduce demand so much that overall tax

revenues fall rather than rise.

Taken at face value, the ‘Ramsey Rule’ gives a clear economic hypothesis: there

would be a more compelling case for an excise on e-cigarettes if they are

price inelastic. We explore the evidence in Section 3.3.

More recently, the economic theory around how best to tax different goods and

services has developed to highlight two key points:7

Even if a product is price inelastic, higher taxes on that product could distort

the demand for other goods and services unless there are no cross-price

effects. Cross-price elasticities cannot, therefore, be ignored.

When governments have the option to tax income as well as goods and

services (as is the case in all developed economies), these taxes cause

distortions to how much people are willing to work. The economic case for

varying tax rates on goods and services then rests more on whether these

7 Summarised in Crawford, I., M. Keen and S. Smith (2010), ‘VAT and excises’, in J. Mirrlees et al., Dimensions

of Tax Design, Oxford: Oxford University Press (https://www.ifs.org.uk/uploads/mirrleesreview/dimensions/ch4.pdf)




distortions to work incentives can be mitigated. In particular, tax rates should

be lower on goods and services which are associated with working

(such as formal clothes or uniforms) and higher on good and services

which are associated with leisure time (such as casual clothes).

On the former point, we therefore develop a second hypothesis: purely on

revenue-raising grounds, there would be a more compelling case for an

excise on e-cigarettes if they are substitutes for other highly-taxed

products. This is because taxing e-cigarettes would increase the demand for

these products, and so raise revenue. However, as we discuss below, there

would clearly be negative consequences in terms of health from this substitution.

On the latter point, it is important to be clear that no practical examples exist of

taxes on products being introduced or raised on the basis of them being

associated with leisure time, and there is little reliable evidence on how far

individual products are particularly associated with work or with leisure that could

be used as the basis for designing tax policy. Some studies have looked at the

extent to which, for example, tobacco is associated with work or with leisure, but

as summarised in Crawford et al. (2010) in the influential Mirrlees Review:8

“… in the current state of knowledge, it is unlikely that cigarette

consumption is sufficiently complementary with leisure to warrant high

taxation on those grounds alone.” (p. 319)

Given the lack of evidence on this for e-cigarettes, we do not consider it further.

3.3 Is demand for e-cigarettes price inelastic?

Perhaps unsurprisingly, given that e-cigarettes have not been available for very

long, there is limited evidence on own- and cross-price elasticities of demand for

these products. This is certainly true compared against the quite voluminous

literature on elasticities for traditional cigarettes.9 We reviewed the literature with

a detailed keyword search using search engines for academic publications and a

general search of the so-called ‘grey’ literature (policy reports and non-academic

publications). In total, we identified only five studies, summarised in Figure 4,

which attempted to estimate own- or cross-price elasticities of demand for e-

cigarettes. In terms of our main hypotheses:

Almost all studies find that e-cigarettes are price elastic, which would not

rationalise a new excise tax on them. The one exception (Stoklosa et al,

2016) finds that e-cigarettes are price inelastic in the short-term, but price

elastic in the long-term once the addictive nature of demand is accounted for.

All studies find that e-cigarettes and traditional cigarettes are substitutes.

This suggests that an excise tax on e-cigarettes would raise demand for

traditional cigarettes, which are highly taxed, which could raise tax revenues

overall. However, this completely ignores the health and addiction issues in

encouraging e-cigarette users to switch back to traditional tobacco which we

address in Chapters 4 and 5.

8 Crawford, I., M. Keen and S. Smith (2010), ‘VAT and excises’, in J. Mirrlees et al., Dimensions of Tax Design,

Oxford: Oxford University Press (https://www.ifs.org.uk/uploads/mirrleesreview/dimensions/ch4.pdf) 9 Gallet and List (2003), for example, identified more than 80 studies on tobacco price elasticities (Gallet, C. and

J. List (2003), ‘Cigarette demand: a meta-analysis of elasticities’, Health Economics, 12(10), 821–35.




Figure 4 Evidence on the price elasticity of demand for e-cigarettes

Study Method Own-price elasticity Cross-price elasticity Comments

Zheng, Y. et al. (2016)

Analysis of scanner data sales, tobacco and e-cigarette products. Uses systems approach to demand estimation. The e-

cigarette category includes disposables, starter kits and replacement cartridges.

-2.1

(price elastic)

Cross-price elasticity of e-cigarettes with respect to

cigarette prices is +1.9.

(substitutes)

Good theoretical foundation but relies on scanner data so does not fully capture e-cigarette market. However, e-

cigarette prices do account for quality changes.

Pesko, M. et al. (2016)

Online hypothetical purchase experiment. 1,200 smokers in US

-1.8

(price elastic)

Hypothetical choice experiment may lack real-world validity. Representative sample of smokers, not e-cigarette users.

Stoklosa, M. et al. (2016)

Panel data of monthly e-cigarette and conventional cigarette sales in 6 EU

countries, Dec 2011 to Oct 2014. Time series analysis of impact of prices on e-

cigarette demand, controlling for country fixed effects, time trends and various other

variables.

Static models: -0.8 (price

inelastic)

Dynamic models, allowing for addictive nature: short-

run elasticity -0.3 (price

inelastic); long-run elasticity -1.1 to -1.2 (price elastic).

Cross price elasticity of e-cigarettes with respect to

price of conventional cigarettes estimated at +3.6 to +4.6 in static model, and

+6.5 in dynamic model (substitutes)

Model passes statistical tests for panel data validity. Data do not provide good coverage of e-cigarette sales and exclude

e-liquids. Prices may not account for quality changes. “Long-run” elasticities measured over short time period.

High cross price elasticity could reflect relative immaturity of e-cigarette market (rapid time series growth) not fully

captured in time trends in specification. Also finds substitution between snus and e-cigarettes in Sweden.

Grace, R. et al. (2015)

Experimental approach with sample of 210 smokers in New Zealand; and asked

hypothetical purchase questions at higher and higher conventional cigarette prices.

Not estimated; interest was in cross-price elasticities.

Average cross price elasticity of e-cigarettes with

respect to conventional cigarette price +0.2

(substitutes).

Hypothetical choice approach so not clear how valid to real-world decisions. Only included those who had never used e-

cigarettes so not applicable to whole population.

Huang, J. et al. (2014)

US scanner data, quarterly, 59 geographic areas, 2009 to 2012. Panel data

estimation to identify elasticities, including market, time and store effects. Analyse

disposable and reusable e-cigarettes separately as quite distinct products.

Disposable e-cigarettes: -1.2 (price elastic);

reusable: -1.9 (price elastic).

Cross price elasticities of e-cigarettes (disposable and

reusable) with respect to conventional cigarette

prices positive (substitutes); not statistically significant.

Data limited to sales in the stores captured by the scanner company, so does not account for online sales, and does not cover vaping products. High own-price elasticity could partly

reflect substitution to vaping.

Sources: Zheng, Y., C. Zhen, D. Dench and J. Nonnemaker (2016), ‘US demand for tobacco products in a system framework’, Health Economics; Pesko, M., D. Kenkel, H. Wang and J. Hughes (2016), ‘The effect of potential electronic nicotine delivery system regulations on nicotine product selection’, Addiction, 111(4), 734–44; Stoklosa, M., J. Drope and F. Chaloupka (2016), ‘Prices and e-cigarette demand: evidence from the European Union’, Nicotine and Tobacco Research, 18(10), 1973–80; Grace, R., B. Kivell and M. Laugesen (2015), ‘Estimating cross-price elasticity of e-cigarettes using a simulated demand procedure’, Nicotine and Tobacco Research, 592–98; Huang, J., J. Tauras and F. Chaloupka (2014), ‘The impact of price and tobacco control policies on the demand for electronic nicotine delivery systems’, Tobacco Control, 23(3), 41–7.

Note: Elasticity estimates rounded to nearest 0.1 to avoid spurious precision.



The evidence on the own-price elasticity of demand for e-cigarettes suggests that

a small increase in price could lead to a significant fall in demand. There are a

number of potential explanations for this finding:

The market for e-cigarettes is relatively immature. Consumer preferences for

e-cigarettes may not be well entrenched and so susceptible price changes.

The introduction of e-cigarettes means that smokers now have a greater

range of substitutes than before. High e-cigarette own price elasticities may

be picking up the ability to substitute to combustible tobacco, refill products,

heat not burn products, and so on. When there are more substitutes for a

product, own-price elasticities are more elastic.

The relatively low base in e-cigarette demand means that small changes in

quantity resulting from substitution from conventional tobacco products

translates into large percentage changes, which may be correlated with

movements in e-cigarette prices.

Current modelling of elasticities may not be able to fully account for other

drivers of demand which are also correlated with price (such as changes in

the quality of e-cigarettes).

The latter explanation also reflects difficulties in modelling price elasticities for e-

cigarettes given a lack of high quality data. Most of the non-experimental studies

cited in Figure 4 use a short time series of sales data from different ‘markets’

(regions or countries) and construct prices for e-cigarettes based on observed

volume and values of sales. The models estimated may not fully capture changes

in the quality of e-cigarettes, and typically do not capture online sales which, as

we saw in Chapter 2, are a significant source of e-cigarette sales.10

Ideally, estimation of e-cigarette elasticities would be based on a long time series

of data with prices varying across time and location, fully observing the market for

e-cigarettes (types of product and online/offline sales) and including similar data

for close substitutes such as combustible tobacco. This would allow a ‘demand

system’ to be estimated, consistent with economic theory.

While none of the studies cited fully achieve this, the one that comes closest

(Zheng et al, 2016) still finds that the own-price elasticity of demand for e-

cigarettes is price elastic; indeed, at –2.1 it is the most elastic of all estimates in

the literature. Their study does estimate a demand system, including combustible

tobacco, and all types of e-cigarettes including refillables. However, the data do

not account for the online market. It is not clear what impact this has on the

estimated own-price elasticity for e-cigarettes. If the estimate is partly capturing

(unobserved) substitution from retail to online purchases, then the market-level

demand for e-cigarette products would be less price sensitive. However, if retail

purchasers are less price sensitive than online purchasers (who can more readily

compare prices and switch retailers) then the market-level demand for e-

cigarettes could be more price sensitive.

10 High elasticities could also therefore reflect an unobserved substitution to online sales of e-cigarettes.



3.4 Conclusion

Economic theory suggests that there would be a stronger case for an excise tax

on e-cigarettes if demand for them is not very sensitive to their price. While the

evidence base on this question is fairly limited, the best available evidence from

both experimental and observed data suggests that, if anything, the demand for

e-cigarettes is price sensitive. Own-price elasticities of demand for e-cigarettes

range between –1.1 and –2.1.

On this basis, there is no strong rationale for a new excise tax.

The literature does point to combustible cigarettes and e-cigarettes as being

closely substitutable. Purely from a revenue-raising perspective, therefore, an

excise tax on e-cigarettes would increase demand for combustible cigarettes

which are already highly taxed, and therefore raise additional revenue. However,

this ignores the health and addiction issues raised by encouraging current users

of e-cigarettes to switch to combustible tobacco. We turn to these in the next

Chapters.



4 EXTERNALITIES

4.1 Introduction

In this section we set out the economic principles of externality based

consumption taxes and their potential application to e-cigarettes. On the basis of

current evidence, we find:

No clear rationale in the current market for significant excise taxes on e-

cigarettes on the basis of externalities:

□ E-cigarettes are substantially less harmful than smoking conventional

tobacco products and the evidence suggests that the vast majority of e-

cigarette users are already smokers;

□ switching to e-cigarettes reduces the harm to health for these smokers,

and reduces the associated costs to wider society.

In a world without conventional cigarettes there would be some residual case

for an externality-based tax driven by potential health harms from nicotine

intake – but the best current evidence suggests these would be much lower

than any taxes on conventional tobacco products.

4.2 The negative externality rationale for taxation

There is a longstanding literature on negative externalities as a rationale for

taxation.11 Negative externalities occur where the consumption of a good or

service leads to costs to wider society. These costs are not fully reflected in the

price of the product, and so not taken into account by individuals making private

decisions about how much of the product to consume. As a result, there is too

much consumption of these goods and services when looked at from a societal

perspective. Goods that cause environmental costs are a classic example.

Taxation can be used to adjust for this. In particular, economic theory is clear that

an optimal externality-correcting tax should be set such that the external cost to

society of consuming one more unit of the product is exactly equal to the tax on

that unit.12 Assuming the tax is reflected in the price of the product, demand will

fall to the socially desirable level.

These negative externality arguments have been increasingly given as a

rationale for taxation of conventional tobacco products over recent decades.13

There are two main types of negative externalities from smoking conventional

tobacco, both relating to health impacts:

Costs to society from the health impacts on the smoker: these relate to

publicly funded healthcare costs of treating smokers for the harm caused by

11 The economic theory discussed here was first set out in Pigou (1962). Such taxes are often referred to as a

‘Pigouvian tax’. 12

This is what economists mean by taxes set at the marginal external cost. This is not the same as saying that the total revenue raised from the tax should be equal to the total social harms done by the product in question. An optimal externality-correcting tax could raise more, or less, than the social harms.

13 See, for example, Chaloupka and Warner (2000), ‘The economics of smoking’; and, for a summary of the

evidence on the magnitude negative externalities, see Crawford et al (2010), ‘Value added tax and excises’.



their own smoking (note that this is separate from the costs to the smokers

themselves, which we discuss in Chapter 5).

Costs resulting from the health impacts on others: these relate to the

costs from passive smoking, both in terms of the individual costs to passive

smokers and the costs relating to public funding of their healthcare.

An optimal tax would therefore be set equal to the marginal increase in these

costs from smoking an additional unit of tobacco.

4.3 Negative externalities and e-cigarettes

We now consider the extent to which the negative externalities rationale outlined

above applies to taxation of e-cigarettes. This depends upon: the health impacts

for e-cigarette users, the health impacts for bystanders from passive inhalation,

and interactions with the use of conventional tobacco products.

4.3.1 Health impacts for e-cigarette users

There is a growing literature assessing the potential health impacts from the use

of e-cigarettes. The evidence base is not as mature as that for conventional

tobacco products, particularly in terms of any long-term impacts from nicotine

exposure. Nonetheless, the current evidence base points to e-cigarettes being

substantially less harmful than conventional tobacco products.

Public Health England (PHE) have commissioned three expert reviews on the

health impacts of e-cigarettes. The latest review, in 201514, updates and expands

on the evidence from the previous reviews. The review concludes that a

reasonable estimate is that e-cigarettes are around 95% safer than smoking. This

estimate draws principally on Nutt et al (2014)15, which used an international

expert panel to estimate the relative harm of e-cigarettes.

Subsequent UK publications have been consistent with these findings. In 2016,

PHE published a joint statement on e-cigarettes with 12 leading UK public health

organisations. This concludes that,

“All the evidence suggests that the health risks posed by e-cigarettes are

relatively small by comparison [with conventional cigarettes] but we must

continue to study the long-term effects”.16

West et al (2015)17 provides a review of e-cigarette evidence presented to the UK

All Party Parliamentary Group on Smoking and Health. This also finds that e-

cigarettes are much less harmful than smoking, but not 100% safe.

14 McNeill, Brose, Calder, Hitchman, Hajek and McRobbie (2015), E-cigarettes: an evidence update. A report

commissioned by Public Health England’ 15

Nutt, Phillips, Balfour, Curran, Dockrell, Foulds, Fagerstrom, Letlape, Milton, Polosa, Ramsey, Sweanor (2014), ‘Estimating the harms of nicotine-containing products using the MCDA approach’

16 PHE (2016), ‘E-cigarettes: a developing public health consensus’. The organisations on the joint statement

are: Public Health England, Action on Smoking and Health, Association of Directors of Public Health, British Lung Foundation, Cancer Research UK, Faculty of Public Health, Fresh North East, Healthier Futures, Public Health Action, Royal College of Physicians, Royal Society for Public Health, UK Centre for Tobacco and Alcohol Studies, and UK Health Forum.

17 West, Hajek, McNeill, Brown, and Arnott (2015) ‘Electronic cigarettes: what we know so far. A report to UK

All Party Parliamentary Groups.’



Glasser et al (2017)18 provides a systematic review of evidence on e-cigarettes.

The review included 687 articles, with the majority assessing patterns of e-

cigarette use and consumer perceptions, followed by studies examining health

effects and product features. The authors find that the evidence suggests e-

cigarettes pose substantially less harm to smokers than cigarettes, while further

research is needed to assess long-term health effects.

Shahab et al (2017)19 provide an assessment of the nicotine, carcinogen and

toxin exposure in long-term e-cigarette users relative to nicotine replacement

therapies and conventional cigarettes. The authors find that e-cigarette only

users, and nicotine replacement therapy only users, obtain roughly similar levels

of nicotine compared with smokers of conventional cigarettes. Long-term e-

cigarette only use is associated with substantially reduced levels of measured

carcinogens and toxins relative to smoking. NNAL levels20 in e-cigarette only

users were significantly lower than all other groups studied, with levels reduced

by 97% compared to smoking. E-cigarette only users also had significantly lower

levels of all major metabolites of selected toxic and carcinogenic volatile organic

compounds than smokers. However, dual users of conventional cigarettes with e-

cigarettes or nicotine replacement therapies had largely comparable results to

users of conventional cigarettes only. The results suggest fully replacing

conventional cigarette use with e-cigarettes may reduce health risks significantly.

Some studies have suggested risks for specific sub-groups from nicotine

exposure. The World Health Organisation (WHO) (2014) examines emerging

evidence on the health impacts of e-cigarettes. The report identifies specific risks

for children, adolescents and pregnant women, because of a potential for foetal

and adolescent nicotine exposure to have long-term consequences for brain

development. Similarly, England et al (2015)21 finds evidence of risks from

nicotine exposure for foetal brain and lung development, and altered

development of cerebral cortex and hippocampus in adolescents.

Overall the evidence in the current literature suggests e-cigarettes are

substantially less harmful to users than smoking conventional tobacco products.

Potential risks are identified for specific groups, or from long-term effects from

nicotine exposure, but further research is needed to understand the extent of any

risks to health. The literature has not so far tied e-cigarette use to public costs of

health service provision, but the low health risks of e-cigarettes and (as

discussed below) the fact that e-cigarettes substitute for consumption of

combustible tobacco suggests that the public health costs at present are likely to

be negative, as a result of discouraged consumption of tobacco products.

18 Glasser, Collins, Pearson, Abudayyeh, Niaura, Abrams and Villanti (2017), ‘Overview of Electronic Nicotine

Delivery Systems: A Systematic Review’ 19

Shahab, Goniewicz, Blount, Brown, McNeil, Udeni Alwis, Feng, Wang and West (2017), ‘Nicotine, Carcinogen, and Toxin Exposure in Long-Term E-Cigarette and Nicotine Replacement Therapy Users: a cross-sectional study’

20 The carcinogenic metabolite 4-(methylnitrosamino)-1-(3-pyridyl)-1-butanol.

21 England, Bunnell, Pechacek, Tong and McAfee(2015), ‘Nicotine and the Developing Human: A Neglected

Element in the Electronic Cigarette Debate’



4.3.2 Health impacts from passive use of e-cigarettes

There have been a number of recent studies into the potential for e-cigarettes to

cause social costs through passive ‘smoking’. The evidence is limited. Most

studies suggest that the release of nicotine and other chemicals into

surroundings is low; some nonetheless identify potential health risks, but the risks

appear small compared to passive smoking of conventional tobacco products.

Long (2014)22 examined the composition of exhaled air from the use of two

leading e-cigarette brands in the United States. The composition was found to be

over 99.9% water and glycerine, and less than 0.06% nicotine. Bertholon et al

(2013)23 estimated the ‘half-life’ of particles exhaled by users at 11 seconds from

e-cigarettes, compared to 19-20 minutes from tobacco smoke.

Maloney et al (2016)24 outlined results from two studies to measure indoor air

concentrations of chemicals from e-cigarettes. A validated industrial hygiene

sampling methodology was used to test concentrations of nicotine, menthol,

propylene, glycol, clycerol, formaldehyde and total particles. The studies found

that the use of e-cigarettes does not produce chemical constituents at

quantifiable levels.

As outlined in Section 4.3.2 above, Shahab et al (2017) assesses the nicotine,

carcinogen and toxin exposure in long-term e-cigarette users. The authors find

that those switching entirely from conventional cigarettes to e-cigarettes have

substantially reduced levels of measured carcinogens and toxins relative to

smoking. This suggests any related risks from passive intake of e-cigarettes may

also be much lower than conventional cigarettes.

Two recent systematic reviews of the literature have reached slightly different

conclusions on the potential health risks. Hess et al (2016) undertakes a

systematic review of the literature on passive use of e-cigarettes, identifying 16

relevant studies (including Long (2014) above). Limitations were identified in all

of the studies, such as a focus only on short-term effects, issues translating

animal studies to humans, and very small sample sizes. The authors conclude

that current evidence shows the potential for health impacts from passive

exposure to vapours from e-cigarettes, but that the risk is likely to be lower than

from conventional cigarettes. McNeill et al (2015) undertakes a review identifying

25 studies regarding nicotine content of ambient air, e-liquid and vapour. The

authors conclude that e-cigarettes release negligible levels of nicotine into

ambient air and that there are no identified health risks to bystanders.

Overall the evidence in the literature suggests that health risks from the passive

use of e-cigarettes are significantly lower than passive smoking of conventional

tobacco products. There are mixed findings on the extent of the remaining risk,

reflecting limitations in the current evidence base.

22 Long (2014), ‘Comparison of Select Analytes in Exhaled Aerosol from E-Cigarettes with Exhaled Smoke

from a Conventional Cigarette and Exhaled Breaths’ 23

Bertholon, Becquemin, Roy M, Roy F, Ledur, Annesi Maesano and Dautzenberg (2013), ‘Comparison of the aerosol produced by electronic cigarettes with conventional cigarettes and the shisha’

24 Maloney, Thompson, Oldham, Stiff, Lilly, Patskan, Shafer and Sarkar (2016), ‘Insights from two industrial

hygiene pilot e-cigarette passive vaping studies’



4.3.3 Prevalence of e-cigarettes

The overall health impacts of e-cigarettes can only be understood when

considering their place in the market alongside conventional tobacco products.

The impacts depend critically on the extent to which e-cigarette use is the result

of switching away from conventional tobacco products, or take-up by those that

did not previously smoke.

European survey data on ‘current use’ shows low prevalence throughout Europe

in 2014, as show in Figure 5 below.25 Average prevalence is 2% across the EU,

with the highest being 4% in the UK and France, and the lowest being 0%,

reported in Hungary, Romania, Slovenia and Sweden.

Figure 5 Prevalence of e-cigarette users in EU countries 2014 (%)

Source: Eurobarometer 2014 data

Using the same dataset, Filippidis et al (2016)26 estimate changes in e-cigarette

use in EU countries from 2012 to 2014. Prevalence of ever having used e-

cigarettes across 27 EU member states is found to have increased from 7.2% in

2012 to 11.6% in 2014. However, only around 1 in 7 ‘ever users’ describe

themselves as ‘current users’. Current smokers are found to be around 23 times

more likely to have ever used e-cigarettes than those who have never smoked,

and former smokers are around 7 times more likely.

ASH (2016a)27 outlines recent survey evidence on e-cigarette use in Great

Britain. Among adults, 51% of e-cigarette users are found to be current smokers

and 47% are ex-smokers. E-cigarette use by those who have never smoked is

found to be very rare, and has been stable since 2012. Evidence for e-cigarette

25 European Commission (2015), ‘Attitudes of Europeans towards tobacco and electronic cigarettes’

26 Filippidis, Anthony, Laverty, Vasiliki, Gerovasili, Constantine and Vardavas (2016), ‘Two-year trends and

predictors of e-cigarette use in 27 European Union member states’ 27

ASH (2016), ‘Use of electronic cigarettes (vapourisers) among adults in Great Britain’

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

EU BE BG CZ DK DE EE IE EL ES FR HR IT CY LV HU NL AT PL PT RO SI SK FI SE UK



use among children gives similar results. ASH (2016b)28 surveys use of e-

cigarettes among 11-18 year olds. Use is again almost exclusively among current

or ex-smokers. Just 4% of never smokers are found to have ever tried e-

cigarettes, and 0% use them once a month or above. This compares to 38% of

current smokers and 28% of ex-smokers who have tried e-cigarettes.

A review of international evidence on e-cigarette use is provided in McNeill et al

(2015). Current use of e-cigarettes is found to be associated with being a smoker

or ex-smoker, similar to findings for the UK. However, McNeill et al (2015) notes

a number of difficulties in making international comparisons, notably

inconsistencies around terminology and measures. The authors highlight this as

an area in need of further research.

The evidence shows that the vast majority of e-cigarette use is from current or

former smokers, while use among those that have never smoked is relatively

rare. This is the case both for adults and children.

4.4 Conclusion

The available evidence suggests there is not a clear externalities rationale for

taxing e-cigarettes in the current market.

We have found that e-cigarettes are substantially less harmful than conventional

tobacco products. The evidence suggests this is the case both for users of e-

cigarettes and passive intake. It is possible that a residual risk to health remains

for both groups, but evidence on the scale of this risk is an area in need of

additional research.

To the extent that there is a residual health risk from e-cigarettes, this could in

theory provide a rationale for a tax if considering the e-cigarette market in a world

without conventional tobacco products. The optimal level for such a tax would

need to be proportionate to the social costs, which is very difficult to determine

precisely on the basis of the current evidence. However, it would be a much

lower rate than the equivalent optimal tax rate on conventional cigarettes.

More importantly, the e-cigarette market does not operate in isolation. It is

essential to take into account interactions between e-cigarette use and

conventional tobacco smoking to determine the marginal impact of e-cigarette

use. The evidence shows that the vast majority of e-cigarette use is from current

or former smokers. E-cigarettes reduce the health risks for these individuals and

for passive smokers, and therefore reduce the social costs. Meanwhile, take-up

of e-cigarettes by those that have never smoked is relatively rare. This suggests

there may be positive externalities from e-cigarettes as a substitute for

conventional tobacco.

This conclusion could change in a future world in which consumption of

conventional cigarettes is relatively low and the market is dominated by e-

cigarettes or other nicotine delivery services. In that world, an externality-

correcting excise tax at a rate commensurate with the marginal external costs

would be more strongly justified.

28 ASH (2016), Use of electronic cigarettes (vapourisers) among children in Great Britain’



5 INTERNALITIES

5.1 Introduction

In this section we outline the economic principles around ‘internality’ effects, and

their potential application as a rationale for taxation of e-cigarettes. Negative

internalities relate to inconsistencies between a consumer’s long-term wellbeing

and the decisions they make in the short-term. These are especially relevant to

addictive products.

We find that:

whilst in principle this argument could be applied to e-cigarettes (given the

addictive nature of nicotine), there is not a clear rationale for excise taxation in

the current market because of the role that they play in reducing consumption

of conventional tobacco products;

consumers tend to overestimate the relevant health risks of e-cigarettes

compared with tobacco;

low current take-up of e-cigarettes among non-smokers suggests any

internality from addiction to e-cigarettes for this group are currently very

limited, though the evidence base here is limited; and

an excise tax would be a blunt instrument compared with effective information

provision and regulation to ensure people make informed decisions about

using e-cigarettes.

5.2 The rationale for taxing goods that have internalities

The rationale for taxation on the basis of internality effects is very similar to that

of externalities. Indeed, internalities are sometimes defined as “externalities to a

future self” – the idea being that rather than consumption of a product causing

costs to other people, it causes a cost to the individual consuming it by going

against what he or she “truly” wants to do.

The internality argument builds on a growing literature influenced by behavioural

economics that demonstrates so-called ‘time inconsistencies’ in consumer

decision-making.29 The basic insight is that, for some products, consumers have

a ‘rational’ side that understands that consumption could be harmful, but a short-

term side that craves it. These different ‘selves’ can conflict. For example, if you

ask someone on a diet in the morning whether they plan to eat fatty food for

dinner in a restaurant, they may say no; but then when choosing from the menu

they succumb to the temptation to pick the fatty dish – which they may then later

regret. In such cases, a consumer’s long-term wellbeing can sometimes be

enhanced by influencing or restricting their choices in the short-term: for

example, not going to a restaurant with unhealthy options on the menu.

29 For a review, see Frederick, S., G. Loewenstein and T. O’Donoghue (2002), ‘Time discounting and time

preference: a critical review’, Journal of Economic Literature, 40(2), 351–401.



Internalities have been given as an additional rationale for taxes on conventional

tobacco products. This reflects that consumers may underestimate the future

harm to their health at the point of deciding to smoke a cigarette; or addiction

may mean that they continue to smoke despite wanting to quit. Gruber and

Koszegi (2004)30 develop a model accounting for time-inconsistency in cigarette

consumption. They find taxation can provide a ‘self-control’ function valued by

consumers who would like to quit but cannot. Mullainathan and Gruber (2005)31

assess empirical evidence with subjective well-being data in the US and Canada.

Cigarette taxes are found to improve the subjective wellbeing of those with a

propensity to smoke. Leicester and Levell (2016)32 repeat this finding with British

data, finding a positive impact of cigarette taxes on the wellbeing of those with a

high propensity to smoke, but no impact of other tobacco control policies such as

bans on smoking in public places.

Internalities may give a stronger economic rationale for traditional ‘paternalistic’

reasons for excise taxation: where it is believed that public authorities are better

informed about the harms associated with consuming particular goods and

services than individuals, and so wish to deter their consumption even if there is

no externality. While a theoretical case has been made for an ‘internality’ tax on

cigarettes, it is hard in practice to estimate what the ‘optimal’ tax would be.33

There are also no concrete examples of ‘internalities’ having been used to justify

the introduction of a new excise, or increases in existing excise duties.

5.3 Are there internalities from e-cigarettes?

We now consider whether the internalities rationale for taxation applies to e-

cigarettes. Such a tax would be motivated by:

the addictive nature of nicotine, and;

any future health risks that users of e-cigarettes overlook.

Given our findings that e-cigarettes are substantially less harmful to users than

conventional tobacco products, the internalities rationale depends critically on

interactions between the e-cigarette and tobacco markets. We explore this below

through evidence on motivations for e-cigarette use, and take-up among non-

smokers. This gives us an understanding of whether those starting to use e-

cigarettes fully understand the addictive nature of nicotine.

5.3.1 Motivations for e-cigarette use

We have seen that the vast majority of e-cigarette users are current or ex-

smokers. Any potential internalities effects will therefore be strongly influenced by

interactions between e-cigarette use and smoking.

Stopping or recuing smoking is an important motivation for people using e-

cigarettes. European survey data for 2014 shows 67% of respondents listed

30 Gruber and Koszegi (2004), ‘Tax incidence when individuals are time-inconsistent: the case of cigarette

excise taxes’ 31

Mullainathan and Gruber (2005), ‘Do Cigarette Taxes Make Smokers Happier?’ 32

Leicester and Levell (2016) ‘Anti-smoking policies and smoker well-being: evidence from Britain’ 33

Marron (2015), ‘Should we tax internalities like externalities?’



stopping or reducing smoking as an important reason for starting to use e-

cigarettes.34 This compares to 44% motivated by using e-cigarettes in places

where tobacco smoking is not allowed and 24% who considered them attractive,

cool or fashionable. Filippidis et al (2016)35 provides analysis of the motivations

for e-cigarette use in the European survey data for 2012 and 2014. The authors

find that those using e-cigarettes as a cessation aid were much more likely to

become ‘current users’, whereas those who tried e-cigarettes because they

considered it attractive were not more likely to become ‘current users’.

There is evidence that e-cigarettes help some, but not all, users to reduce or stop

smoking. The European survey data shows 14% of e-cigarette users stopped

smoking entirely and 21% reduced their smoking but did not stop (Figure 6). 36

Figure 6 Success in smoking reduction or quitting for e-cigarette users in EU 2014

Source: Eurobarometer 2014 data

West et al (2017)37 provides survey evidence of e-cigarette use in England. E-

cigarettes are now the most popular quitting aid in England. The latest data from

2016 finds that e-cigarettes are used by over 40% of smokers trying to stop in

their most recent quitting attempt. Ash (2016a) assesses the reasons why people

use e-cigarettes in Britain. The top reason for ex-smokers use of e-cigarettes is

“to help me stop smoking entirely” (67%) and for current smokers it is “to help me

reduce the amount of tobacco I smoke, but not stop completely” (41%). Saving

money compared with tobacco is also among the top three reasons for both

34 European Commission (2015), ‘Attitudes of Europeans towards tobacco and electronic cigarettes’

35 Filippidis et al (2016), ‘Two-year trends and predictors of e-cigarette use in 27 European Union member

states’ 36

European Commission (2015), ‘Attitudes of Europeans towards tobacco and electronic cigarettes’ 37

West, Beard and Brown (2017), ‘Trends in electronic cigarette use in England’

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

stopped smokingcompletely

stopped for awhile but started

again

reduced but didnot stop

did not reduce atall

increased don't know



groups.38 This again suggests e-cigarettes have a potentially important role in

reducing use of conventional tobacco products.

McNeil et al (2015) review the literature on the effectiveness of e-cigarettes as a

quitting and reduction aid. A number of random-control trials are assessed as

well as evidence from UK and international population studies. The authors find

evidence that e-cigarettes can help people to quit and reduce their cigarette

consumption.

While the majority of e-cigarette users are current or former smokers, and so

presumably aware of the addiction issues around nicotine consumption, there

may be an internality-based rationale for excise taxes on e-cigarettes if those

using them underestimate the health or addiction risks of e-cigarettes relative to

conventional tobacco products. However, if anything the evidence points the

other way. Ash (2016a) find that only 15% of surveyed adults in Britain correctly

identified e-cigarettes as a lot less harmful than smoking, down from 21% in

2013. Tan and Bigman (2014)39 find a similar trend in US data, with the

proportion of current smokers believing that e-cigarettes are less harmful than

smoking declining between 2010 and 2013.

Evidence on motivations for e-cigarette use does not appear consistent with the

internalities argument. Those using e-cigarettes appear to be primarily motivated

by a desire to reduce or stop smoking conventional cigarettes. There is also a

recent growing trend of consumers tending to overestimate the health risks of e-

cigarettes compared to smoking.

5.3.2 Use of e-cigarettes by non-smokers

Whilst most e-cigarette users are current or former smokers, take-up by those

that have never smoked could potentially lead to internality effects if there are

future risks to health for these individuals. This could result from non-smokers

becoming addicted to e-cigarettes, and the costs would be highest if e-cigarettes

provide a ‘gateway’ into smoking.

European survey data for 2014 shows which products individuals use first (Figure

7).40 Boxed cigarettes are by far the most frequent product smoked first (83%),

followed by hand-rolled (6%) and water-pipe (5%); e-cigarettes are essentially

never the first product used. Whilst this will be influenced by the relatively recent

availability of e-cigarettes, there is no evidence to date of a gateway effect from

e-cigarettes to tobacco products in the data.

38 This is consistent with the findings in Section Error! Reference source not found. that consumers see e-

igarettes and conventional tobacco as substitutes, and their relative prices influence consumer choices between them.

39 Tan and Bigman (2014), ‘E-Cigarette Awareness and Perceived Harmfulness: Prevalence and Associations

with Smoking-Cessation’ 40

European Commission (2015), ‘Attitudes of Europeans towards tobacco and electronic cigarettes’



Figure 7 Tobacco-related products first tried, EU, 2014

Source: Eurobarometer 2014 data.

Note: the remaining 3% were listed as “other (spontaneous)” and “don’t know”.

McNeil et al (2015) highlight flaws and misconceptions in the gateway argument,

suggesting that the terminology is abandoned until there is clarity over how it

could be tested. WHO (2014) review international studies on e-cigarette use

among adolescents. They find rapid increases in experimentation among

adolescents, but there are very few e-cigarette users who have never smoked

(mostly around 1% of the population). Friedman (2015) studies the causal

impacts of e-cigarette access for adolescents based on variations in policies

between US states. It is found that recent smoking is higher in states with bans

on e-cigarettes. Friedman concludes that this result is consistent with e-cigarette

access reducing smoking in adolescents.

Overall, e-cigarette use is rare among non-smokers and there does not appear to

be any evidence to date of a gateway effect into smoking. Whilst there could be a

potential internalities rationale for taxation to deter uptake up-take of e-cigarettes

by non-smokers in the future, this would be a poorly targeted measure in the

current market where the majority of use is by current or former smokers.

5.4 Conclusion

As with externalities, in theory there could be an internalities rationale for taxation

of e-cigarettes in a world without conventional tobacco products. Such a tax

would be based on the future costs that are overlooked when an individual

decides to use e-cigarettes, in particular if consumers are not fully aware of the

health or addiction risks from consuming them. However, there is little evidence

on the scale of any such internality.

83%

6% 5%

1% 1% 1% 0% 0% 0% 0%

Boxedcigarettes

Hand-rolledcigarettes

Water pipe Pipe Oraltobacco

Cigars Cigarilos Nasal snuff Chewingtobacco

Total e-cigarettes



In reality, the vast majority of e-cigarette consumption is from current or ex-

smokers. The evidence suggests that motivations for e-cigarette use are driven

primarily by a desire to quit or reduce smoking of conventional tobacco products.

E-cigarettes are now the most popular quitting aid in England. These interactions

with smoking are very important, as e-cigarettes would likely reduce future costs

where they help users to reduce or quite smoking. Consumers also tend to

overestimate the relative health risks of e-cigarettes, making it less likely that any

future costs are overlooked. Both points suggest that most current users of e-

cigarettes are not underestimating the risks associated with their use, and so do

not point to a compelling internality-based rationale for an excise tax.

The potential for uptake of e-cigarettes non-smokers could be an area of

particular relevance if those that would not otherwise have smoked become

addicted to e-cigarettes. However, e-cigarette use is rare among non-smokers

and there does not appear to be any evidence to date of a gateway effect into

smoking. Even if there are future concerns about whether non-smokers are

making fully-informed decisions about whether to start and continue using e-

cigarettes, this need not imply that a new excise tax is the ideal policy response,

since it would also affect other users for whom there are benefits from switching

to e-cigarettes from conventional smoking. Better provision of information and

regulation of advertising would be more sensible interventions.



6 ADMINISTRATION AND COMPLIANCE

6.1 Introduction

Chapters 3, 4 and 5 have focused on the ‘efficiency’ costs of excise taxes: aiming

to minimise or correct distortions to ensure that the tax system is as effective as

possible. There are, however, other costs associated with taxation:

Administration costs to public authorities to design the tax and put

processes in place to collect it, including enforcing the tax rules; and

Compliance costs for those who have to remit taxes to the authorities.

These costs can largely be thought of in monetary terms, but (particularly for

compliance and enforcement) there can also be significant opportunity costs for

those involved – time spent enforcing tax rules or complying with legal tax

obligations could perhaps be put to more productive use.

All else equal, taxes which generate lower administration and compliance costs

are clearly preferable: they leave more net revenue to spend, and cause less

financial and hassle costs to people remitting taxes. Where the potential yield

from a tax is low, issues around administration and compliance become more

acute. There is a degree of ‘economies of scale’ in tax compliance: there are

some fixed costs of setting up a structure to administer and comply with a new

tax. For very low yield taxes, there may be a risk that administration and

compliance costs could even exceed tax revenues.

A recent analysis of these issues in tax design highlighted a number of factors

which could be associated with lower administration and compliance costs for

excise duties:41

the tax is simple – with few rates, exemptions and ‘borderlines’ of what is

taxable, meaning reporting requirements are relatively straightforward and the

potential for legal dispute is minimised (this has been highlighted as the key

cost relating to excise duties on tobacco in the EU)42;

the tax is stable and ‘future-proofed’ – the scope of the tax is not subject to

frequent change meaning that authorities must alter collection processes and

those remitting the tax their compliance processes;

there are a small number of large remitters of the tax, given likely

economies of scale in tax compliance;

the product being taxed is fairly immobile – that is, it is hard to separate

where the product is taxed from where it is consumed.

41 Shaw, J., J. Slemrod and J. Whiting (2010), ‘Administration and compliance’, in J. Mirrlees et al., Dimensions

of Tax Design, Oxford: Oxford University Press (https://www.ifs.org.uk/uploads/mirrleesreview/dimensions/ch12.pdf)

42 Pedersen, H. et al (2012), Study on the measuring and reducing of administrative costs for economic

operators and tax authorities and obtaining in parallel a higher level of compliance and security in imposing excise duties on tobacco products, report for TAXUD prepared by Ramboll, The Evaluation Partnership and Europe Economics (http://publications.europa.eu/en/publication-detail/-/publication/a5d22256-3d16-4c7f-bb9e-3209447e517e/language-en)


http://publications.europa.eu/en/publication-detail/-/publication/a5d22256-3d16-4c7f-bb9e-3209447e517e/language-en

http://publications.europa.eu/en/publication-detail/-/publication/a5d22256-3d16-4c7f-bb9e-3209447e517e/language-en



We assess each of these points in terms of a potential excise duty on e-

cigarettes to come to a view on the likely scale of administration and compliance

costs and the potential revenue yield.

6.2 Application to the e-cigarette market

6.2.1 The scale of potential revenues

The revenue available from any new excise tax on e-cigarettes will clearly

depend on the specific design and rates. However, whatever the design, the

scale of revenues is likely to be small given the current market size, and certainly

much lower than the revenues from excise on traditional tobacco products.

As shown in Chapter 2, in 2015, e-cigarette sales in the EU were around €2.8

billion, compared with (licit) sales of traditional cigarettes of €125.1 billion.

Estimates of the total EU-wide yield from excise taxes on traditional tobacco

products were some €83.6 billion that year.

EC Directive 2011/64/EU stipulates that at least 60% of the average retail selling

price for cigarettes must come from excise duty. Assuming that an excise were

levied on e-cigarettes at half this level (reflecting a view that they are less harmful

than traditional tobacco products) and fully passed through to prices, even

without any impact on e-cigarette demand the revenue from e-cigarette duty

would be only around €0.8 billion. Given our estimates from Chapter 2 that the

own-price elasticity of demand for e-cigarettes is fairly high (between –1.1 and –

2.1), we would also expect a 30% increase in retail prices to see a very large fall

in e-cigarette demand (between –33% and –63%), suggesting that overall

revenues after behavioural response could be as little as €0.3 billion to €0.6

billion from a new e-cigarette excise duty. This would be something between

0.4% and 0.7% of the revenue from traditional cigarettes.

Given the very low current potential yield, administration and compliance issues

would need to be very seriously considered to ensure that the net impact on

exchequer revenues was not, in fact, negative.

6.2.2 Simplicity and stability

The way that any new excise tax on e-cigarette was implemented would clearly

determine how simple the tax was to administer and comply with. Decisions

around what was taxed (the tax base), whether there were multiple rates and

exemptions and so on would have to be taken at the tax design phase.

There is a clear link between issues of simplicity of any excise tax on e-cigarettes

and the need for the tax to be ‘future proofed’ against future innovation in the

market. When the market is dynamic and the nature of products changes rapidly,

it is much harder to design a simple system that encompasses current and future

products without needing to be rewritten regularly. A new excise tax designed in

2012, for example, may have been a unit tax on ‘cig-a-likes’ but would rapidly

have been rendered inadequate by the arrival of refillable e-liquid tanks with the

tax rules having to be rewritten to determine how to accommodate them,

generating additional compliance and administration costs. This compares with



conventional cigarettes – while there has been innovation in their design, the

core product as a taxable unit (the ‘stick’) has essentially been unchanged for a

long period. It could also be challenging to define the tax base for e-cigarettes in

a way that distinguishes them sufficiently from nicotine reduction therapies, with a

potential ‘grey area’ between nicotine products that are taxed and those that are

promoted by health authorities as quitting aids for smokers.

This suggests that for a nascent, continually-evolving product like e-cigarettes it

would be somewhat more challenging to devise a simple, stable tax regime that

would be easy to administer and comply with. This could change as the market

for e-cigarettes matures and consolidates in future years.

6.2.3 Market fragmentation

Excise duties are formally levied on manufacturers and importers of the products

being taxed, rather than on end consumers (though in practice the tax is passed

on in whole or in part to consumer prices).43 This reduces the number of people

who have to comply with the tax.

Figure 8 Market share of top four refill liquid brands, by market, 2015

Source: Euromonitor estimates

For tobacco excises, the number of companies remitting the tax in Europe is

relatively low. There are four major companies with a combined market share in

excess of 90% for combustible cigarettes (Philip Morris International, JTI,

Imperial Tobacco and British American Tobacco). The EU market for combustible

cigarettes has become more concentrated over time, with the market share for

these four companies rising from more than 60% to more than 90% since 2001.

43 In the UK, the tax authority (HM Revenue and Customs) assumes one-to-one pass through of excise taxes to

consumer prices for tobacco products in determining the impact of tax reform on demand. Much of the empirical literature has found one-to-one pass through or close to this (DeCicca et al., 2010; Espinosa and Evans, 2012; Pesko et al., 2013), sometimes with variation by product type (Xu et al, 2014; Chiou and Muehlegger, 2014).



For other traditional tobacco products, the market is still relatively concentrated

among the four leading firms, though somewhat less than for cigarettes (around

70% for hand-rolling tobacco, and 40% for cigars).44

For e-cigarettes, the situation is somewhat different. The market is dominated by

distributors rather than producers and many more small companies. Estimates for

2015 for the market share of the top four brands of refillable liquids (only a subset

of the overall e-cigarette market) in key EU markets range between 21% and

70% (see Figure 8), with a large number of smaller brands. This suggests there

would be many more taxpayers in the current market for a new e-cigarette

excise, potentially increasing administration and compliance costs. This could

change with market consolidation and maturity, but it seems clear that the costs

involved for a new excise on e-cigarettes would be somewhat larger than costs

for duties on tobacco products.

6.2.4 Mobility

A significant cost of administration and compliance for excise duties relates to

dealing with fraud and evasion. The UK government estimates that in 2015-16,

for example, around £2.4 billion of expected tobacco duty was lost to ‘illicit’

tobacco products where the duty was not paid.45 Smuggled and illegal dutiable

products also bring social costs associated with crime. Although regular

estimates of the costs incurred by tax authorities to deal with this are not

published, estimates suggest that in 2011-12, for example, the UK government

spent almost £69 million on its strategy to reduce tobacco smuggling.46

One driver of these costs is the ease with which consumers can purchase

products from locations where duty is not levied and those can enter the country

without having duty added. For e-cigarettes, where the market is fragmented and

products are regularly sold online, the costs of imposing and enforcing an excise

duty could be very large. Evidence from IFF Research (2016) for HMRC in the

UK suggests that among those who buy e-cigarettes, around 38% of users make

most or all of their purchases online, compared with around 59% who buy most

or all in retail outlets (and 3% using both equally).47 An excise duty on e-

cigarettes could lead consumers to switch online purchases to non-taxed

jurisdictions, and costly enforcement mechanisms would need to be put in place

to ensure that these were subject to duty at the point of import.

6.3 Conclusions

Relative to conventional tobacco, the fragmented and mobile nature of the e-

cigarette market suggests that the administration and compliance costs of an

excise duty would be large, both in terms of the number of taxpayers being larger

and the potential ease with which consumers could purchase from other, non-

44 Matrix Insight (2013), Economic analysis of the EU market of tobacco, nicotine and related products,

Executive Agency for Health and Consumers (http://ec.europa.eu/health//sites/health/files/tobacco/docs/tobacco_matrix_report_eu_market_en.pdf)

45 See https://www.gov.uk/government/statistics/tobacco-tax-gap-estimates.

46 See p.8 of https://www.publications.parliament.uk/pa/cm201415/cmselect/cmhaff/200/200.pdf.

47 IFF Research (2016), Understanding the online e-cigarette market

(https://www.gov.uk/government/publications/understanding-the-online-e-cigarette-market)

http://ec.europa.eu/health/sites/health/files/tobacco/docs/tobacco_matrix_report_eu_market_en.pdf

https://www.gov.uk/government/statistics/tobacco-tax-gap-estimates

https://www.publications.parliament.uk/pa/cm201415/cmselect/cmhaff/200/200.pdf

https://www.gov.uk/government/publications/understanding-the-online-e-cigarette-market



taxed jurisdictions. Given the relatively small potential revenue from a new e-

cigarette excise at present, these costs could be significant.

As the e-cigarette market matures and consolidates, it is likely that there will be

fewer market actors and greater scope to more easily co-ordinate tax approaches

across physical and electronic borders. These could reduce the administration

costs associated with a new excise duty.



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