Show download pdf controls

    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 financial 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.

    Find out about:

    Selecting the methodology

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

    We examined external data sources, but 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. We produced our estimate using a model-based bottom-up methodology drawing on supply-side channel analysis. This approach is considered the most suitable given the body of cross-agency seizure data available.

    Applying the methodology

    We used five steps when applying the bottom-up methodology to estimate the tobacco tax gap. The steps are summarised in Figure 3 and then described in detail.

    Figure 3: Steps to estimate the tobacco tax gap

    This image is a pictorial representation of the five calculation steps outlined in the text following this image. This image provides the names of the steps only.

    Find out about:

    Step 1: Estimate illicit tobacco arriving through importation

    Step 1 involves estimating illicit tobacco arriving through importation. A statistical analysis was developed 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 719 tonnes of illicit tobacco was imported into Australia in the 2017–18 financial year. This represents $637 million worth of tobacco duty. A portion of this, valued at $360 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.

    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.

    In 2017–18, we seized 98 tonnes of domestically grown tobacco worth $87 million in tobacco duty. Our overall assessment of likely illicit growing activity is 295 tonnes in Australia. This represents tobacco duty of $261 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 performed an inventory reconciliation to gauge whether the system is prone to leakage of tobacco without duty paid.

    Our analysis suggests that around 222 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 $196 million tobacco duty was lost through leakage of tobacco from the warehouse system for 2017–18.

    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 step 1 to step 3 arrives at the total of illicit tobacco from all the supply channels in Australia. This forms our gross gap of $1,094 million for 2017–18. The total of these is the amount theoretically subject to tobacco duty in Australia.

    Table 2 shows the value of illicit tobacco that comes in from each supply channel, from 2015–16 to 2017–18.

    Table 2: Total illicit tobacco, 2015–16 to 2017–18 (value)

    Supply channel

    2015–16
    ($m)

    2016–17
    ($m)

    2017–18
    ($m)

    Importation

    441

    496

    637

    Domestic chop-chop

    116

    263

    261

    Warehouse leakage

    163

    175

    196

    Total

    720

    934

    1,094

    Legal clearances of tobacco represented $11.9 billion in 2017–18. 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 be likely to 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. Around 505 tonnes of tobacco was seized and destroyed in 2017–18, with a hypothetical duty value of $447 million.

    This results in a net gap of $647 million, or 5.0% of the total market.

    Summary of the estimation process

    Table 3 provides a summary of each step of the estimation process and the results for each year by dollar value, as well as the gross and net gap percentages.

    Table 3: Applying the methodology for tobacco tax gap

    Step

    Description

    2015–16

    2016–17

    2017–18

    1

    Estimate of illicit tobacco importations ($m)

    441

    496

    637

    2

    Estimate of illicit domestic chop-chop cultivation ($m)

    116

    263

    261

    3

    Analysis of licensed warehouse leakages ($m)

    163

    175

    196

    4.1

    Gross gap (total Step 1–3) ($m)

    720

    934

    1,094

    4.2

    Legal clearances of tobacco ($m)

    9,928

    10,612

    11,914

    4.3

    Total theoretical clearances of tobacco ($m)

    10,648

    11,546

    13,008

    5.1

    Seizures and compliance outcomes ($m)

    135

    355

    447

    5.2

    Net gap (Gross gap less seizures and compliance ) ($m)

    585

    579

    647

    5.3

    Gross gap (%)

    6.8

    8.1

    8.4

    5.4

    Net gap (%)

    5.5

    5.0

    5.0

    International comparisons

    We have compared our methodology and approach with other tax jurisdictions that also measure the tobacco tax gap. 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.

    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 13% and roll-your-own (loose) tobacco gap of 15% in 2017.

    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. This yielded a gap estimate of 9.7% for cigarettes and 33% for hand-rolling (loose) tobacco in 2018, with an overall tobacco duty gap of 14.2%.

    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. Judgment calls are 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. This is to allow for any increase in seizures from increased compliance reach in this area, to sustain this factor through time.

    Warehouse analysis

    Warehouse analysis is contingent on the quality of data entry by each warehouse licensee or customs broker. Keying or inventory errors may affect the final result. This reconciliation may not detect under-reporting 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 that smokers of illicit tobacco may reduce their smoking rates if 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.

    Accounting for the black economy

    For tax gap purposes, we focus on the black economy definition in the Black Economy Taskforce final report. This definition is based on Organisation for Economic Co-operation and Development (OECD) definitions of underground production and illegal activityExternal Link.

    The OECD definition of underground production is key, and covers activities that are productive and legal but are deliberately concealed. This is to avoid payment of taxes and/or compliance with regulations. Therefore, the black economy element in this gap is related to underground production.

    The tobacco gap arises as a result of illegal activity and, therefore, the entire gap falls into the black economy.

    Updates and revisions to previous estimates

    The 2019 revision has used the same methodology used in the 2018 release of the tobacco tax gap. The results for 2015–16 are similar in both releases, with slight revisions resulting from updated data.

    Figure 4 displays the gross gap and net gap from our current model compared to the previous estimate.

    Figure 4: Current and previous tobacco tax gap estimates, 2015–16 to 2017–18

    This graph provides a visual representation of the current and previous PAYGW net gap estimates for the years 2015–16 to 2017–18 provided at Table 4.

    Table 4: Summary of published tobacco tax gap net percentages

    Gap release year

    2015–16
    (%)

    2016–17
    (%)

    2017–18
    (%)

    2018

    5.6

    na

    na

    2019

    5.5

    5.0

    5.0

    Data sources

    The methodology draws on the operational data of ATO, Home Affairs, and the Australian Bureau of Statistics (ABS).

    Reliability

    An independent expert panel has assessed the ATO estimate of the tobacco tax gap. This is described in Principles and approaches to measuring gaps.

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

    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.

    Figure 5: Reliability rating scale from very low to very high – tobacco tax gap

    This image is a graphical representation of the reliability rating for the current fuel excise gap estimate. It graphically represents a rating of medium, which is a score between 16 and 20. The maximum score is 31.

    See also:

    Return to:

      Last modified: 17 Oct 2019QC 55324