The Uttar Pradesh government’s decision in early May to halve value added tax (VAT) on cigarettes to 25%, within 10 months of raising it from 17.5% to 50%, was forced by flagging legitimate sales of cigarettes in the state since, state officials said.

The cut in VAT is likely to help producers such as ITC Ltd, India’s biggest cigarette maker.

Taxable monthly sales of cigarettes in Uttar Pradesh plummeted from an average of 620.82 million sticks in the April-June quarter of fiscal year 2013 to 280.26 million in the three-month period till December, a decline of 55%, on account of which tax revenue stagnated despite the steep hike in VAT from July last year.

Consumers took to contrabands and inferior tobacco products, Biresh Kumar, principal secretary in Uttar Pradesh’s department of commercial taxes and entertainment tax, said in a phone interview.

Cigarette producers have for long been warning that creating substantial difference in local taxes between neighbouring states results in rampant interstate smuggling. They were vindicated after legitimate sales in Uttar Pradesh crashed following steady growth during fiscal year 2012.

In the 10 months since July last year, neighbouring Delhi’s tax collections from cigarettes almost doubled, according to Shyam Mohan Agarwal, president of lobby group UP Cigarette Vyapar Sangh. “The same thing had happened when (former chief minister) Mayawati raised local taxes (on cigarettes) in 2007,” Agarwal added.

The aim was to increase tax collection, but the state was forced to withdraw most of the hike within only 10 months because its result was the opposite, Uttar Pradesh official Kumar said, adding that VAT on cigarettes has now been reduced to a level at which it is expected to result in tax buoyancy.

Industry estimates show Uttar Pradesh earned Rs.26.78 crore a month in VAT from cigarettes between April and June last year, but average collection between August and February remained unchanged despite the tax rate being raised to 50%.

When it comes to deciding tax rates on cigarettes, states “walk a tightrope”, said Varun Lochab, managing director and co-head of research at Religare Capital Markets Ltd, a stockbroking firm.

Uttar Pradesh’s move to raise VAT to 50% “boomeranged because the hike was too steep”, added Lochab.
Uttar Pradesh, according to his estimates, accounts for around 5% of India’s legitimate cigarette sales.

The cut in VAT will “definitely help” producers such as ITC, Lochab added.

ITC expects the current financial year to be a “challenging” one for its cigarette business, the company said in a statement in mid-May. The company appears to be concerned that it may not be able to pass on to consumers further increases in local and central taxes.

Besides central excise duty, which is raised almost every year, cigarette producers pay VAT to states on the price they invoice to their local wholesalers.
However, some analysts are of the view that demand for cigarettes is “price-inelastic”.

Several states had increased VAT in the fiscal year ended March, forcing ITC to raise prices, said V. Srinivasan, an analyst at Angel Broking Pvt. Ltd, but that did not impact sales or operating profit from its cigarette business.

Calculated on net revenue, ITC’s operating margin from cigarettes in the quarter till March was at 58.3% compared with 54.09% in the same period a year ago.
For the full year, ITC’s operating margin from the segment was at 59.98% as against 56.04% in fiscal year 2012. Compared with the previous year, ITC’s net revenue and operating profit from cigarettes grew 12.62% and 20.5%, respectively, in fiscal year 2013.

However, for a company like ITC, which has interest in other consumer goods as well, disruptive increases in local taxes on cigarettes have far- reaching implications because it typically uses the same distribution channel for selling other products as well.

When a state raises VAT on cigarettes to such a level that local trade partners are almost driven aground by smuggling, sales of ITC’s other consumer goods are also affected.

Traders in Uttar Pradesh launched an agitation against last year’s VAT hike and pressured the government into withdrawing it, said Agarwal of the cigarette traders’ lobby group.

ITC refused to comment for this story.