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  • Tobacco tax gap

    The tobacco tax gap is the difference between the estimated value of excise or customs duty raised from tobacco according to the law ('tobacco duty') and the value actually raised for a financial year.

    All tobacco and tobacco products produced in or entering Australia are subject to tobacco duty. Tobacco duty is applied on a per-stick basis for cigarettes and a per-kilogram rate for loose tobacco and other tobacco leaf products.

    Since 2015 when regulated domestic manufacturing ceased, Australia has imported all of its legal tobacco products. Before then, the ATO collected tobacco excise on domestically manufactured tobacco and managed the licensing of tobacco growers. All licences to grow domestic legal tobacco were withdrawn in 2006.

    This tobacco tax gap estimate covers:

    • illicit tobacco importation
    • unlicensed domestic cultivation
    • leakage of pre-taxed ('underbond') legal tobacco product from warehouses.

    The estimate does not cover:

    • the inbound air passenger allowance of 25 sticks
    • e-cigarettes or nicotine replacement therapies (these do not attract tobacco duty).

    Tobacco duty collection is jointly administered by the ATO and the Australian Border Force, which sits within the Department of Home Affairs (Home Affairs). We have partnered to jointly produce this analysis on the gap. This report reflects the involvement of both agencies in managing the risk of illicit tobacco in Australia.

    This estimate is currently the first year that we have looked to measure the tobacco gap within the Australian economy; therefore no trend data is available at this time. However we will look to provide more information regarding this gap estimate in future years. The net gap for this estimate for the 2015–16 year was $594 million or 5.6%.

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    Measuring the gap

    Our approach to measuring the tobacco gap uses a bottom-up methodology. This incorporates a number of separate analyses across the various supply channels where tobacco may enter consumption without tobacco duty applied.

    The specific supply channels through which illicit tobacco enters the Australian market are:

    • tobacco domestically grown without a licence, commonly referred to as ‘chop-chop’
    • leakages of 'underbond' tobacco from licensed customs warehouses
    • tobacco arriving through international post without tobacco duty paid
    • tobacco brought in through international passenger arrivals in excess of the 25-stick limit, without tobacco duty paid
    • sea and air cargo – the most significant source of detected illicit tobacco currently entering Australia. This typically comprises a small number of high-value detections in sea cargo and smaller amounts through air cargo.

    Administration of tobacco duty

    Australian Border Force, which sits within the Department of Home Affairs (Home Affairs), is responsible for levying customs duty on imports of tobacco as excise equivalent goods (EEG). This duty is applied at the same rate as the tobacco excise duty rate, allowing consistent treatment of imported and local goods.

    The warehouse system of tobacco distribution is jointly administered between Home Affairs and the ATO. Customs duty has become the primary source of tobacco duty revenue since the end of domestic tobacco manufacturing in 2015.

    Tobacco duty may be levied on tobacco as it enters the country at import. Alternatively, the goods may be entered into the customs warehouse system as goods ‘underbond’. Duty payment is then deferred until the tobacco leaves or ‘clears’ the warehouse and enters into home consumption.

    Duty is indexed twice a year, in March and September. Increases in tobacco excise and excise equivalent customs duty of 12.5% will apply to all tobacco products every year on 1 September from 2017 until 2020. This will see tobacco excise or customs duty on a packet of 20 cigarettes reaching at least $19.77 in 2020, an increase from $12.35 in 2016.

    Administrative responsibility and supply channels for illicit tobacco

    This image shows the administrative responsibilities and supply channels for illicit tobacco: Administered by ATO: Domestic chop chop, Warehouse leakage.  Administered by Department of Home Affairs (Australian Border Force): Warehouse leakage, International postage, International passengers, Sea and air cargo.

    Home Affairs data is used for international sea and air cargo, and international post supply channels. The domestic chop-chop cultivation data have been sourced from ATO systems. Data on customs warehouses are from both the ATO and Home Affairs, reflecting the involvement of both agencies in administering this part of the system.

    We have compiled these estimates of tobacco lost through each channel to calculate the total amount of illicit tobacco entering home consumption without duty paid. This combined figure represents the ‘tobacco duty gap’ amount. This, together with the total duty collected, is the estimate of the total amount hypothetically due for collection, assuming full compliance with the law.

    Latest findings

    The following table shows the tobacco duty reported, adjustments for compliance seizures, and the gross and net gap estimates for 2015–16. Given this is the first year of measurement, only one year is available. Future releases will start to establish a trend over time.

    Tobacco tax gap estimates 2015–16(a)(b)(c)

    Measure

    Amount

    Percentage

    Tobacco duty reported

    $9,928m

    na

    Gross gap

    $731m

    6.9%

    Seizures of illicit tobacco

    $137m

    na

    Net gap

    $594m

    5.6%

    (a) Amounts and percentages may not reconcile due to rounding.(b) No duty is applied on seizures as these are withheld from market and destroyed. The seizures figure represents the hypothetical duty value of tobacco seized.(c) Amounts are rounded to the nearest $1 million.

    The following graph shows the tobacco duty reported and the net gap over the same period.

    Tobacco duty amount reported and net gap 2015–16

    Chart showing the excisable amounts in $ millions visually - the tobacco duty reported is $9,928 million and the net gap is $594 million.

    Government action to reduce the gap

    The ATO administers tobacco duty collection jointly with Home Affairs, and we work together with other government partners to control the illicit tobacco trade.

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    Investigations and prosecutions

    Illicit tobacco is a serious organised crime priority of the Australian Government. The response to imported illicit tobacco is managed by the Department of Home Affairs, under the ABF's Tobacco Strike Team. This team aims to target, disrupt and dismantle the most serious and organised crime elements of the illicit tobacco trade, including disrupting global supply chains. In the 2016–17 Budget the government announced $7.7 million in additional funding for the team over a two-year period that will end on 30 June 2018.

    The ATO actively pursues intelligence received about domestic tobacco crops. We receive information from law enforcement agencies and the public. We act decisively when we detect instances of illicit tobacco growing and manufacturing in Australia by destroying crops, disrupting the activities and prosecuting those involved.

    We also work together with federal and state law enforcement agencies to remove the profit from organised crime. We make sure that businesses, such as tobacco retailers, are correctly declaring income and sales, for both income tax purposes and goods and services tax (GST) reporting.

    Warehouse licence and compliance checks

    Most warehouses that store underbond tobacco are licensed by the ATO in accordance with the provisions of section 79 of the Customs Act 1901. Licensing data is regularly matched between the ATO and Home Affairs to ensure licensed entities have been registered consistently by both agencies.

    We undertake a range of compliance activities and strategies on licensed warehouses. Where we identify non-compliance, we take appropriate action to ensure future compliance. This ranges from education to penalties and licence cancellation.

    We communicate regularly with warehouse managers about appropriate record keeping and stock management. We also manage requests for the destruction of underbond tobacco and physically supervise any requests assessed as high risk.

    Our relationship managers are in regular contact with our larger tobacco clients. We help to monitor any revenue risk and provide required assistance and advice.

    Media approaches

    We have recently adjusted our media approach to tobacco crop seizures with a greater focus on local media. This has led to an increase in referrals made by members of the community.

    We will continue to issue targeted media releases to local communities. This will further increase community awareness, and ensure the community continues to refer illicit tobacco crops to state or federal law enforcement agencies or the ATO.

    In the 2017 financial year, we issued six media releases relating to eight of 15 warrants executed. Our current media approach includes communications to land owners and rural communities.

    Supporting the law reform agenda

    There are inconsistencies in the penalties for tobacco offences because of differences between the Excise Act 1901 and the Customs Act 1901. Prosecutions require the origin of the illicit tobacco to be proved before prosecution or penalty infringement notices can issue. Proving the point of origin can be difficult to establish for prosecution at a retail level.

    A range of policy and regulatory reform measures are currently before parliament to tackle the trade in illicit tobacco. In the 2016–17 Budget, the government announced that it would increase the range of enforcement options available for illicit tobacco offences. This will provide enforcement officers with access to a broader range of enforcement options, offences and appropriate penalties.

    You can find out more about the legislation at Illicit tobacco offences.

    Working with government partners

    The ATO and Home Affairs are stakeholders on the Interdepartmental Committee on Tobacco Control, chaired by the Department of Health. This committee meets twice a year and aims to influence deterrence through a whole-of-government approach to the risk.

    Home Affairs chairs the Illicit Tobacco Industry Advisory Group, and the ATO chairs the Tobacco Stakeholder Group (TSG). We are each members of both forums. These groups allow industry members and government representatives to meet and discuss current issues on tobacco control and the illicit tobacco trade.

    The ATO and Home Affairs are also working with Treasury and the Department of Health to co-design options for possible future taskforce approaches. Combined approaches will strengthen the government response to the illicit trade in tobacco.

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    Methodology

    All tobacco and tobacco products produced in or entering Australia are subject to excise or customs duty (‘tobacco duty’). The collection of tobacco duty is jointly administered by the ATO and Home Affairs.

    The tobacco tax gap is defined as the difference between the amount of tobacco duty collected and the amount hypothetically due assuming full compliance with the law.

    The tax gap estimate is made on the basis of the law as applicable for the relevant income year. New or recent law changes will not be reflected in tax gap estimates.

    The methodology we have selected to estimate the theoretical tobacco duty is outlined below. We detail our assumptions, limitations, data sources and reliability rating as assessed by an independent expert panel.

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    Selecting the methodology

    In selecting a methodology we considered both top-town and bottom-up methods.

    We examined external data sources. We did not find any independent source that would enable a top-down estimate to provide a reliable and credible estimate.

    We considered survey approaches, but these have a pronounced tendency for respondents to understate their consumption. An example is the largest survey of smokers in Australia, the triennial National Drug Strategy Household Survey, conducted by the Australian Institute of Health and Welfare. Our analysis found that smokers reported smoking markedly less than the amount of tobacco legally bought in Australia, without even taking into account the untaxed illicit products.

    We investigated measuring the community's tobacco consumption through wastewater analysis. Reading nicotine metabolites contained in sewerage can objectively indicate trends in tobacco consumption. This exploratory research can provide insights to tobacco usage, however it doesn't meet our measurement needs in providing a whole-of-consumption view.

    We consulted with our independent expert panel for the most suitable approach, and produced our estimate using a supply-side, bottom-up approach. This approach is considered the most suitable given the body of cross-agency seizure data available.

    Applying the methodology

    We adopted a market supply-side methodology. This methodology incorporates a number of separate approaches across the various channels where tobacco may enter consumption without tobacco duty applied. As this is the first year of analysis we have results only for the 2015–16 year.

    Steps to estimate the tobacco tax gap

    We use the following five steps in applying the bottom-up methodology to estimate the tobacco tax gap:

    Step 1: Estimate illicit tobacco arriving through importation

    Step 1 involves estimating illicit tobacco arriving through importation. Home Affairs has developed a statistical analysis to estimate the quantity of illicit tobacco arriving through sea, air cargo and international post channels.

    This approach is calculated using data from non-targeted tobacco detections and non-targeted inspections at the border. This determines an implied uplift, or leakage rate, for illicit tobacco crossing the border. This non-targeted activity occurs outside of specifically targeted cargo inspections based on intelligence.

    The implied leakage rate for international sea cargo, air cargo and international post is extrapolated across total import volumes for each channel. This derives the amount of illicit tobacco in these streams. An estimate for the amount of tobacco lost through the international passenger channel has not yet been developed, but the leakage rate through this channel is currently assessed as small.

    The total of these analyses suggests around 642 tonnes of illicit tobacco is imported into Australia. This represents $441 million worth of tobacco duty. A portion of this, valued at $98 million, is seized through compliance activity before it reaches the domestic market.

    Step 2: Estimate the size of domestic chop chop cultivation

    Step 2 involves estimating the size of domestic 'chop chop' cultivation. An excise licence is required to cultivate tobacco, which places strict rules and conditions on growers. There are currently no licences issued for the cultivation of tobacco in Australia for either commercial or personal use. Therefore all tobacco grown in Australia for consumption is illicit.

    The ATO is responsible for managing risks related to the domestic cultivation of tobacco without the necessary licence. We conduct crop seizures in partnership with other agencies such as the Australian Federal Police (AFP).

    We have developed an estimate of the value of this channel. We have analysed the value of seizures, risk, and intelligence referrals and created an uplift factor. This covers domestically cultivated tobacco that has not been detected or reported to authorities. This uplift was developed through referencing under-reporting of crime statistics from the Australian Institute of CriminologyExternal Link.

    We seized 59 tonnes of domestically grown tobacco in 2015–16 worth $39 million in tobacco duty. Our overall assessment of likely illicit growing activity is 177 tonnes in Australia. This represents tobacco duty of $118 million.

    Step 3: Analyse the licensed warehouse system

    Step 3 involves analysing the licensed warehouse system. Customs duty on tobacco products may be applied directly at importation. However, for the majority of tobacco imports the customs duty is deferred until it exits the licensed warehouse system. Tobacco is classified as ‘underbond’ while it is held in the warehouse system – that is, with no duty yet applied. Duty is collected on these products as they exit the warehouse system and enter into home consumption.

    'Leakages' occur where tobacco that has entered the warehouse system exits without tobacco duty being paid. This is distinct from tobacco that is smuggled into the country through the sea and air cargo channels, because this tobacco has been declared at importation, rather than concealed. The point of entry into home consumption is from the warehouse system, not the port of importation. This is why it is treated separately in this analysis.

    We have partnered with Home Affairs to analyse the warehouse reporting system. We have performed an inventory reconciliation for 2015–16 to gauge whether the system is prone to leakage of tobacco without duty paid.

    Our analysis suggests that although duty-paid stock withdrawals almost match stock entries, around 250 tonnes of tobacco was unaccounted for. A portion of this may be due to keying errors affecting data quality and the complexity of the warehouse system. The system features several classes of movement permissions, which can make precise reconciliation difficult.

    However, despite allowances for complexity, we cannot rule out that a portion of this was due to leakage. We estimate around $172 million tobacco duty lost through leakage of tobacco from the warehouse system for 2015–16. This represents less than 2% of warehouse throughput.

    Step 4: Compare total illicit amounts to legal clearances

    Step 4 involves comparing total illicit amounts to legal clearances of tobacco to arrive at the gross gap. Combining the estimates from steps one to three arrives at the total of illicit tobacco from all the supply channels in Australia. This forms our gross gap of $731 million. The total of these is the amount theoretically subject to tobacco duty in Australia.

    Total illicit tobacco 2015–16

    Supply channel

    Tobacco

    Importation channels

    $441m

    Domestic chop chop channel

    $118m

    Warehouse leakage

    $172m

    Total

    $731m

    Legal clearances of tobacco represented $9,928 million in 2015–16. Adding the illicit amount to the legal clearances gives the amount theoretically subject to tobacco duty in Australia.

    A portion of this would not be realistically recoverable, even if the illicit market was eliminated. This is because smokers of illicit tobacco would likely reduce their smoking rates if they had to smoke more expensive legal tobacco.

    Step 5: Deduct compliance and seizures to determine net gap

    Step 5 involves deducting the total of ATO and Home Affairs compliance activities and seizures of illicit tobacco to determine the net gap. These activities include seizures across the sea and air cargo channels, international post, and domestic crop destructions. 205 tonnes of tobacco was seized and destroyed in 2015–16, with a hypothetical duty value of $137 million.

    This results in a net gap of $594 million, or 5.6% of the total market.

    Tobacco duty – gross and net gap estimates 2015–16

    Gap

    Amount

    Percentage

    Gross gap

    $731m

    6.9%

    Net gap

    $594m

    5.6%

    Summary of estimation process

    Step

    Description

    2015–16

    Step 1

    Estimate of illicit tobacco importations

    $441m

    Step 2

    Estimate of illicit domestic chop chop cultivation

    $118m

    Step 3

    Analysis of licensed warehouse leakages

    $172m

    Step 4.1

    Gross gap (total Step 1–3)

    $731m

    Step 4.2

    Legal clearances of tobacco

    $9,928m

    Step 4.3

    Total theoretical clearances of tobacco

    $10,659m

    Step 5.1

    Seizures and compliance outcomes

    $137m

    Step 5.2

    Net gap (Gross gap less seizures and compliance )

    $594m

    International comparisons

    Irish Tax and Customs

    Irish Tax and Customs use a top-down approach. They compare tobacco duty clearances against a commissioned survey of community tobacco consumption. These resulted in a cigarette gap of 12% and roll your own (loose) tobacco gap of 9% in 2015.

    HM Revenue and Customs

    HM Revenue and Customers (HMRC) in the United Kingdom also use a top-down approach. They compare tobacco duty clearances against estimates of community consumption compiled by the Office of National Statistics (ONS). This yielded a gap estimate in the vicinity of 13% for cigarettes and 32% for hand-rolling (loose) tobacco in 2015.

    It is important to note there are some key contextual differences with other countries. This includes the existence of land borders and proximity to other jurisdictions with differing tobacco duty rates.

    Definitions

    Top-down approaches

    Top-down approaches use externally-provided aggregated data sources to estimate the size of the tax base. From this we estimate theoretical tax liability. The difference between the theoretical tax liability and the amount we receive is the estimated tax gap.

    Bottom-up approaches

    Bottom-up approaches involve a detailed examination of data sources. These include tax returns, audit results, risk registers or third-party data-matching information. We then extrapolate the results to establish the extent of non-compliance across the whole population. From this we estimate the tax gap. This approach generally involves applying statistical techniques to estimate the incidence and value of non-compliance. A bottom-up approach is typically used for direct taxes.

    Chop chop tobacco

    Illicitly grown domestic tobacco is often referred to as 'chop chop', which is unbranded loose-leaf tobacco sold without tobacco duty applied.

    An excise licence is required to cultivate tobacco, placing strict rules and conditions on the grower. There are currently no licences issued for the cultivation of tobacco in Australia for either commercial or personal use. Therefore all tobacco grown in Australia for consumption is illicit.

    Licensed warehouses

    The movement of excisable goods such as tobacco is controlled through a system of licensed warehouses. These are jointly administered by the ATO and Home Affairs. Movement permissions are needed to transfer stock between warehouses or for export.

    Underbond

    'Underbond' is the term used to describe excisable goods in the licensed warehouse system, such as tobacco, that have not yet had duty paid on them. Duty is paid on these goods as they exit the warehouse system and enter into home consumption.

    Home consumption

    The release of excisable goods to the domestic market is referred to as being released to home consumption.

    Tobacco clearances

    Tobacco clearances are payments of tobacco duty, which allow tobacco to be released or 'cleared' into home consumption.

    Limitations

    For each of the three core components of the model, the following limitations apply:

    Home Affairs sea, air and international post statistical model

    The methodology assumes that the sampling data set available for analysis is a truly random sample. Where the sampling method has changed from the original design, the methodology analyses the relationship differences between the historic and current intervention activities.

    Domestic chop chop analysis

    The revenue forgone figure is approximate given the high-level nature of some of the referrals, with judgment calls made regarding the likely yield for given acreages under cultivation. This includes crop spacing, the quality of crop management in regard to fertiliser and pesticide application, and the quality of seed.

    In future years, the uplift to seizures to cover crops not detected may need revision should any increase in seizures sustain itself through time, reflective of increased compliance reach in this area.

    Warehouse analysis

    This reconciliation is contingent on the quality of data entry by each warehouse licensee or customs broker, and keying or inventory errors may affect the final result. This reconciliation may not detect underreporting of physical quantities of tobacco into the data system.

    The legal tobacco market suppliers

    The revenue integrity of large tobacco companies is monitored through transaction assurance warehouse checks, our client relationship management framework, and continuing intelligence and monitoring activities. An assumption has been made that there is minimal gap attributable to these clients.

    Tobacco duty realistically recoverable

    We recognise smokers of illicit tobacco may reduce their smoking rates should they have to pay the higher legal price that includes tobacco duty. This would impact on the amount of tobacco duty realistically recoverable if the illicit market was eliminated.

    Data sources

    The methodology draws on the operational data of the Australian Tax Office (ATO) and the Department of Home Affairs (Home Affairs).

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    Reliability assessment

    Our estimate of the tobacco tax gap has been assessed by an independent expert panel. This is described in our Principles and approaches to measuring gaps.

    As with all gap estimates the tobacco tax gap estimate remains sensitive to assumptions made. We will be continuing to monitor and test the overall approach as we improve it in future releases.

    Based on advice from the independent expert panel, the reliability rating for the tobacco tax gap estimate is medium.

      Last modified: 06 May 2018QC 55324