Towards Balanced Cigarette Taxation

As the compensation cess nears its end, India’s debate on cigarette taxation must balance revenue, health goals and enforcement realities—drawing on decades of domestic experience and global best practices

- PC JHA

The 56th GST Council meeting marked a significant moment in India’s indirect tax administration, bringing, inter alia, the structure of cigarette taxation back into the policy focus, especially with the compensation cess nearing its end. Given that cigarettes are a highly regulated and socially sensitive product, the choice of tax structures must rest on the reality of past experience, striking a right balance among fiscal, administrative, and public health considerations. India’s own fiscal journey with tobacco and past reforms offer sound lessons on what is effective and what should perhaps be avoided.

Before 1983, cigarettes were taxed under an ad-valorem excise regime. This system led to frequent disputes between the government and assesses, particularly regarding the inclusion of Post Manufacturing Expenses (PME) in the assessable value, resulting in protracted litigation and blocking of revenue for long periods. The ad-valorem system soon proved ineffective. In theory, ad-valorem taxes linked collections to product pricing. However, in practice, they created scope for disagreement, valuation disputes, and administrative complexity. After the resolution of the PME disputes, the government introduced an MRP-based levy on cigarettes, which led to widespread undervaluation and duty evasion. However, this system also turned out to be counterproductive on two counts. First, it created a spiralling effect on taxation, where even a small increase in tax rates resulted in a disproportionately higher increase in retail prices. Second, in order to avoid paying tax based on a higher MRP, some unscrupulous operators would show a lower MRP, while the amount charged to the consumer was transacted in cash. The regime, therefore, became distortionary, difficult to enforce, and incentivised evasion of taxes.