Taxing tobacco and cannabis: history learned – or forgotten?

Fred O’Riordan is the Ernst & Young Canada tax policy leader and a former director-general of excise duties and taxes at the Canada Revenue Agency.

We are only months away from legal cannabis sales in Canada and seeing whether the federal government can achieve its stated twin goals of “keeping cannabis out of the hands of youth and profits from its sale out of the hands of criminals.”

There is an inevitable and unintended trade-off between keeping the tax low to increase the proportion of total sales that are legal and the desire to set the tax higher to make it less affordable (and, therefore, less accessible) to youth. Set the rate too low and legal access is less restricted. Set it too high and black-market sales and profits continue to flourish, undermining the objectives of legalization.

There are encouraging signs the federal and provincial governments have struck the right rate and revenue-sharing balance. Last November, the federal government proposed an excise duty framework for cannabis products and made a 50/50 revenue-sharing offer to the provinces. In December, the provinces agreed to the combined federal-provincial tax rate of the higher of $1 a gram or 10 per cent of the producer’s sale price plus HST and agreed in principle to a revised two-year 25/75 federal/provincial revenue split.

Statistics Canada then launched an online crowdsource survey to determine black market prices for cannabis as a guide to pricing competitively to crowd out illegal sales. Whether this strategy is successful, and the current level of co-operation between the federal and provincial governments is sustainable, remains to be seen.

Examining the history of tobacco taxation in Canada provides a sense of what may happen. Although there are differences between the public policy objectives of legalized cannabis and tobacco, there are striking similarities – in particular, the tax and non-tax measures, such as restrictions over packaging, advertising and public consumption by which governments have chosen to regulate their sale and availability.

The stated objective of tobacco tax policy is to increase rates to reduce the prevalence of smoking. But these taxes are also an important source of revenue for both federal and provincial governments. Some might even see their past actions as a form of tax competition – one side first increasing its own rates, or strategically matching rate increases of the other, in order to preserve or gain a bigger share of the same tobacco “tax pie.”

This arguably was a factor in sizable tax increases in the early 1990s that had immediate unintended consequences. The trigger event was a $6/carton federal excise duty increase announced in the 1991 federal budget, quickly matched by provincial increases. The result was a significant price increase and sharp decline in legal tobacco sales. On the surface, it looked like a victory for health advocates.

But the news was too good to be true. Smoking prevalence did not decrease by anywhere near the reduction in legal tobacco sales. The huge price increase created a profit incentive for smugglers of contraband tobacco. Many smokers switched to much lower-priced contraband. In 1994, Statistics Canada estimated it had increased from 1 per cent of the total Canadian market in 1987 to 31 per cent by 1993. In Ontario and Quebec, its share was much higher.

Government authorities responded by ramping up enforcement activity but couldn’t stem the tide of contraband flooding the market. Finally, when things reached the crisis point in 1994 the federal government sharply reduced tobacco taxes, offering to match any provincial decreases up to $5 a carton. This ensured each side would preserve its share of the tax pie. Following this rollback, legal sales bounced back by 50 per cent and contraband sales declined markedly.

This experience almost certainly informed federal-provincial decision making around cannabis taxation. Sadly, the story for tobacco tax policy does not end there. After a period of calm, the federal government introduced a Federal Tobacco Control Strategy in 2001, resulting in a 68-per-cent increase in federal levies over a three-year span from 1999 to 2002. Provinces again increased their taxes more or less in tandem. Sales of contraband rebounded and the black market experienced a resurgence.

One positive takeaway for tax authorities was that gradual, predictable tax increases are preferable to periodic large increases. Sharp spikes in legal prices appear to influence smokers’ propensity to switch to contraband more strongly.

As a result, the Harper government announced in its 2014 budget it would tie future federal tobacco tax rates to the consumer price index, adjusting them every five years. Following this lead, the Ontario government announced, in its 2016 budget, that it would base its future increases on inflation over the next five years, beginning in 2017.

This apparently co-ordinated tax arrangement didn’t last long. Rather than the expected inflation-adjusted increase in its 2017 budget, Ontario abruptly changed course and announced a massive $10-a-carton increase to be implemented in three stages over a two-year time frame. The federal government responded in the 2018 budget on Feb. 27 by adding another $2.29 a carton – and accelerating its inflation adjustments to every year instead of every five years.

Whether Ontario’s revenue predictions from these increases pan out remains to be seen. Between 2013 and 2017, revenue fell short of its forecasts by $240-million. By some estimates it could fall short by another $235-million a year for fiscal 2018-19 and 2019-20.

The contraband market in Ontario is already estimated at one-third of total consumption and more than 80 per cent of total contraband across Canada. It could grow even larger, meaning less revenue for both federal and provincial governments.

Canadians have reason to expect their governments will do better with cannabis, but their record with tobacco is cause for concern. Revenue from cannabis is projected to be relatively modest initially.

However, if legal sales grow, with the expected entry of new edible products for example, and the resulting tax pie grows with it, all bets are off.

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