The illicit cigarette trade and the proposed increase in excise taxes.

This article has been prepared as part of the public discussion of the project Budget Message on the Main Directions of Tax Policy for 2025−2027. The draft budget message plans to significantly increase the excise tax rate on cigarettes in 2025. How might such an increase in tax burden affect the prices of legal producers, the size of the shadow turnover, and budget revenues from cigarette sales taxes?

Scale of the Shadow Cigarette Market and Its Consequences

In 2021-23, the share of illegal cigarette turnover sharply increased in Uzbekistan, primarily due to smuggling from Dubai: from 4.3% in September 2020 to 24.8% in July 2023 (see Figure 1). However, in 2024, a significant reduction of this indicator occurred: down to 10.8% in September. This is quite significant progress over a relatively short period. Although the volumes of illegal turnover are still considerable.

Figure 1. Ratio of Legal and Illegal Cigarette Trade in Uzbekistan, as a Percentage of Natural Sales Volumes, 2013-24

Sources: Reports on the tobacco market research in Uzbekistan conducted by international consulting firms “Nielsen” and “Kantar,” as well as the Tashkent State Economic University. Data for 2024.

Cigarette smuggling prevents local producers from fully expanding their production and sales volumes, which negatively affects:

— employment levels in the cigarette production industry and related sectors of the economy, and the amount of wages paid to enterprise workers;

— utilization of production capacities, which threatens to increase the cost per unit of production (the so-called economies of scale, which allow for reducing costs per unit through higher production volumes, are less engaged) and correspondingly further decrease its competitiveness;

— investment attractiveness of the tobacco industry, which may lead to a decline in investment inflows or even an outflow, and consequently to future reductions in official production.

The losses to the state budget are also evident, as it misses out on substantial amounts from sales that have been displaced from the legal market. The authors of the report “Shadow Turnover in the Pharmaceutical, Alcohol, and Tobacco Markets: Volumes, Consequences, Causes, and Proposed Measures for Reduction” estimated the budget losses for 2023 solely from excise and VAT at 1 trillion sums, which constitutes 0.43% of the planned budget. Using the same methodology, we can estimate the approximate losses for the budget in 2024 – approximately 700 billion sums.

Illegal products are “exempt” not only from tax payments but also from state control over product safety. Consumers of illegal cigarettes purchase products made by unknown manufacturers from unknown raw materials and materials. Often, the tar and nicotine content in such cigarettes far exceeds the figures indicated on the packaging.

Factors Contributing to the Growth of the Shadow Cigarette Market

The authors of the aforementioned report “Shadow Turnover in the Pharmaceutical, Alcohol, and Tobacco Markets: Volumes, Consequences, Causes, and Proposed Measures for Reduction” indicate that key factors contributing to the expansion of the shadow cigarette market in 2021-23 were:

— high tax burden on tobacco products and its significant increases in previous years;

— relatively high customs duties on imported tobacco products;

— the cancellation in 2018 of the deposit rule (the excise amount) for transit tobacco products transported through Uzbekistan, which led to the so-called “interrupted transit” becoming a major smuggling channel, where products imported into the country supposedly for transit are not exported and are illegally sold on the local market;

— the situation of “interrupted transit” was exacerbated by the lack of agreements between customs and border services of neighboring countries, allowing them to halt and prohibit the transit of cigarettes showing clear signs of smuggling;

— insufficiently effective measures against smuggling and shadow turnover.

The primary reason for the dramatic growth of the shadow cigarette market in Uzbekistan during 2021-23 is considered to be the significant increase in the excise tax rate. If in January 2020 the excise for local producers was 141,500 sums per 1,000 pieces + 9% of the factory price, then in 2023 it rose to 223,850 sums per 1,000 pieces + 10% of the factory price. It is easy to calculate that the excise increased by more than 60%, and that was just over three years. This increase is obviously much higher than the inflation rate and occurred against the backdrop of declining purchasing power due to the pandemic.

Thus, the average price of a legal pack of filter cigarettes at retail in the summer of 2023 was 14,800 sums. Indirect taxes (excise and VAT), which are not paid by illegal producers, accounted for 45.6% of this amount. Consequently, shadow operators had the opportunity to sell smuggled cigarettes at much lower prices. As the tax burden on legal production has significantly increased in recent years, the gap between the prices of legal and illegal cigarettes has widened (see Figure 2).

Figure 2. Price Gap Between Legal and Illegal Cigarettes Using the Example of Legal Filter Cigarettes and Smuggled “Milano” Cigarettes.

If in 2019 the price difference between legal and illegal cigarettes was relatively insignificant – 17.6%, then in 2023 it exceeded 70%, which is quite substantial for consumers. Therefore, it is not surprising that consumers are switching to illegal products. In 2024, thanks to measures taken by the state (which will be discussed below), the gap between the prices of legal and illegal cigarettes has significantly narrowed. However, it still remains high.

High customs duties on imports also facilitate cigarette smuggling. Although these duties have decreased in recent years, the customs and tax burden still significantly raises the price of legally imported cigarettes. Legally imported cigarettes cost consumers about one-third more than local ones precisely because of customs duties.

Another factor contributing to the price gap between domestically produced legal cigarettes and smuggled products is the high customs duties on components for cigarette production, which increases the production costs for local manufacturers and makes them less competitive. Table 1 shows the differences in such customs duties between Uzbekistan and the countries of the EAEU Customs Union (using Kazakhstan as an example). The gap in customs payments is quite significant in most cases, placing Uzbek producers at a disadvantage compared to their neighboring competitors.

Table 1. Customs Duties on Components for Cigarette Production
in Uzbekistan and Kazakhstan

Additionally, a potential ban on the circulation of electronic cigarettes and heated tobacco products, as implied in the draft Law “On Amending and Supplementing Certain Legislative Acts of the Republic of Uzbekistan Regarding the Prohibition of the Circulation of Devices for Tobacco and Nicotine Consumption, Electronic Cigarettes, and Heated Tobacco Systems, Including Certain Types of Tobacco Products, and Establishing Responsibility,” developed by the Ministry of Health, could further enhance the “shadowing” of tobacco trade. If this measure is adopted, it will not only expand the illegal market for tobacco products but also harm consumer health (leading to a partial switch to more harmful tobacco products), budget losses (uncollected excises, VAT, and customs duties), and losses for local legal producers who have already invested in the production of such tobacco products.

Reasons for the Reduction of the Shadow Cigarette Market in 2024

However, the situation in the market significantly changed in 2024: the share of illegal turnover fell to 11% by September. What led to this change?

— The growth rates of the specific component of the excise on cigarettes in 2023 and 2024 slowed down and became comparable to the inflation rate: in 2023, the tax increased from 203,500 to 223,850 sums per 1,000 cigarettes (an increase of 10%), and in 2024, it rose to 250,700 sums per 1,000 cigarettes (an increase of 12%).

— The tax burden on cigarette sales decreased due to a reduction in the VAT rate from 15% to 12% starting January 1, 2023.

— The specific component of the excise on imported cigarettes continues to decrease: from 342,000 sums for 1,000 cigarettes in 2023 to 325,000 sums in 2024. Moreover, the government plans to unify the excise tax rates on imported and domestically produced tobacco products starting July 1, 2025.

Thus, we see that in 2023-24, the tax and customs burden on the sale of legal cigarettes in real terms has somewhat decreased, which undoubtedly positively impacted the competitive positions of official local producers. However, it is unlikely