BUDGET SUBMISSION 2008

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1 BUDGET SUBMISSION 2008 The Wine & Spirit Trade Association International Wine & Spirit Centre Bermondsey Street London SE1 3XF Registered number: England Limited by Guarantee

2 INDEX Chapter Page 1. Executive Summary 3 2. Background Information Wine & Spirit Trade Association 2.2. UK wine & spirit industry supply-chain 2.3. Value of the alcohol beverage industry to the UK Economy 2.4. A Socially Responsible Industry 3. Wine duty Market Conditions 3.2. Harvests 3.3. Raw material and other costs 3.4. Tax as a percentage of price for wine 3.5. A freeze on wine & fortified wine duty rates 3.6. Parity for sparkling wine 3.7. Wine & Beer Duty 4. Pre-announcement of changes in wine duty Spirit Duty Market conditions 5.2. Raw material and other costs 5.3. Tax as a percentage of price for spirits 5.4. A freeze on duty rates for spirits and RTDs 6. Impact of a Rise in Wine & Spirit Duty Cross Border Trade Anti-fraud activity Fuel duty Alcohol consumption & misuse Alcohol consumption Enforcing existing legislation Taxation and harmful consumption consequences of increased taxations Annex 1 Impact of a Rise in Alcohol Duty - A report prepared by Europe Economics Annex 2 Project to assess the average alcohol content of wines sold in the UK 2005 Annex 3 Wine duty administration removing a significant administrative burden A report prepared by Ernst & Young page 2 WSTA Budget Submission 2008

3 1. EXECUTIVE SUMMARY This submission demonstrates that the wine and spirit sectors face a very challenging year in 2008 with poor market conditions, shortages in raw materials and significant cost increases. The whole alcohol drinks trade is under pressure and has lost growth. The low supplier margins in recent years mean that even duty rises that keep pace with inflation are damaging to the trade and are unlikely to raise any extra net revenue for the Treasury. The Wine & Spirit Trade Association (WSTA) Budget 2008 Submission calls for the Chancellor to recognise the need for: A freeze in the excise duty rates for wine and fortified wine; A freeze in the excise duty rates for spirits; Parity in still and sparkling wine excise duty rates; Announcement of changes to wine duty in the Pre-Budget Report. The WSTA believes that increased costs, very tight industry margins and increasingly difficult market conditions will push the consumer price of alcoholic drinks up in This would be further compounded by any increase in excise duty. Tough market conditions in 2008 Both the wine and spirit sectors are facing tough market conditions in These conditions are exacerbated by increased regulation in the on-trade where wine sales have fallen by -4%, and spirits sales have fallen by -3% from This is particularly damaging as the industry has traditionally reported higher margins in the on-trade than in the off-trade. Increased costs The wine and spirit sectors are facing significantly increased costs. In addition to energy costs, which have risen by approximately 50% over the last three years, businesses will also feel the effects of risings price of glass, packaging, raw materials and transport. Overall, WSTA members have estimated that costs will rise by between 8% and 10%, although some members are forecasting cost increases of between 10% and 20%. For the purposes of modelling in this submission, cost increases for next year have been based at 8%. The wine sector The wine sector has been squeezed by successive duty increases that could not be passed through to the consumer and has now gone ex-growth; a period of stability is now needed with no duty increases (whether inflationary or not). Overall, there has been a 3% volume increase for light wines, despite a decrease of -4% in the on-trade. The market for fortified wines continues to decline at -4% by volume (source: AC Nielsen 2008). The spirit sector Both spirits and RTDs are past the point of tax maximisation. The RTD sector is showing ongoing and significant decline. The spirits sector is slightly more robust but any increase in spirits duty is unlikely to produce additional revenue. In a similar pattern to the figures for wine sales, spirits are performing more strongly in the offtrade than in the on-trade. Overall, volume sales for spirits rose 3% 2006 to 2007 (source: AC Nielsen 2008). page 3 WSTA Budget Submission 2008

4 Falling consumption HMRC statistics show that overall Treasury receipts for alcohol have fallen by 5.3% over the past two years. Total alcohol consumption has fallen from 9.4 to 8.9 litres per capital from 2004 to 2006 (source: HMRC). Taxation & alcohol misuse There has been pressure on the Government to increase duty on alcohol in an attempt to tackle alcohol misuse. We firmly believe that this would not be effective and would simply penalise the vast majority of responsible consumers in response to the misuse of a very small minority. According to the Cabinet Office Strategy Unit report in 2003, 81% of drinkers in England drink within the Government daily alcohol guidelines and just 4% were classed as heavy drinkers. If the Government were to increase taxation in an attempt to change the drinking patterns of such heavy drinkers they would be penalising 81% of responsible drinkers, or even 96% of those who are not classed as heavy drinkers, for the sake of just 4% if the drinking population. The industry works hard to ensure that its products are produced, marketed and sold in a socially responsible manner. Impact of a tax increase on the industry The WSTA considers that there is currently no scope for the industry to absorb further tax increases. Any duty increase would therefore have an unintended impact on the wider economy, either through inflationary pressures, or by damaging the output and employment prospects of the supply chain for the wine and spirit sectors. The WSTA commissioned Europe Economics to develop models to quantify the estimated impact of possible duty increases given the current and predicted market conditions. A copy of their full report is included as Annex 1. The table below summarises the estimated impact if the Chancellor announced an inflationary or a 10% duty increase for wine and spirits. Summary of quantified effects of an increase in excise duty RPI increase 10% increase Wine Spirits Wine Spirits Total cost impact (% of retail price) 5.7% 5.5% 7.6% 7.5% Impact on retail price (% of retail price) 12.5% 6.7% 12.5% 6.7% Impact on consumption by average consumer (%) -7.8% -8.3% -7.8% -8.3% Impact on consumption by problem users (%) -1.9% -4.8% -1.9% -4.8% Impact on industry sales to households ( ) - 802m - 644m - 802m - 644m Impact on industry employment -28,000-23,000-28,000-23,000 Impact on duty receipts ( ) - 100m 21m 38m 21m Impact on VAT receipts ( ) - 140m - 113m - 140m - 113m Combined impact on VAT and duty receipts ( ) - 240m - 92m - 102m - 92m Deadweight loss consumer surplus ( ) - 4.4m - 4m - 10m - 9m First degree linkage effect on UK output ( ) - 1,572m - 1,262m - 1,572m - 1,262m Source: Europe Economics estimate page 4 WSTA Budget Submission 2008

5 Further, an increase in alcohol duty may also have an effect on alcohol smuggling and private imports because of the larger duty gap between the UK and the rest of the EU. We are also concerned that the UK is becoming an increasingly unattractive market for global alcohol producers, who may ultimately decide that other markets, particularly emerging markets in China, Russia, India and the burgeoning US market offer more attractive opportunities. This will mean that the UK consumer, currently enjoying one of the most diverse markets in the world, will face substantially reduced choices. Impact of a tax increase on the consumer Given the tough market conditions expected this year, it is extremely likely that the price of wines and spirits will increase. Some industry operators have estimated that the price of a bottle of wine might increase by as much as 0.50 just to reflect industry costs. Any increase in duty would compound this inflationary pressure and consumers would be faced with even higher prices. The alcohol drinks industry operates on extremely tight margins, so there is no scope for the supply chain to absorb any increases in duty. This is particularly true for the wine sector which is very sensitive to price points, which may amplify the impact of increases in costs and duty. Impact of a tax increase on the wider economy A rise in the duty on alcohol may have several impacts on the economy as a whole. As well as impacting on the profitability of the sector, there may also be impacts on employment, consumer welfare, tax revenue and inflation. These impacts are set out in more detail in Annex BACKGROUND INFORMATION 2.1. The Wine & Spirit Trade Association (WSTA) The WSTA has 322 members and is the only UK organisation which represents the whole of the wine and spirit supply chain including producers, importers, wholesalers, bottlers, warehouse keepers, logistics companies, brand owners, licensed retailers and consultants. It is uniquely placed to offer comment on matters relating to the sector. The aim of the WSTA is to create and sustain a profitable market where customers are offered a wide variety of high quality products which are made, packaged, marketed and sold in a responsible manner UK wine & spirit supply chain The UK wine and spirit sector is diverse and includes a large number of small businesses which reflects its entrepreneurial and creative character. The sector is renowned for innovation, high quality products and wide consumer choice. It is vital that the Chancellor maintains a trading environment where responsible businesses can thrive. To that end, we are keen to work with the Government to reduce the burden of bureaucracy, minimise the administrative burden caused by duty increases and ensure stability in the market. The UK is seen as one of the key market places for the world s wine exporters. The UK consumer currently enjoys perhaps the most diverse choice of wine available anywhere in the world. page 5 WSTA Budget Submission 2008

6 The UK market is: a uniquely open market, with little home-produced wine; one of the most competitive wine markets, with a wide range of suppliers, both small and large; an increasingly diverse market, moving from being dominated by beer and spirits to offering greater variety, with consumers selecting from a wider range of beverages according to their mood, occasion and social context; a responsive market there has been an increasing demand for wine as a result of more travel, holidays and improvements in the quality of wine at reasonable prices. Nevertheless, UK consumption of wine is modest by world standards 24th in the international league and consumption is only a third of that of France. The UK is one of the world s great producers of spirits. However, about one-third of spirits consumed in the UK are imported and the UK is often used as a staging post for exporters from around the world to reach the European market. Similarly, many exporters of wines from outside Europe use the UK s free-trade environment as the headquarters of their European operations. In addition, the UK is home of one of the largest fine wine markets in the world. Imported wines and spirits benefit the UK economy directly. In excess of 5 billion is raised through excise duty and VAT, together with 3 billion in added value to the UK economy (through bottling/packaging and distribution), of which 600 million is paid to the Exchequer in income or corporation tax. These figures do not include jobs and investment provided by the restaurants and bars and other parts of the hospitality industry which sell these goods. Approximately four fifths of the money a customer spends on an imported product remains in the UK. UK wine production is only a small part of the market, but quality has improved significantly in recent years and UK wine has won many international prizes. The vineyards are a picturesque addition to the UK rural landscape and attract tourists, providing much needed employment in the countryside. However, UK producers suffer from competition from cross-border shopping as well as high-cost land and variable weather and domestic production needs supporting facilities on a scale that is comparable to what is available elsewhere. In France and other EU Member States, producers receive financial assistance for many activities, including training and marketing which are not widely available in the UK. page 6 WSTA Budget Submission 2008

7 2.3. Value of the alcohol drinks industry to the UK Economy WSTA member companies range from multinationals down to SMEs. The UK alcohol drinks industry contributes approximately 14 Billion to the Exchequer each year, 57.8% of this comes from wine, cider, perry and spirits. Consumer expenditure on alcohol drinks was approx. 41 Billion in 2005, representing 5% of their total expenditure. Of this, 19 Billion was on beer; 14 billion on wine and 8 Billion on spirits. 28 Billion of this consumer spending was in pubs, hotels, restaurants, clubs and related trades. An estimated 1.6 million people are employed in the alcoholic drinks industry including the off-trade, pubs, hotels, restaurants and related trades - about 5% of the nation s active population. Breweries, distilleries, orchards, vineyards, retailers and pubs are at the heart of communities, support jobs across the wider local economy and throughout the supply chain. The lifeblood of many communities is related to our trade. In many places there are few alternative job opportunities. The British pub is one of the top five icons that attract millions of tourists to this country every year. Looking externally, the UK alcohol beverage industry exports 3 billion at Customs valuation. Together, the alcohol drinks industry accounts for approximately 25% of total UK food and drink exports A socially responsible industry Attempting to tackle alcohol misuse through increased taxation would not be effective and would penalise the vast majority of responsible consumers. It makes little sense to punish the millions of British people who drink responsibly with higher taxes in response to the misuse of a very small minority. The WSTA is at the very forefront of ensuring that the industry lives up to its claim of being socially responsible. Our members work hard to ensure that the principles of social responsibility (as set out in the Social Responsibility Standards document published jointly by industry and the Government in November 2005) are reflected in all aspects of their companies operations. Recognising how important it is that the industry gets things right, the trade as a whole has subjected itself to a further set of regulations on marketing and promotions over and above the existing statutory requirements. The Code, run by the operationally-independent Portman Group, is subject to public scrutiny and, importantly, anyone from inside or outside the industry can refer industry practices for consideration. A report at the end of 2007 showed that the drinks industry has been successful in reducing the influence of advertising on young people. By working in conjunction with government, in particular Ofcom and the Advertising Standards Agency, the number of young people exposed to television adverts has decreased and the report showed that young people are less likely to say the advertising is appealing to them. Recently, the Government has highlighted the importance of reducing opportunities for young people to access alcohol. This is something that the industry has been concentrating on for page 7 WSTA Budget Submission 2008

8 some time. Through the WSTA-run Retail of Alcohol Standards Group, WSTA members have already put in place robust policies to ensure staff uphold the law, in particular the national Challenge 21 policy. By working together retailers have increased awareness and enforcement of the law and made it much more difficult for young people to buy alcohol showed substantial reduction in sales to young people and increased compliance with the law. There is more progress to be made here but the results so far are extremely positive. The WSTA and its members are also fully committed to fund and support the Drinkaware Trust. The Trust has already been successful in educating Britons of the danger of abusing alcohol and the need to enjoy alcohol responsibly. Their work is supported by the increased industry use of unit labelling, including the Government s sensible drinking advice, on alcohol products. The work of the Trust, supported by industry activity, has shown real results as fewer young people are choosing to drink, consumption across all ages has decreased and the number of Britons who know about sensible drinking guidelines has increased. The work of the Trust is vital if we are to successfully promote responsible drinking, reduce alcohol misuse and minimise alcohol related harm. The drinks industry has demonstrated that when industry and government work in partnership we can be effective in reducing misuse of alcohol and underage drinking. 3. WINE DUTY 3.1. Market conditions This has been a particularly challenging year for the entire drinks industry, particularly for the ontrade which has been affected by a combination of poor summer weather, the smoking ban and an absence of a major summer sporting event. Annual volume % changes by trade sector (October October 2007) BEER SPIRITS RTD'S LIGHT WINE CIDER TOTAL TRADE ON TRADE OFF TRADE [Source: A C Nielsen] As with other sectors, the wine industry is facing significant increases in the cost of their inputs and raw materials. Not only have companies faced heavy increases in energy costs of around 50% in the last three years, but they will also feel the effects of rising costs for manufacturers of bottles and packaging, and the rising costs of raw materials and transport. Overall, there has been a 3% volume increase for light wines, despite a decrease of -4% in the on-trade. The market for fortified wines continues to decline at -4% by volume (source: AC Nielsen 2008). page 8 WSTA Budget Submission 2008

9 The Treasury maintains that inflationary increases on wine duty amount to a freeze because all of the Treasury s costs are increasingly at an inflationary level. This is not the case. The UK wine market has grown considerably over the last 10 years. That growth has increased the Treasury tax take considerably above the level of inflation. In times of market growth an inflationary increase provides the Treasury with above inflationary tax revenue. The wine market is no longer able to sustain this level of growth with increased costs and reduced growth in sales. A further increase in duty, at inflation or higher, would speed this slowdown and decline, decreasing the profitability of the industry and, eventually reducing tax take. The wine sector is particularly sensitive to this because, as a market based on an agricultural product, changes take three to five years to filter through. In the face of an economic slowdown, we would ask the Treasury not to hit the industry with another tax hike. This will have a damaging effect on job creation, investment and savings at exactly the wrong time in the economic cycle Harvests As a result of two poor harvests in Australia and poor harvests in many of the other major wine producing countries the gap between global production and demand is closing. According to preliminary 2007 estimates from the IWSR Drinks Record still light wine production (excluding wine for distillation) will rise marginally to million hectolitres (hl) up from million hl in 2006, while consumption will rise to million hl from million hl in This leaves a global surplus of 27.8 million hl, down from 45.7 million hl just two years ago. This is at a time when markets in China and India are opening up for the global wine industry. Still light wine: production vs consumption, including forecasts (volumes in 000s of hectolitres) Year Production (excluding brandy) Consumption of all wines (excluding rice and fruit wines) Difference: production vs consumption , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,479.0 [Source: IWSR / Vinexpo] The global market is moving closer to equilibrium for a number of reasons including rising consumption, reduced plantings, and a dry season in parts of Southern Europe, as well as the drought in Australia. In the southern hemisphere in the first half of 2007, the grape harvest was expected to be at an average level, despite a major drop in Australia. In the northern hemisphere, most southern European wine-producing countries have seen a considerable decrease in their production. In both the short and medium term the result will be the rising costs of grapes and higher prices for wine. Estimate forecasts for the coming year from major markets Australia New Zealand Prices have more than doubled on the bulk market for both white and red. Spot prices have risen from AU$0.40 per litre in 2006 to AU$ per litre in Global demand for Sauvignon Blanc has resulted in cost price increases. page 9 WSTA Budget Submission 2008

10 South Africa Australian demand for bulk South African wine for consumption is growing. Prices for the 2008 vintage expected to increase by 5%. Chile Prices have increased significantly with fear of smaller harvests in Chile is filling some of the void left by Australia and China is now the largest bulk market for Chilean wine. Prices have risen from US$0.50 per litre for red wine to US$1 per litre during 2007 and white wine has increased by a higher level. Argentina Price increases of about 10% are expected in France France was affected by the poor harvest in 2007 and the estimates for 2008 are patchy. Production in Gascony is down 40% and prices are up by 30%. Languedoc will see rises of 15% for red and 8% for white. Spain Price increases of between 5 and 10% are expected in Italy USA There could be some dramatic price increases from different parts of Italy following the smallest harvest in 40 years. Grape prices for pinot grigio have increased from 0.81 to 1.50 per litre. The market is fairly stable with demand and supply pretty much in equilibrium and only modest price increases of about 5% expected Raw material & other costs Alongside the poor harvests and the rising price of grapes the wine industry is also seeing considerable increases in other costs including energy prices, glass, packaging and transportation costs. Energy prices We are unlikely to see any reduction in the current levels in energy prices, impacting on both transport and production costs, and in fact are more likely to see greater increases, as a key component of both glass and conversion costs. The price of crude oil has risen over the 50% in three years with much volatility in the market which makes long term planning incredibly difficult. Packaging The cost of tin and aluminium has increased by 90% over the last three years as a result of world demand and there is no sign of abatement. Used paper prices (a key component of cartons) have risen by 40% over the last three years and 20% last year alone as a result of world demand. Freight The cost of transportation is expected to rise by a minimum of 3-4% in the coming year as a result of high crude oil costs, increasing fuel duty, consolidation in the industry and capacity issues such as driver shortage. Glass There are widespread concerns about the rising cost of glass. There has been considerable industry consolidation in the US and Western Europe. Over the last 5 years increases have been suppressed but this is no longer sustainable with considerable energy cost and batch material cost increases. page 10 WSTA Budget Submission 2008

11 Exchange rates Given that the vast majority of wines sold in the UK are imported (barring the 0.2% of English and Welsh wines), movements in the exchange rate can have a significant impact on the cost of wine in the UK. The considerable weakening of Sterling against the Euro will place added pressure on the wine industry. Production costs are increasing in most areas of Europe, and these increased costs will be exacerbated by the exchange rate difference. This will be reflected either in increased consumer pricing for wines imported from Europe or lower profitability in the industry. The variability of the impact of exchange rate movements, with current strong Euro and weak Stirling, US and Australians Dollars, creates huge uncertainty about costs for the UK wine market. Any additional duty at a time when Sterling is weakening would cause significant damage to the industry. Impact of increasing costs Overall, WSTA members have estimated that costs will rise by between 8% and 10%, although some members are forecasting cost increases of between 10% and 20% depending on the country of origin. WSTA members have indicated that it will be necessary for them to pass on cost increases to consumers over the next 12 months, which will have an inflationary impact on the whole wine category Tax as a percentage of price for wine The average retail price for a bottle of wine in the UK off-trade was 4.01 in December 2007 (source: AC Nielsen). UK tax represents 48.17% of the average purchase price of a bottle of wine in the UK market. This has increased from 46.25% in In an industry where margins are very tight annual increases in duty have simply become a tax on margin. Average price (pence) Excise Duty (pence) Tax as a % of price (off-trade only) % duty in price VAT rate VAT (in pence) VAT + Duty (pence) Tax (% of price) % 17.50% % % 17.50% % [Source: AC Nielsen] 3.5. A freeze on wine & fortified wine duty rates EU wine duty rates 2006 pence per 75cl Ireland UK Sweden Finland Denmark Estonia Netherlands Belgium Lithuania Latvia Poland France Hungary Romania Slovenia Slovakia Czech Republic Austria Bulgaria Germany Portugal Luxembourg Italy Spain Malta Greece Cyprus [Source: European Commission, Excise Duty Rates, 1/7/07] page 11 WSTA Budget Submission 2008

12 Over the last six years, wine duty has increased in line with inflation and this has had a profoundly damaging effect on trade in the fiercely competitive UK wine market. Because of consumer resistance in the off-trade to increases above set price points, as a rule duty increases have not been fully passed onto the consumer. At a time when overall costs of operating in the UK are rising, markets in China and India have been opening. These countries potentially offer better commercial opportunities to producers in the global wine market, and it is possible that producers will stop prioritising the UK market to the detriment of UK consumer choice. The failure to pass duty increases through the supply chain has meant that wine duty is no longer a tax on the consumer but a tax on margins within the supply chain and presents significant administrative and cost burdens. This has several consequences: Reduction in company profits; Reduction in investment in brands, innovation, marketing and promotion; Increased consolidation in the industry and the decline of small wine businesses; The UK becoming a less attractive market to supply, which will result in reduced consumer choice; Inevitably there will be a decline in the quality of the product in the longer term; Threats to market investment and employment; Threats to Treasury revenue Parity for sparkling wine The continuing surcharge on sparking wine is a historic anomaly dating from the refitting of the Victorian navy, when it was seen as a method of raising needed money from the rich. It has no place now when sparkling wine consumption is spread over all classes more widely than still wine. In addition to the simple fairness argument, bringing sparkling wine duty in line with still wine duty would eliminate market distortion and would be likely to benefit the wine market as a whole. For the last few years until 2007, the freeze in sparkling wine duty rates has done much to address this, but the situation was exacerbated last year by the unexpected 7 pence increase in sparkling wine duty. The tax on the bubble means that duty on sparkling wine is approximately 38 pence higher than for a bottle of still wine. Previously the industry had understood that Treasury policy was to correct this anomaly over time, and so the industry was not prepared for the duty increase which caused significant problems for a number of businesses with sparkling wine interests. 15% of English and Welsh wine is sparkling: a reduction in this duty would therefore help domestic production. We call on the Chancellor to align the excise duty rate on sparkling wine with that of still wine Wine and beer duty The European Court of Justice ruled in 1983 [European Commission vs UK, ECJ 170/78] that still wine and beer were competing products and that taxing wine in excess of the equivalent rate of beer in a beer-producing and wine-importing country was against the Treaty of Rome, since it discriminated against products of other Members States. As a result of this ruling, the UK was required to bring wine and beer duty rates approximately into line (in terms of the duty for a given alcoholic content) and rates for wine and beer have moved roughly in parallel ever since. page 12 WSTA Budget Submission 2008

13 The current position is that over 99% of wine on the UK market is imported, whilst 89% of beer is home-produced [Source: A C Nielsen]. Moreover, the European Commission has reinforced the argument by ruling that Sweden has been in breach of the Treaty because its duty rate for wine was higher than that for beer. The British Beer and Pub Association (BBPA), in its Budget Submissions since 2004, has suggested that the link should be revised to charge wine more, since wine had increased in average strength and this was not reflected in the duty rate (all still wines between 5½ and 15% abv pay the same rate per hectolitre, whilst beer is taxed in relation to its strength). The BBPA s own research indicates that the average strength of wine only increased by 0.02% (12.51% %) from 2004 to 2005 when they conducted their study. The WSTA presented evidence to the Treasury in 2005 that wine duty had, over the years, moved ahead of beer duty (particularly in the early 1990s) and that it would require EU wine to be at least 13% abv on average to equate to beer duty. Whilst there has been considerable speculation about the rise in the average strength of wine in the UK market place there has been no reliable source of information since the WSTA Wine Strength Project in 2005, which is still considered to be entirely valid. The Wine Strength Project Sainsbury s was selected as a major wine seller that was representative of consumers, neither too up- nor down-market. Wine strengths were gathered from lines representing 99% of sales and the sales volumes over a year were used to produce weighted average strengths. The full details are given in Annex 2. The average strength was 12.48% abv, but the EU and non-eu wines were very different and have to be considered separately: The EU wines (relevant to the ECJ judgement) averaged 11.79% abv. The wine duty is 10.1% higher than the beer equivalent and a relative reduction of wine duty of 9.2% would be required to achieve parity. The non-eu wines have a higher strength average 13.10% abv. However, non-eu wines pay the external EU tariff (CCT) in addition to excise duty, unlike beer (which is virtually all produced in the EU). Taking this into account, taxation on non-eu wine is 5.4% higher than beer and EU wine duty (excluding CCT) and so would need to fall by 5.4% to achieve parity. Taking both together, since non-eu wine forms about half of the market, a fall in wine duty relative to beer of 7.5% would bring beer and wine into rough parity. Within the categories (EU and non-eu) there is no reason to believe that there have been significant changes in the average strength since PRE - ANNOUNCEMENT OF CHANGES IN WINE DUTY The timing of announcements for changes in wine duty imposes unnecessary administrative burdens on the wine supply chain reducing productivity and increasing administration. The WSTA would like to see any changes in wine duty announced at the time of the Pre-Budget report, in common with the announcement of the personal allowance and National Insurance Contribution levels, which are announced at the Pre-Budget Report for administrative reasons. Currently, the duty on wine is set by the Chancellor in the Budget and applies to all wine sold after the Budget Resolution, in a similar way to other duties such as fuel and tobacco duty. However, in contrast to the other duties, the wine buying process has long lead times and lag times and must fit with both the Northern and Southern hemisphere harvests. The current process gives rise to an abrupt change in duty that imposes a significant administrative burden on the industry. There is an immediate change in the economics of the page 13 WSTA Budget Submission 2008

14 contract between the (numerous) suppliers and the (few) retailers, which will result in reductions to margins across the supply chain from those previously negotiated. From an administrative perspective, an individual retailer / supplier can be faced with the need to renegotiate contracts for up to a thousand different wines with potentially hundreds of suppliers / retailers. This renegotiation process is cumbersome and disruptive and could be avoided if the increase was known sufficiently in advance. Given the buying cycle, publication of the duty rate at the Pre-Budget Report stage, for implementation following Budget Day would remove a significant amount of uncertainty and unnecessary administration. Full details of this proposal are contained in Annex SPIRIT DUTY 5.1. Market conditions In a similar pattern to the figures for wine sales, spirits are performing more strongly in the offtrade (5% volume growth), where margins are lower, than in the on-trade (-3%). Overall, volume sales for spirits rose 3% 2006 to For RTDs, volume has fallen -14% since 2006 (source: AC Nielsen 2008) Raw material and other costs The spirits industry is also seeing the same type of cost increases as the wine industry impacting its production with higher raw material costs, energy prices, glass, packaging and transportation costs. This has been exacerbated by exchange rate issues around the strong Euro and weak US dollar. Energy prices We are unlikely to see any reduction in the current levels in energy prices and in fact are more likely to see greater increases, as a key component of both glass and conversion costs. The price of crude oil has risen over 50% in three years with much volatility in the market which makes long term planning difficult. Molasses (used for Rum) The average prices paid for molasses have risen over 50% in over three years (the price of molasses from Mexico rose over 120% albeit from a lower base price). In the past, sugar prices were the drivers for increases in the price of molasses, however recent changes in the molasses price have been the result of the demand for Ethanol as an alternate energy source in the countries of origin. The unstable nature of energy markets has led to significantly more pricing volatility for molasses. Grain (used for imported Whisky) Wheat prices have shown an alarming upward trend based on poor harvests and high demand. Since March 2006 the spot price for wheat is up 130% MATIF Wheat Barley Grains Barley is also showing a similar trend, and prices have risen 130% in the last 18 months. Basic foodstuffs are now exhibiting strong inflationary trends, which are likely to be followed by spirits products. Grapes (used for Brandy) Grape based spirit products will be impacted by the rising costs of grapes as a result of poor global harvests and increased demand from the oct.04 janv.05 avr.05 juil.05 oct.05 janv.06 avr.06 juil.06 oct.06 janv.07 avr.07 page 14 WSTA Budget Submission 2008 juil.07

15 wine industry, as well as the reform of the EU wine regime which is seeking to reduce over capacity and remove subsidies. Agave (used in the manufacture of Tequila) Although prices are currently low, plant maturity profile and future crop information prices are set to increase substantially in the coming year, industry estimates are for increases to be as high as 10%. Packaging The cost of tin and aluminium has increased by 90% over the last three years as a result of world demand and there is no sign of abatement. Used paper prices (a key component of cartons) have risen by 40% over the last three years and 20% last year alone as a result of world demand. Freight The cost of transportation is expected to rise by a minimum of 3-4% in the coming year as a result of high crude oil costs, increasing fuel duty, consolidation in the industry and capacity issues such as driver shortage. Glass There are considerable concerns about the rising cost of glass. There has been considerable industry consolidation in the US and Western Europe. Over the last 5 years price increases have been suppressed but this is no longer sustainable with considerable energy cost and batch material cost increases. This combination of increased costs is likely to have an inflationary impact on the price of spirits Tax as a percentage of price for spirits The average retail price for a bottle of spirits in the UK off-trade was 9.66 in December 2007 (source: AC Nielsen). UK tax represents 71.62% of the average purchase price of a bottle of spirits. Average price (pence) Excise Duty (pence) Tax as a % of price (off-trade only) %duty in price VAT rate VAT (pence) VAT + Duty (pence) Tax (% of price) % 17.5% % % 17.5% % % 17.5% % 5.4. A freeze in Duty Rates for spirits and RTDs We welcome the previous decisions of the Chancellor to freeze the duty on Spirits. We call on the Chancellor to continue this freeze in UK Spirits duty remains among the highest in the European Union and spirits are amongst some of the most heavily taxed products in the UK marketplace. The cumulative burden of tax, regulation and costs remain high and the alcohol drinks industry has been significantly impacted by the range of cost increases detailed above and particularly by raw material and energy costs. page 15 WSTA Budget Submission 2008

16 EU spirit duty 2006 pence per 40% abv Sweden Ireland UK Finland Romania Malta Denmark Belgium Netherlands France Germany Poland Greece Bulgaria Luxembourg Austria Estonia Portugal Czech Republic Lithuania Latvia Hungary Spain Italy Slovakia Slovenia Cyprus Both Spirits and RTDs are past the point of tax maximisation with the Spirits sector showing only slow growth (3% volume) and the RTD sector continuing to decline (-14% volume). Any increase in Spirits duty is unlikely to produce additional revenue (source: AC Nielsen). Previous research on price elasticity and tax published by HMRC has shown that further increases in spirits duty would not necessarily increase revenue (source: Econometric Models of Alcohol Demand in the United Kingdom by Chao-Dong Huang, published by HMC&E, May 2003). We call on the Chancellor to freeze excise duty rates for Spirits and RTDs. 6. IMPACT OF A RISE IN WINE AND SPIRIT DUTY During the past year, the WSTA has observed increasing pressure on the Government to revisit the basis and the quantities of excise duty levied on alcohol. In particular, several lobbying organisations have explicitly called on the Government to substantially increase the duties on wine and spirits. The WSTA considers that there is no scope for the industry to absorb further tax increases in current and expected market conditions without negatively impacting the industry and so the WSTA commissioned Europe Economics to evaluate the potential impacts of such an increase. A full copy of the Europe Economics Report is at Annex 1. Although WSTA members estimated that the increase in business costs in 2008 could be as high 20%, for the purposes of modelling in this submission, we have based cost increases for next year at 8%. Europe Economics noted that whilst advocates of a duty increase might expect various benefits, such as: reduced costs associated with antisocial behaviour; reduced excessive or irresponsible consumption of alcohol; gains to public health; and, increased revenue to the Exchequer. It is debatable whether a rise in alcohol duties would make a material contribution towards achieving these goals. There is evidence that heavy or problem users of alcohol are less responsive to changes in prices than the great majority of drinkers. Using estimates put forward by the proponents of an increase in duty, Europe Economics found that tax increase on consumption of wine by normal users can be four times as large as that of problem users. Europe Economics also found that an increase in duty could lead to a situation where the industry cannot maintain profitability without passing costs on to final consumers. Their results page 16 WSTA Budget Submission 2008

17 imply that if duty increases were levied in addition to the predicted cost increases (grapes, glass, packaging, fuel etc), prices may increase significantly. Owing to the price point mechanism, and the fact that for the last few years a significant proportion of duty increases have been absorbed by the supply chain, it is likely that the difference between the increase in costs and the triggered increase in prices might be surprisingly large. This implies that a rise in taxation would raise prices and so damage the innocent enjoyment of non-problem drinkers, whilst at the same time having little or no effect upon the amount consumed by heavy drinkers. Further, the resulting fall in consumption of wine and spirits by consumers as a whole, and the associated negative impact on the industry output and employment, have also a substantial effect on total tax revenue collected. Europe Economics found that increases in the excise duty on either spirits or wine could potentially lead to a significant fall in tax revenue collected directly on sales of the product, even before considering likely additional impacts on revenue via falls in corporation and income tax receipts. In addition to a fall in total tax revenue collected from sales, an increase in the duty could also lead to other major unintended side effects on the economy, in the first instance from reductions in the output and employment of the sector supply chain. They estimate the negative first order linkage effects on UK economy to be measured in billions, before even considering further ripple effects throughout the economy. Further, an increase in alcohol tax duty may also have an effect on alcohol smuggling or private imports from the continent and elsewhere. Europe Economics quantify only a subset of the possible undesirable side effects of an increase in excise duty. The results are stark. They found that a 10% increase in the duty on wine could lead to a direct deadweight loss of 9.7m in the welfare of non-problem drinkers, combined 102m fall in excise duty and VAT revenue, - 802m fall in industry sales revenue, as well as to a 1.6bn fall in GDP outside the wine sector. Indeed, an increase in the excise duty on wine and spirits could run the risk of a quadruple whammy leaving heavy drinking unaffected, reducing the consumer surplus of innocent drinkers, encouraging illegality through smuggling, and losing tax revenue as a direct consequence of a fall in domestic consumption as well as through encouraging massive crossborder transactions. 7. CROSS-BORDER TRADE Until late 2005 the WSTA, BBPA and Gin & Vodka Association (GVA) monitored the quantity of cross-border shopping through a survey carried out by MRSL. In 2005, the UK market share for wine represented by cross-border shopping was estimated to be around 7%, this is down from 15% at the highest point during the survey period. The WSTA believes that this figure is probably fairly similar now. Based on this assumption, this represents a huge distortion of the market adding up to; revenue loss of 200 million to the UK Government; loss of 150 million in added value to the UK trade. page 17 WSTA Budget Submission 2008

18 Wine imports and Cross-border shopping - MATs / '000 Hl Home Sales X - border Spirits imports and Cross-border shopping - HLPA - MATs / Home Sales X-Border In the case of wine, the vast majority of purchases are made by legitimate shoppers, which cannot be stopped by Governments operating in the single market. The cross channel market is clearly related to the size of excise duty in the UK ( 1.33 a bottle) in relation to that in neighbouring countries (2p a bottle in France). If duty differential continues to increase at the same time as other cost increases are coming through the supply chain more consumers will use this route of purchase and pose a threat to Government revenues from the sector. page 18 WSTA Budget Submission 2008

19 A recent survey for the WSTA of 1000 regular wine consumers found that a significant hike in UK tax on wine and spirits would prompt nearly a third to consider more shopping trips abroad (source: Wine Intelligence Vinitrac online survey December 2007). 8. ANTI-FRAUD ACTIVITY WSTA members have been voicing their growing concerns over the last two years over the level of growth in fraudulent wine appearing in the UK marketplace. Whilst the WSTA has provided information to HMRC, greater visibility of anti-fraud action by HMRC at trade association level will encourage further activity by the trade in providing information to mutual advantage. The WSTA believes there is an urgent need for high profile prosecutions so that the industry can see that HMRC is taking the matter seriously and to deter others. The presence of fraudulent product creates price-compression and reduces the profitability of legitimate businesses. 9. FUEL DUTY The WSTA calls on the Chancellor to review the policy set out in the 2007 Budget* and freeze duty on diesel whilst world oil prices continue to be high and volatile. The UK alcohol drinks sector and all the jobs it supports, is reliant on efficient and dependable transport. Fuel represents a high proportion of haulage costs, and so any further increase in fuel duty would have a significant impact on costs passed on to consumers. At a time when the alcohol drinks industry is facing huge cost pressures on raw materials, packaging and general business costs, any additional transportation costs would contribute significantly to inflationary pressures. Many hauliers are investing in overhauling their fleets to ensure they can provide a more environmentally-friendly service. Further increases in costs, in the form of UK fuel duty, may curtail investment as UK operators in the distributive chain seek to compete with haulage firms based on the continent where fuel duty is significantly lower. *Extract from BN53: From 1 October 2007, excise duty on main road fuels will increase by 2 pence per litre (ppl). These rates will be increased by a further 2 ppl on 1 April 2008 and 1.84 ppl on 1 April page 19 WSTA Budget Submission 2008

20 10. ALCOHOL CONSUMPTION AND MISUSE 10.1 Alcohol consumption There is a misconception that British people have a particular problem with alcohol, and that they drink more than in other countries. Official statistics from the World Health Organisation show that British people drink around the European average, and that UK consumptions levels are below countries like France, Germany and Ireland. Alcohol Consumption (Litres/Capita) Bulgaria Malta Per Capita Alcohol Consumption in Europe Sweden Poland Romania Italy Greece Netherlands Finland Latvia Lithuania Slovenia Belgium UK Portugal Slovakia Denmark France Spain Austria Ireland Germany Hungary Estonia Czech Republic Luxembourg [Source: World Health Organization Regional Office for Europe, Figures shown for the latest year known] Male mortality from chronic liver disease and cirrhosis, 2004 aged under 65, standardised death rate per 100,000 population Hungary Romania Slovenia Lithuania Slovakia Estonia Finland Czech Austria Bulgaria Poland Latvia Germany Denmark Portugal Luxembourg France Belgium England Italy Spain Malta Ireland Sweden Greece Cyprus Netherlands [Source: England ONS Mortality data and WHO, Health For All Database-Jun 2007] HMRC statistics show that overall alcohol consumption fell by 5.3% over the past two years. Consumption fell from 9.4 to 8.9 litres per capita from 2004 to page 20 WSTA Budget Submission 2008

21 The percentage of British men and women drinking more than the recommended units of alcohol in one week (21 for men and 14 for women) and in one day (3/4 for men and 2/3 for women) have been falling since Percentage of men who drank more than 21 units in one week (ONS, General Household Survey 2006) Percentage and over Year (statistics only available for these years) Percentage of women who drank more than 14 units in one week (ONS General Household Survey 2006) Percentage and over Year (statistics only available for these years) Office of National Statistics methodology The Office of National Statistics recently changed its methodology for assessing British drinking figures. This includes recognising different wine glass sizes and an average wine strength of 12.5% (previously 11%). This does not affect the fact that people are drinking less. The amount people are drinking will simply be dropping from a higher base Enforcing existing legislation In order to tackle the problems related to alcohol misuse, the police and local authorities have been given a wide range of powers. For example, there are already laws banning children from buying alcohol and banning pubs and bars serving people who are drunk. The police have the ability to arrest people for drunk page 21 WSTA Budget Submission 2008

22 and disorderly behaviour or for being drunk and incapable and local authorities have the authority to revoke licenses where their conditions are breached. A summary of existing powers and legislation Problem Underage drinking Overconsumption Anti-Social Behaviour Drink-driving Alcohol advertising Legislation It is illegal for an under-18 to buy alcohol It is illegal for an adult to buy alcohol for an under-18 It is illegal to sell alcohol to an under-18 Licensing Act 2003 gave new flexible powers to councils and police to amend or revoke licenses It is illegal to sell alcohol to someone who is drunk It is illegal to buy alcohol on behalf of someone who is drunk Police empowered to issue on the spot Penalty Notice for Disorder with a 50 or 80 fine Designated Public Places Order (allowing police to confiscate alcohol in specified areas) Directions to Leave and Drink Banning Orders (allowing police to ban known trouble makers from certain localities for a specified period) Up to six-month imprisonment, up to 5000 fine and 12 month driving ban BCAP TV Advertising Code BCAP Radio Advertising Code (both tightened in 2005) CAP Advertising, Sales Promotion and Direct Marketing Code Constantly under independent review This shows that laws already exist to deal with the real problems of under-age drinking, overconsumption by adults and the anti-social behaviour such misuse can cause. The WSTA would support greater enforcement of these laws, and is calling for central government to encourage councils and police forces to make more effective use of their existing powers Taxation and harmful consumption Overall alcohol consumption has fallen across the UK in the last two years, and the figures show that the number of people exceeded Department of Health sensible drinking guidelines is falling. In spite of this, there are increasingly vocal calls for significant increases in alcohol duties in order to reduce consumption and harm arising from misuse. There is limited correlation between tax rates and overall consumption or, more specifically, harmful consumption. Those drinking at harmful levels are generally the least sensitive to price changes. Those with dependency issues will find money to buy alcohol, often to the detriment of other spending. The UK s excise duty rates are among the highest in the European Union. Clearly, if high tax rates were an effective tool required to eliminate abusive or irresponsible consumption then the UK and other northern European countries would be expected to have very few such problems. page 22 WSTA Budget Submission 2008

23 Country UK France Spain Italy Germany Ireland Sweden Finland Beer (per pint at 5%) Wine duty (per 75 cl bottle below 15%) Spirit duty (per 70cl bottle at 40%) However, even a cursory study would suggest that there would appear to be no causal link between excise duties and consumption. 16 No Correlation Between Excise Duty on Spirits and Consumption Austria Belgium Bulgaria Czech Republic Denmark Estonia Finland France Germany Greece Hungary Consumption (Litres/Capita) Ireland Italy Latvia Spirit Duty ( /70 40% abv) Lithuania Luxembourg Malta Netherlands Poland Portugal Romania Slovakia Slovenia Spain Sweden [Source: World Health Organisation, Regional Office for Europe, Alcohol Control Database] It is also important to remember that alcohol provides enjoyment to at least 80% of the adult population and in moderation has proven health and societal benefits. Tax increases would penalise producers and the vast majority of sensible drinkers while having little impact on those who abuse alcohol. The Industry fully supports proven methods to tackle alcohol-related harm such as education and awareness, treatment and prevention programmes and is committed to promoting responsible drinking and working with all stakeholders to reduce alcohol misuse and the associated consequences (see Section 2.4). The industry fully supports the HM Treasury position that changes to excise duties should be based solely on economic considerations.. the view that the Government take it is the view that we have consistently taken in the Treasury is that that sort of social harm and social concern is best tackled by social legislation and by working with the trade in self-regulation, rather than by taxation, which, in this circumstance, is an instrument that is not best suited to deal with the social problems that we are discussing. In fact, it would be likely to penalise the vast majority of responsible drinkers rather than affecting the minority who cause us concern. Financial Secretary to the Treasury, Finance Bill, 8 May UK page 23 WSTA Budget Submission 2008

24 10.4 Consequences of higher taxes Excise duties are regressive. Increasing excise duty rates on alcohol will damage UK employment prospects and compound regional unemployment and lead to the closure of businesses and subsequent loss of jobs within the supply chain and the rural economy. Cross border shopping Recent history demonstrates that with higher duties, there will be an increased incentive for a return to large-scale cross-border shopping, smuggling, fraud and illicit production undermining government revenues, legitimate producers and increasing the purchasing and consumption of alcohol outside of a controlled environment, including increased access for under-age drinkers. Alcohol smugglers target the young and vulnerable which is likely to increase harm associated with misuse. High tax differentials with neighbouring countries in a Single Market lead to downward pressure on retail prices to compete with the ensuing cross-border trade. Higher taxes also damage export markets and international competitiveness. Public perceptions The public are opposed to tax rises which will make the alcohol they drink more expensive. The overwhelming majority of people drink sensibly they do not drink excessively, they do not damage their health, and they do not cause problems on the streets or at home after drinking. A survey for the WSTA conducted by Wine Intelligence in December 2007 found that: 3 out of 4 UK regular wine consumers think current UK tax on alcoholic drinks is too high ; 4 in 10 say UK tax on alcoholic drinks is much too high ; Only 1 in 20 UK regular wine drinkers claim that UK tax on wine and spirits is too low. 50% 40% The current taxes on alcohol are 1.57 per 750ml of wine, 6.44 per 700ml of spirits and 45p per pint of beer. In your view, are these taxes on alcohol are too high, too low, or about right? (Vinitrac UK November 2007) n= % 39% 30% 20% 20% 10% 0% 2% 3% 1 - Much too low 2 - A bit too low 3 - About right 4 - A bit too high 5 - Much too high 1% 6 - I don't know [Source: Wine Intelligence Vinitrac online survey December 2007] For further information: Kate Coleman page 24 WSTA Budget Submission 2008

25 WSTA Budget Submission 2008 ANNEX 1 IMPACT OF A RISE IN ALCOHOL DUTY A report prepared by Europe Economics, 2008

26 Impact of a rise in Alcohol Duty Report for WSTA Europe Economics Chancery House Chancery Lane London WC2A 1QU Tel: (+44) (0) Fax: (+44) (0) January

27 TABLE OF CONTENTS 1 Executive Summary 1 2 Introduction 4 3 Context of the Study 6 Policy Context 6 Industry Background and Expectations 9 4 Impact of a Rise in the Duty on Wine and Spirits 15 Possible Effects of a Duty Rise 15 Estimated Direct Impacts of a Duty Increase 19 Estimated Indirect Impacts of a Duty Increase 34 Summary of Results 36 5 Conclusions 40 Appendix 1: Analysis of Questionnaire Responses 42 Lessons from the Questionnaire Responses 49

28 1 Executive Summary 1 Executive Summary 1.1 The UK wine and spirit sector is a very important part of the UK economy. Consumer expenditure on alcoholic drinks in 2006 was 41.3bn or 5.6 per cent of total expenditure. Of this, 14.5bn was spent on wine and 7.8bn on spirits. The alcohol and associated industries are estimated to employ 1.5 million people, roughly 5.5 per cent of the active population. The sector also makes a major contribution to Government tax revenue, via excise duty, VAT and corporation tax receipts. All together the alcoholic drinks industry contributes 14bn to the Treasury each year from direct sales taxes. Of this, 2.6bn comes from duty receipts on sales of wine, cider and perry, 2.3bn comes from duty receipts on sales of spirits, 3bn from the duty on beer, and 6.2bn from VAT revenue associated with sales of alcoholic drinks. 1.2 The WSTA is the only UK organisation representing the whole of the wine and spirit supply chain including producers, importers, wholesalers, bottlers, warehouse keepers, logistics specialists, brand owners, licensed retailers and consultants. The WSTA was established in 1824 and currently has 321 members. The WSTA works with its members to promote the responsible production, marketing and sale of alcohol and to share best practice with the entire trade. As such, it has unique insight into the whole of the sector, and can provide accurate industry data relevant for policy making purposes. 1.3 During the past year, there has been increasing pressure on the Government to revisit the basis and the quantities of excise duty levied on alcohol. In particular, several lobbying organisations have explicitly called on the Government to substantially increase the duties on wine and spirits. The WSTA considers that there is limited, if any, scope for the industry to absorb further tax increases in current and expected market conditions, and commissioned Europe Economics to estimate the potential impacts of such an increase. 1.4 Advocates of a duty increase might expect various benefits, such as reduced costs of antisocial behaviour and other social problems associated with excessive or irresponsible consumption of alcohol, gains to public health, and increased revenue to the Exchequer. 1.5 Yet it is highly debatable whether a rise in alcohol duties would make a material contribution towards achieving these goals. There is evidence that heavy or problem users of alcohol are less responsive to changes in prices than the great majority of drinkers. Using estimates put forward by the proponents of an increase in duty, we find that tax increase on consumption of wine by normal users can be four times as large as that of problem users. 1.6 We find that the expectation of WSTA members is that an increase in the duty would lead to a situation where the industry could not maintain profitability without passing some of the costs on to final consumers. Our results imply that, in the forthcoming situation (following recent cost increases for grapes, glass, packaging, and fuel), even alcohol duty rises that might appear, at first sight, relatively modest, would raise 1

29 1 Executive Summary prices by more than costs, as retailers move prices up to the next price point. This difference between the increase in costs and the triggered increase in prices might be surprisingly large. This implies that a rise in taxation would raise prices and so damage the innocent enjoyment of non-problem drinkers, whilst at the same time having little or no effect upon the amount consumed by heavy drinkers. 1.7 We quantify only a subset of the possible effects of an increase in excise duty. The below table summarises the estimated impact on wine and spirits in our baseline scenario for a 10 per cent increase in duty. Table 1.1: Summary of quantified effects Estimated impact from a 10% increase in the duty Wine Spirits Total cost impact (% of retail price) 7.6% 7.5% Impact on retail price (% of retail price) 12.5% 6.7% Impact on consumption by average consumer (%) -7.8% -8.3% Impact on consumption by problem user (%) -1.9% -4.8% Impact on industry sales to households ( ) - 802m - 644m Impact on industry employment -28,000-23,000 Impact on duty receipts ( ) 38m 21m Impact on VAT receipts ( ) - 140m - 113m Combined impact on VAT and duty receipts ( ) - 102m - 92m Deadweight loss consumer surplus ( ) - 10m - 9m First degree linkage effect on UK output ( ) - 1,572m - 1,262m Source: Europe Economics estimate 1.8 The results can be summarised in the following six key points: (a) Because of the importance of price points in this industry, a rise in costs as a result of any increase in duty could have a disproportionate effect on retail prices; (b) The resulting increase in retail prices could have a significant impact on the consumption and enjoyment of wine and spirits of the average non-problem drinkers, whilst having much less impact on consumption by problem drinkers. This reduced consumption by non-problem drinkers could have an adverse impact on the prospects of the industry. (c) Increases in the excise duty on either spirits or wine could potentially lead to a significant fall in tax revenue collected directly on sales, even before considering possible additional impacts on revenue via falls in corporation and income tax receipts. 2

30 1 Executive Summary (d) In addition to a fall in total tax revenue, an increase in the duty could also lead to other major unintended spillover effects on the wider economy, in the first instance from reductions in the output and employment of the supply or distribution chain of the industry. (e) Further to the above, rises in alcohol duties at this time would contribute to inflation, adding to an already difficult inflation situation for the Bank of England s Monetary Policy Committee, potentially reducing its scope to cut interest rates in response to slowing economic growth. (f) We estimate the negative GDP impacts from the above effects combined, for some of the more negative scenarios, to be of the order of billions of pounds and that is before considering further ripple effects throughout the economy. Further, an increase in alcohol tax duty may also have an effect on alcohol smuggling or private imports from the continent and elsewhere. 1.9 To summarize, increasing the excise duties on wine and spirits could run the risk of a quintuple whammy leaving heavy drinking unaffected, reducing the enjoyment of innocent drinkers, encouraging illegality through smuggling, losing tax revenue as a direct consequence of a fall in domestic consumptions as well as through encouraging massive cross-border transactions, and reducing GDP by damaging an important British industry. Perhaps this is why the government has previously regarded tax rises as an inappropriately blunt instrument for addressing problem drinking. 3

31 2. Introduction 2. Introduction 2.1 During the past year there has been increasing pressure on the Government to revisit the basis and the quantities of excise duty levied on alcohol. In particular, several lobbying organisations have explicitly called on the Government to substantially increase the duties on wine and spirits. Those advocating such duty increases presumably have two broad objectives in mind: (a) Reducing public health and other social costs (anti-social behaviour etc) associated with excessive or irresponsible consumption of alcohol; and (b) Raising revenue for the Exchequer. 2.2 The WSTA believes that there no scope for the industry to absorb further tax increases in the current and expected market conditions without adverse impacts on the industry, and that a rise in price of wine and spirits would probably do little to address the social policy concerns associated with excessive consumption. 2.3 In this light, the WSTA commissioned Europe Economics to consider whether it could produce well-founded economic reasoning and statistical evidence supporting a case that a rise in alcohol duty: (a) Might lead to disproportionate increases in prices of wine and spirits, owing to price points and existing cost trends eroding margins; (b) Would lead to a direct welfare reduction on the part of the major alcohol consuming population; (c) Might lead to a reduction in tax revenue from the duty due to the price elasticity of demand of a majority of consumers, as well as adverse effects on other taxes such as VAT and corporation tax receipts; (d) Would be both a blunt and a weak instrument for achieving social policy goals (reducing alcohol-related illness and disorder) due to different responses to price increases by problem user groups compared to that of the major alcohol consuming population; (e) Might lead to a fall in the growth of the industry in UK; (f) Might have adverse interactive effects on total economic output; (g) Would increase inflation; (h) Might have adverse employment effects; and (i) Might increase incentives towards smuggling, or otherwise lose sales in UK to elsewhere in the EU (e.g. through imports for personal use). 4

32 2. Introduction 2.4 We study these effects via economic modelling of the likely magnitudes of and linkages between the different effects of an increase in the excise duties on wine and spirits. As an input to the modelling, we used data from the industry, the National Statistics, as well as responses to a brief survey of WSTA members. 2.5 The purpose of the survey was to gauge the views of those operating within the wine and spirits market concerning the current status of and future developments within the industry. The survey questionnaire covered a broad range of topics, from the general performance of the firm and sector to more specific questions regarding price points, the source and impact of any anticipated cost changes (including excise duty) and the firms anticipated change in employment levels. We received responses covering every section of the supply chain and a wide distribution of company sizes. We discuss the responses at various points through out the report, where they are relevant to the analysis. 2.6 The rest of this report is structured as follows: (a) Section 3 discusses the context in which this study has been prepared. First, we introduce the policy context surrounding the study, and then discuss the current and expected future state of the UK wine and spirits industry. (b) Section 4 contains the discussion of the various possible impacts of a tax increase, description of our modelling approach, and presents our results for those impacts that we were able to quantify within the study, including a summary of headline results. (c) Finally, Section 5 offers conclusions on the likely impacts of an increase in the excise duty on wine and spirits. (d) Appendix 1 contains a fuller discussion of the questionnaire responses for the interested reader. 5

33 3. Context of the Study 3. Context of the Study 3.1 This section briefly discusses the policy context of the study, and introduces some background on the alcoholic drinks industry in the UK. We present data on the industry in general, drawing also on a survey conducted to gauge the views of WSTA members on the characteristics of the industry, as well as on its future prospects and expected trends. Policy Context 3.2 This study is set against a background of increasing concern about the harmful effects of excessive or socially irresponsible consumption of alcohol. The issue is often debated in the media, and is fresh on the minds of both the Government and the Opposition. This is witnessed by the 2007 publications of an update to the National Alcohol Strategy ( Safe. Sensible. Social. The next steps in the National Alcohol Strategy, HM Government), and the report containing policy recommendations for the Conservative Party ( Breakthrough Britain: Addictions, Social Justice Policy Group). 3.3 During the past year the WSTA has observed increasing pressure on the Government to revisit the basis and the quantities of excise duty levied on alcohol. In particular, several lobbyist organisations have explicitly called on the Government to substantially increase the duties on wine and spirits. 3.4 In contrast, we note that the original Alcohol Harm Reduction Strategy for England, published by the Cabinet Office in 2004, seemed distinctly lukewarm about the prospect of using tax as a tool to achieve the desired social policy objectives. The following quote summarises the conclusions about using tax as a social policy instrument in this area 1 : There is a clear association between price, availability and consumption. But there is less sound evidence for the impact of introducing specific policies in a particular social and political context: our analysis showed that the drivers of consumption are much more complex than merely price and availability; evidence suggested that using price as a key lever risked major unintended side effects; the majority of those who drink do so sensibly the majority of the time. Policies need to be publicly acceptable if they are to succeed; and measures to control price and availability are already built into the system. 1 Cabinet Office (2004): Alcohol Harm Reduction Strategy for England, page

34 3. Context of the Study So we believe that a more effective measure would be to provide the industry with further opportunities to work in partnership with the Government to reduce alcohol related harm. 3.5 The recent update to the strategy stood by the analysis and conclusions of the 2004 study. The results reported later on in this study, also, reflect many of the governments previous conclusions, including estimates of the side effects of increased taxation. 3.6 Indeed, the UK currently already has the highest alcohol taxation rates for beer, second highest for wine and third highest for spirits in the EU, as shown in Table 3.1 below. 7

35 3. Context of the Study Table 3.1: Excise duty rates in the EU ranked by country Beer per pint at 5% abv 1 Wine per bottle at 11% abv 1 Spirits per bottle 40% abv 1 Country by rank Duty rate Country by rank Duty rate Country by rank Duty rate UK 0.39 Ireland 1.39 Sweden Ireland 0.38 UK 1.34 Ireland 7.47 Finland 0.37 Sweden 1.21 UK 5.48 Sweden 0.31 Finland 1.08 Finland 5.38 Denmark 0.13 Denmark 0.42 Malta 4.44 Slovenia 0.13 Estonia 0.34 Denmark 3.83 Italy 0.11 Netherlands 0.3 Belgium 3.34 Hungary 0.1 Belgium 0.24 Netherlands 2.86 Netherlands 0.1 Latvia 0.22 France 2.76 Austria 0.09 Lithuania 0.22 Germany 2.48 Cyprus 0.09 Poland 0.18 Poland 2.23 Belgium 0.08 France 0.02 Greece 2.08 Poland 0.08 Austria 0 Luxembourg 1.98 Estonia 0.07 Bulgaria 0 Austria 1.9 Slovakia 0.07 Cyprus 0 Estonia 1.85 Portugal 0.06 Czech 0 Czech 1.8 France 0.05 Germany 0 Hungary 1.8 Greece 0.05 Greece 0 Portugal 1.78 Bulgaria 0.04 Hungary 0 Lithuania 1.76 Czech 0.04 Italy 0 Latvia 1.69 Germany 0.04 Luxembourg 0 Slovakia 1.6 Latvia 0.04 Malta 0 Spain 1.58 Lithuania 0.04 Portugal 0 Italy 1.52 Luxembourg 0.04 Romania 0 Romania 1.5 Malta 0.04 Slovakia 0 Slovenia 1.32 Romania 0.04 Slovenia 0 Cyprus 1.15 Spain 0.04 Spain 0 Bulgaria ) abv = alcohol by volume Source: British Beer & Pub Association Statistical Handbook Table 3.2 shows the current level of duty for spirits and different types of wine. Whilst taxation of spirits has been frozen for the last ten years, duty on wine has generally risen with inflation in each Budget. The WSTA believes that there is no scope for the wine industry to absorb further tax increases without adverse impacts on the industry. 8

36 3. Context of the Study Table 4.1: UK Excise duty on spirits and wine Type Rate ( ) Rate base Spirits per litre of pure alcohol Wine and made-wine: 1.2% - 4% abv per hectolitre of product Wine and made-wine: 4% - 5.5% abv per hectolitre of product Still wine and made-wine: 5.5% - 15% abv per hectolitre of product Wine and made-wine: Exceeding 15% - 22% abv per hectolitre of product Sparkling wine and made-wine: 5.5% - 8.5% abv per hectolitre of product Sparkling wine and made-wine: 8.5% - 15% abv per hectolitre of product Source: HMRC, note that abv means Alcohol by Volume 3.8 In addition to the above, alcoholic drinks, whether sold on licensed premises or off, are subject to 17.5 per cent VAT on the duty-inclusive price. 3.9 All together the alcoholic drinks industry contributes 14bn to the Treasury each year from direct sales taxes. Of this, 2.6bn comes from duty receipts on sales of wine, cider and perry, 2.3bn comes from duty receipts on sales of spirits, 3bn from the duty on beer, and 6.2bn from VAT revenue associated with sales of alcoholic drinks. Industry Background and Expectations 3.10 The UK wine and spirit sector is a very important part of the UK economy. Consumer expenditure on alcoholic drinks in 2006 was 41.3bn or 5.6 per cent of total expenditure. Of this, 14.5bn was spent on wine and 7.8bn on spirits. The alcohol and associated industries are estimated to employ 1.5 million people, roughly 5.5 per cent of the active population. Expenditure and market trends 3.11 Consumer expenditure on alcohol has grown significantly over the last forty years. According to data from the Office of National Statistics (ONS), total expenditure on alcohol (in 2003 prices) rose from just under 20m in 1966 to 38.5m in 2006, an increase of 92 per cent. The growth in expenditure has not been steady over time. Rather, there was sharp growth during the late 1960s and early 1970s followed by more limited growth until another sharp increase between the mid-1990s and early 2000s. The increase in expenditure is linked to growth in real incomes during the same period from 1966 to 2006 the UK GDP grew by 159 per cent in real terms. Further, the total expenditure by UK households increased by 191 per cent between 1966 and This implies that the share of alcohol in total household expenditure has actually fallen through time In addition to a change in total expenditure on alcohol there has also been a change in purchasing patterns through time. Chart 3.1 illustrates that expenditure on beer accounted for 85 per cent of all expenditure on alcohol in 1966; by 2006 this proportion had fallen to 45 per cent. Expenditure on spirits has remained relatively constant over time, rising from 16 per cent in 1966 to 20 per cent in Because ONS does not have a separate category for expenditure on wine and because of a 9

37 3. Context of the Study lack of alternative data, it has not been possible to track the evolution of wine sales directly over time. However, an indication of the development over the past forty years can be gleaned from an examination of consumer expenditure on the ONS defined category of wine, cider and perry. Expenditure on these beverages as a proportion of total expenditure on alcoholic drinks has risen from 9 per cent in 1966 to 35 per cent in Furthermore, most of this increase has occurred within the last 15 years; in 2006 consumption expenditure on wine, cider and perry was double that in Chart 3.1: UK household final expenditure on alcoholic drinks 1966 and 2006 Source: National Statistics, taken from British Beer and Pub Association Statistical Handbook We also obtained data on the quantity of wine and spirits consumed in the UK from 1990 onwards, as published in the British Beer and Pub Association Statistical Handbook (2007). Chart 3.2 illustrates that whilst the total volume of spirits consumed in the UK during each year remained fairly constant between March 1990 and March 2007, consumption of wine increased dramatically until , but has remained roughly constant in the past three years. 10

38 3. Context of the Study Chart 3.2: Total consumption of wine and spirits (thousand hectolitres) Source: National Statistics, British Beer and Pub Association Statistical Handbook 2007 Cost trends 3.14 Participants in the wine and spirits sector have recently seen cost increases from a variety of sources including a scarcity of raw materials (grapes, barley etc.), rising energy prices, higher costs of packaging materials and higher transport costs. For example, wheat prices have increased by 130 per cent since March 2006, and barley is showing similar trends, having increased by 130 per cent also over last 18 months. Energy prices, which impact glass and transport costs, have risen by over 50 per cent in the last three years. The cost of packaging has also gone up significantly. Driven by global demand, the prices of tin and used paper have risen by 90 and 40 per cent respectively over past three years. Further, wine harvests in southern Europe and Australia are suffering from weather conditions, which are expected to lead to an increase in rising costs of grapes Estimates provided by the industry to the WSTA for its 2008 Budget Submission quantify the expected cost movements over the coming year. Table 3.3 shows the extent to which three of the main cost sources are expected to impact on overall production costs during 2008 for a subgroup of the industry. There is a range of estimates for each category because each category embodies several different factors. For example, within the packaging category are estimates of cost increases of glass, cartons etc. 11

39 3. Context of the Study Source Table 3.3: Production cost impacts Impact on total production costs Raw Materials 5% - 10% Packaging 3% - 6.5% Transport 3% - 4% 3.16 Further information on expected cost pressures can be gained from the responses to our survey. Majority of the respondents expect the cost of labour to rise by between 3-6 per cent in 2008 and the cost of finance by less than 10 per cent. The range of estimates for the rise in the cost of raw materials was greater with some companies expecting zero impact whilst one respondent expects them to double. The median anticipated rise in raw material costs is almost 8 per cent whilst the mean is approximately 14 per cent. Particularly rising fuel and energy are expected to have a major impact on the costs of glass production and transportation. Many respondents also felt that recent poor harvests, coupled in the case of wine with high demand for grapes, would push up the cost of the major ingredients of both wines and spirits Overall then, the data and questionnaire responses suggest an average increase in costs in the main categories of between 3 and 10 per cent. It should be noted that many of the questionnaire responses and the data for Table 3.2 relate to large scale producers that might be in a better position to control input costs than the industry on average. Indeed, the expected increase in total production costs for the industry as a whole is between 8 and 10 percent. 2 Therefore, in the modelling described in Section 4, we have used the three broad cost scenarios (in addition to a rise in the duty): optimistic scenario of zero increase in production costs, reflecting an extreme best case cost scenario; baseline scenario of 8 per cent increase, coinciding with the lower end of central industry expectation; and pessimistic scenario of 10 per cent increase, coinciding with the higher bound of central industry expectation. Price trends and profitability 3.18 Chart 3.3 plots the trends in the UK retail price index (RPI) and the trend in wine and spirit prices from 1990 to The price of wine and spirits was rising at a rate greater than inflation until about For the next four years, the price of wine and spirits increased in line with inflation but since 2001 prices have risen by less than inflation. Indeed, since 1999 the overall RPI has risen by 32.6 per cent whereas the price of wine and spirits has risen by just 21.5 per cent. The excise duty on wine rises in line with inflation each year. Assuming that also other input costs of the sector rise roughly in line with RPI inflation, the price trends shown in Chart 3.3 imply 2 The Wine and Spirits Trade Association: Budget Submission

40 3. Context of the Study that companies operating within the wine and spirits sector could well have suffered significant reductions in their profitability since Chart 3.3: Price trends 1990 to 2006 Source: HM Revenue & Customs, taken from British Beer and Pub Association Statistical Handbook According to the WSTA, oversupply in the market place and intense competition amongst retailers and suppliers may have contributed to price trends in recent years Our questionnaire also asked about actual profitability growth during 2007 and the expected profitability growth for 2008, in absence of a rise in duty. In response, 31 per cent answered that that profitability deteriorated during 2007, 24 per cent reported that it remained about the same and 34 per cent saw an improvement Looking ahead to 2008, 41 per cent of respondents expect their profitability to deteriorate, 24 per cent expect it to remain about the same and 34 per cent expect it to improve. The differences in response could reflect different expectations on ability to pass through costs. It should be noted that these profitability estimates are made with the assumption of the status quo tax regime. Raising the level of alcohol duty could have an additional negative impact on profitability Analysing this response by the type of company, it appears that those towards the beginning of the supply chain producers, wholesalers and distributors have found times the hardest during 2007 and expect further deterioration in profitability during Most retailers, by contrast, state that their profitability rose during 2007 and expect it to rise further during The relative optimism of the sample of retailers about their own prospects could seem, at face value, in contrast with some of the other evidence presented to us, including on cost trends, outlook for the sector in general as well as data on the current retail margins on some products. However, this question was asked again 13

41 3. Context of the Study within the status quo tax regime. Also, it is possible that retailers expect their profitability to improve if they are currently rebuilding their margins from being below sustainable levels previously the questionnaire does not shed light on the quantity of the expected movements, nor the starting level for it The main source of concern for respondents stemmed from sales revenues; 79 per cent feel this will have an impact on profitability and 51 per cent of all respondents feel it will be the most important factor. Rising input costs are the second on the list of profitability concerns of the respondents, with 66 per cent expecting them to have a significant impact. Input costs appear particularly important for the producers, wholesalers and distributors within the sample Finally, all of the respondents to our questionnaire indicated that it would be necessary for them to pass on cost increases to customers over the next 12 months. This is consistent with data on current costs and margins on different wines, provided to us by WSTA and discussed more in Section 4. General expectations for the sector 3.26 The overall message arising from the above discussion is pessimism for the immediate future of the sector. Costs have increased and are expected to increase further, while the prices of the final products have fallen in real terms in recent years. Indeed, few respondents to our questionnaire are optimistic about the sector in 2008; overall 76 per cent are less optimistic about prospects over the next 12 months than they had been a year ago, whilst 14 per cent feel about the same and only 10 per cent feel more optimistic Further, these expectations are in the absence of any further increase in the excise duty on wine or spirits. More than half of respondents were very concerned about a rise in duty even if it were in line with inflation Rise in the duty on alcohol might have several impacts on the sector as well as the economy as a whole. As well as the profitability of the sector, these include impacts on employment, consumer welfare, tax revenue, inflation and possible impacts on illegal imports or other substitution away from UK sales of alcohol, with further linkage effects on the economy as a whole We go on to explore the possible impacts of a rise in duty in the next section. 14

42 4. Impact of a Rise in the Duty on Wine and Spirits 4. Impact of a Rise in the Duty on Wine and Spirits 4.1 This section evaluates the impact that a rise in the excise duty on alcohol would have on the industry and the UK economy. The WSTA believes that there is no scope for the wine industry to absorb further tax increases without adverse impacts on the industry. This has implications for the expected impacts of an increase in the excise duty discussed below. Possible Effects of a Duty Rise 4.2 This section provides qualitative discussion of the possible impacts of an increase in the excise duty. These can be divided into: (a) Comments on whether an increase in duty might achieve its policy goals; (b) Direct impacts on the industry and consumers; and (c) Indirect and induced impacts on the economy as a whole 4.3 The wider impacts on the economy as a whole are difficult to quantify fully. They are, however, as relevant as the direct impacts when considering the costs and benefits of further increases in the duty. Comments on whether an increase in duty might achieve its policy goals 4.4 The advocates of an increase in the excise duty on alcohol might have two broad objectives in mind to be achieved via such an increase: (a) Reduce public health and other social costs (anti-social behaviour etc) associated with excessive or irresponsible consumption of alcohol, for example by reducing consumption by problem user groups (heavy and dependent users); and (b) Raise revenue for the Exchequer 4.5 It is not our remit to comment specifically on the effectiveness of alcohol duty as a social and health policy instrument, or to compare it with possible alternatives. We note, however, that taxation can be a relatively blunt tool for achieving such objectives. In any event, the social and health benefits achieved via increased taxation should be compared with the costs imposed on the economy. 4.6 It is also important to be aware of recent trends in alcohol consumption so that the discussion is anchored in facts. Chart 3.2 above shows that total wine consumption in UK has fallen from its peak in 2001/02, and has remained relatively constant in the past three years. Total consumption of spirits has also remained constant or even fallen slightly since 2002/03. Recent HMRC statistics show that total alcohol consumption in UK fell by 5.3 per cent over the past two years. 3 Similarly, the ONS 3 WSTA briefing on UK Alcohol Debate, December

43 4. Impact of a Rise in the Duty on Wine and Spirits found that the number of men and women exceeding the daily and weekly sensible drinking limits has fell significantly between 2003 and Proponents of an increase in taxation, however, seem to put little weight on these recent developments. For example, the Breakdown Britain (2006) report for the Conservative Party s Social Justice Policy Group quotes figures of alcohol users and problem user groups of alcohol in particular. 5 The report quotes evidence that 88 per cent of all Britons drank alcohol in The report also quotes evidence from a Cabinet Office study setting out the scale of heavy drinking in population terms, as set out in Table 4.1 below. Table 4.1: Number of alcohol misusers in England 2001 Groups Men Women Total Total as % of population Drinking above government weekly guideline 5,910,393 3,203,978 9,114, % Drinking above government daily guideline 5,201,708 3,439,693 8,641, % Heavy drinkers 1,319, ,420 1,930, % Source: Cabinet Office Strategy Unit (2003): Alcohol misuse: How much does it cost? 4.8 Reservations about the current accuracy of the above figures not withstanding, using them implies that 81 per cent of drinkers in England do so within the government guidelines. This would imply that, if adherence to the government daily guidelines ensures no harmful external effects, the innocent enjoyment and wellbeing of 81 per cent of drinkers in England would be impaired by using taxation as a social policy instrument to reduce harmful effects of alcohol use in a minority group of users. Conversely, the figures imply that only 4 per cent of drinkers are heavy drinkers. If most of the harmful effects are associated with heavy use (e.g. there is some safety margin in the government guidelines), the innocent enjoyment and wellbeing of up to 96 per cent of drinkers (all non-heavy drinkers) would be impaired on account of a minority user group. 4.9 Further consideration needs to be given to the responsiveness of different individuals to price changes. Even if total consumption is reduced by higher prices driven by taxation, it is not a guarantee that problem use falls. Indeed, some studies suggest that problem drinkers respond less to price changes than do general consumers. 6 (We return to this in the next section.) 4.10 It is, of course, possible that policy makers would see an increase in the excise duty on alcohol mostly as a revenue raising device, rather than as a social and health policy instrument. The impact on the total tax revenue collected and the economy The Addiction Working Group (2006): The state of the nation report: addicted Britain, page See for instance Raistrick, D. Hodgson, R. and Ritson, B. (1999) Tackling Alcohol Together: The Evidence Base for UK Alcohol Policy (London, Free Association Books) 16

44 4. Impact of a Rise in the Duty on Wine and Spirits more generally, however, will depend on various interconnected effects. Raising alcohol duty could even have an overall negative impact on tax revenue if industry sales and profits fall (lower corporation tax revenues and potentially a fall in VAT and Duty revenues) and if employment levels fall (through lower income tax revenues) as a result of the increase in the Duty. We discuss these possibilities further in the next section. Direct impacts on industry and consumers 4.11 An increase in the excise duty on alcohol would have a direct impact both on the industry and the welfare of the consumers. The possible impacts include: (a) Reduction in retail margins available for the industry; (b) Increase in price, the scale depending on closeness and importance of price points in particular; (c) Reduction in output of the industry (sales) depending on consumers responsiveness to price; (d) Reduction in employment in the industry as a result of falling output and profitability; (e) Slowing of the growth of the sector; and (f) Loss of consumer welfare from a distortion introduced (or increased) by the increase in excise duty In addition the above, there is a concern in the industry that if alcohol duty were to rise, and given the ongoing globalisation of the alcohol market, some producers and suppliers may decide not to supply to the UK since they could sell their produce at a higher margin elsewhere An increase in alcohol tax duty may also have an effect on alcohol smuggling or private imports from the continent and elsewhere: as the expected benefits increase, because of a larger duty gap between the UK and the rest of the EU, alcohol imported illegally or privately may enter into the supply chain on a significantly higher scale. Already the HMRC estimates that, in , illicit purchases counted for 5 per cent of the UK spirits market and cross border shopping a further 4 per cent. This corresponded to a total loss of revenue of 300m Unfortunately we do not have access to data required to quantify the effect on increase in duty on revenue loss via illicit sales and cross border shopping. However, there is the anecdotal-but-not-implausible thought that the bulk of smuggling and private imports could be associated with the social sectors that would also have the highest propensity to binge drinking and other alcohol-related problems. Thereby an increase in smuggling or private imports could further reduce any alleged beneficial impact on problem drinking. An increase in cross-border 7 HMRC (October 2007): Measuring Indirect Tax Losses

45 4. Impact of a Rise in the Duty on Wine and Spirits trading could also lead to further price compression as retailers have to compete against suppliers in lower duty jurisdictions This is analogous to what has already happened in the cigarette sector. According to reports from 2001 as many as a third of cigarettes smoked in the UK were already imported illegally by that time. 8 HMRC estimates that in per cent of cigarettes consumed in UK were sourced through means that avoid the excise duty. 9 This is likely to be due to the tax differential between the UK and the rest of the EU. A packet of cigarettes currently costs around 6 in the UK, 4.3 in France and much less in other European countries. Indirect and induced impacts on wider economy 4.16 In addition to the direct impact on the industry, there are two types of multiplier effects that arise: linkage effects and induced effects. The term linkage effects refers to the output and jobs lost in the supply or distribution chain of the industry. An example would be jobs in a wine importation firm that supplies a retailer, or a glass maker that supplies a wine producer. The jobs of those employed in the importation firm will be directly affected if there is a change in demand from the retailer The second effect is the induced unemployment or the income multiplier effect that arises due to the reduction in expenditure by those that have become unemployed. This reduced expenditure creates further job losses as less money is spent on goods and services a ripple effect. Both types of multiplier will have a further impact on tax revenues (e.g. a loss in income tax) A rise in alcohol duty, leading to an increase in prices, would also increase inflation The next sections discuss the different possible impacts further, and quantify the likely effects for the current situation in the UK HMRC (October 2007): Measuring Indirect Tax Losses

46 4. Impact of a Rise in the Duty on Wine and Spirits Estimated Direct Impacts of a Duty Increase 4.20 We now turn to quantification of the impact of an increase in the excise duty on wine and spirits. To do this, we developed a model in which changes in parameters such as the level of taxation cause changes in other variables which are of interest in this study such as retail prices, sales, tax revenues, employment and so on. General modelling approach 4.21 The modelling approach had to be sufficiently flexible to allow several scenarios to be considered, including the interaction of a rise in alcohol duty with a rise in external costs. The model can also consider the impacts given different degrees of cost pass-through to retail prices for wine and various types of spirit, as well as various other input assumptions Chart 4.1 sets out the overall structure and flow of the model. Each of the boxes in the chart corresponds to a set of calculations in the model. Although not shown, the underlying input data and assumptions sheets of course contribute to all subsequent calculations. Chart 4.1: Overview structure of the model Input Data and Assumptions: Existing costs Current gross retail margins Duty rates Consumption and expenditure Modelled Scenarios: Duty increase Other cost increase Impact on retail margins (total cost impact) Impact on retail prices Inflation Impact Impact on consumption and sales Employment Impact Sales tax revenue impact Consumer surplus impact First degree GDP impact 4.23 First, the input data on assumptions are combined with the various modelling scenarios to calculate the total cost impact and the impact on gross retail margins. 19

47 4. Impact of a Rise in the Duty on Wine and Spirits 4.24 We consider three main tax scenarios an increase in the excise duty on wine and spirits in line with actual RPI inflation, and by 10 and 30 per cent. For the RPI inflation, we use the latest ONS estimate of 4.3 per cent. As shown in Table 3.2 above, the duty rate on wine changes according the type of wine (still or sparkling) and the alcohol content of the wine in question. We used the duty rate on still wine of between 5.5 and 15 per cent abv of 1.78 per litre ( 1.33 per 75cl bottle) as the current wine duty rate estimate used in the modelling, due to limitations on available data on different types of wine. The duty on spirits is based purely on alcohol content, and translates currently to 5.48 for a 70cl bottle of 40 per cent alcohol by volume (abv), which we take as typical As we discussed in Section 3, participants in the wine and spirits sector have recently seen and expect further cost increases from a variety of sources. Based on that discussion, we assume a 0, 8, and 10 per cent increase in costs in our optimistic, baseline and pessimistic cost scenarios respectively In the results below, we use the following as our baseline reporting scenarios: (a) For wine: the effect of a 10 per cent increase in duty and 8 per cent increase in other costs and the 3.99 price point wine as representative of a typical 75cl bottle sold; (b) For spirits: effect of a 10 per cent increase in duty and 8 per cent increase other costs and the price point wine as representative of a typical 70cl of 40 percent abv bottle sold The modelled impact on retail margins is then used to estimate the impact on retail prices. The resulting effect on retail prices feeds directly into the estimated inflation impact, as well as to the estimation of the impact on wine and spirits sales and household expenditure. The impact on household expenditure on wines and spirits is then used, combined with inputs from the data and assumptions sheets, to estimate other various impacts of interest; industry employment, tax revenue from sales of wine and spirits, consumer surplus, and the first degree linkage effects on UK GDP We now move to discuss each step in the model in more detail, first describing the method and then the results and their implications. Impact on retail margins Method employed 4.29 WSTA provided us data on typical costs of wine production across the supply chain of still wines currently priced at the price points of 3.49, 3.99 and 4.99 per 75cl bottle. In particular, this data includes production, distribution and retail costs, which we utilised as the starting point in our modelling. We modelled the impact of the assumed cost and tax increases separately taking each of these types of bottles as a representative of a typical bottle of wine sold in the UK. 20

48 4. Impact of a Rise in the Duty on Wine and Spirits 4.30 For spirits we used hypothetical price points of 10, 15 and 20 per 70cl bottle as a starting point in the model. We modelled the impact of the assumed cost and tax increases separately, taking each of these types of bottle as a representative of a typical bottle of spirits sold in the UK. In other words, we model the impact for the above three assumed weighted average prices of a bottle of spirits and wine. However, in the absence of data on the typical cost structure across the supply chain of spirits at different price points, we used the data on wine products as the basis of assumptions about the cost structure of the spirits supply chain. This is necessary in order for us to model the combined effect of increases in input costs and excise duty The retail margin as a percentage of retail price at the different price points in the wine data varies between 25 and 30 per cent. We used this as the basis of the assumed current retail margin available from sales of spirits. The excise duty on a bottle of spirits of 40 per cent abv is Knowing the retail margin, excise duty and the retail price at the different price points, we can calculate the implied cost of upstream production, such that when the total costs (including excise duty) are uplifted by the VAT, the total equals the retail price. Results and implications 4.32 Having obtained the relevant cost assumptions as the starting point, we were able to model the combined effect of increase in production costs and excise duty. Table 4.2 below shows the total increase in costs per bottle of wine and spirits for the different assumed cost and excise duty increases. For example, a 10 per cent increase in duty combined with the baseline 8 per cent increase in other costs would lead to a 7.7 per cent increase in costs as a percentage of a retail price on a 3.49 bottle of wine. An increase of 30 per cent in the duty alone (i.e. in the optimistic zero cost increase scenario) would lead to an 8.9 per cent increase as percentage of retail price on a 4.49 bottle of wine. 21

49 4. Impact of a Rise in the Duty on Wine and Spirits Table 4.2: Increase in costs as % of retail price Wine Spirits Retail price per bottle RPI tracking duty increase 0% other cost increase 1.6% 1.4% 1.3% 2.4% 1.6% 1.2% 8% other cost increase 5.5% 5.7% 5.8% 4.8% 5.5% 5.8% 10% other cost increase 6.5% 6.7% 6.9% 5.4% 6.4% 6.9% 10% duty increase 0% other cost increase 3.8% 3.3% 3.0% 5.5% 3.7% 2.7% 8% other cost increase 7.7% 7.6% 7.5% 7.9% 7.5% 7.4% 10% other cost increase 8.6% 8.6% 8.6% 8.5% 8.5% 8.5% 30% duty increase 0% other cost increase 11.4% 10.0% 8.9% 16.4% 11.0% 8.2% 8% other cost increase 15.3% 14.2% 13.4% 18.9% 14.8% 12.8% 10% other cost increase 16.2% 15.3% 14.5% 19.5% 15.8% 14.0% Source: Europe Economics estimation 4.33 We are interested in the effect that the above cost increases would have on the retail margins in the wine and spirits sectors, in particular whether the industry would be able to absorb them or whether they would lead to retail price increases. The model defines the cost absorption potential in terms of a minimum sustainable retail margin. The survey results discussed above indicate that the industry on average considers 27.5 per cent to be a minimum sustainable retail margin (as a percentage of retail price). 10 As shown by the WSTA data, retail margins are already close to or below this level at some price points Our results indicate that for almost all price points and scenarios considered, there would have to be some pass through of tax increases to consumers to maintain the minimum sustainable retail margin. The only exceptions are the higher margin products in the optimistic scenario, where the model implies that there might not be a need for cost pass through The above indication is also consistent with the results of our survey, where all of the respondents indicated that it would be necessary for them to pass on cost increases to customers over the next 12 months. Further, the majority of the respondents considered that a rise in the duty even in line with inflation would significantly harm their profitability. 10 The retail margin referred to throughout this report relates to the gross retail margin, from which the retailer is required to cover all costs relating to the retail business. The minimum sustainable retail margin relates to the level of gross margin at which, in the medium term, a retailer can still just cover the costs of business (i.e. leaving a zero net margin). 22

50 4. Impact of a Rise in the Duty on Wine and Spirits Conclusions 4.36 We conclude that an increase in the excise duty on alcohol in the current environment could potentially have a severe effect on already borderline retail margins and profitability of the sector. The impact that the resulting cost pass through might have on retail prices is discussed in below. Impact on retail prices 4.37 The WSTA believes that there is no scope for the wine industry to absorb further tax increases without adverse impacts on the industry. As discussed above, our modelling results reflect this view. Method employed 4.38 The model calculates the amount of cost pass-through required to maintain the minimum sustainable retail margin for each product and scenario considered. This also takes into account the VAT that the companies would have to include in the new retail prices. The extent of the required cost pass through varies depending on the product (wine or spirits) as well as the existing margin and the scenario of cost trends considered Another particularly important driver of the impact on retail prices is the existence of price points at which products are sold. The WSTA advised us that wine consumers in the UK appear to base purchase decisions importantly on price points psychologically significant prices such as 3.99 at which many products gather. In other words, consumers will choose any bottle of wine priced at, for example, 3.99 and are unwilling to purchase a bottle above this level (unless priced at the next price point ( 4.49)). Indeed, the WSTA noted in its 2005 Budget Submission that There have been several attempts to pass through the duty increases, with prices like 4.03 a bottle instead of 3.99, but consumer pressure has almost always brought the prices down to the previous level Price points are a very common pricing strategy. In economic terms, the existence of price points implies that the price elasticity of demand is higher above a price point, but lower below it. Price points can arise for various reasons, including: Substitution price points at a fixed price of a near substitute; Customary price points, where customers are used to paying a certain amount for a certain type and quality of product; and Perceptual price points, such as pricing at 3.99 rather than 4 as the latter can be perceived to be relatively more expensive than it actually is For wines in particular, price points may also be a signal of quality to the consumer, which would be consistent with the WSTA experience that consumers base purchase decisions on price points. Taking prices as a signal of quality, consumers may view 23

51 4. Impact of a Rise in the Duty on Wine and Spirits two wines priced at 3.99 and 4.03 as being of the same quality, and hence (as well as for possible perceptual reasons) prefer the bottle at The existence and importance of price points implies that once the tax increase is such that it breaches the minimum sustainable retail margin, that margin cannot be recovered with a marginal increase in price. Instead, prices have to be increased all the way up to the next price point. This has the effect that even a modest increase in costs that breaches minimum sustainable retail margin can have a substantial effect on price The increment of increase in price points was assumed to be 0.50, consistent with the data provided by the WSTA. This means that after a tax increase that breaches the minimum sustainable retail margin, a 3.99 bottle would be priced at We do not have similar data on the price points of spirits. Therefore we used the same increment of 0.50 for spirits as for wine. These increments of price increase are consistent with the survey results: the respondents indicated that the increment between price points generally lies between 3-7 per cent of retail price for spirits and 5-12 per cent for wine. Results and implications 4.44 As the minimum sustainable retail margin is breached in most scenarios, the retail prices of the products are moved at least to the next price point in all scenarios regardless of the price point used as the representative of a typical bottle of wine or spirits sold (except for the optimistic scenario combined with an RPI tracking duty increase). Table 4.3 below shows the increase in retail prices in the different model scenarios, using various price points as the basis of the analysis. 24

52 4. Impact of a Rise in the Duty on Wine and Spirits Table 4.3: Increase in retail prices as % of original price Wine Spirits Retail price per bottle RPI tracking duty increase 0% other cost increase 14.3% 0.0% 0.0% 5.0% 0.0% 0.0% 8% other cost increase 14.3% 12.5% 11.1% 10.0% 6.7% 5.0% 10% other cost increase 14.3% 12.5% 11.1% 10.0% 6.7% 7.5% 10% duty increase 0% other cost increase 14.3% 12.5% 11.1% 10.0% 3.3% 2.5% 8% other cost increase 14.3% 12.5% 11.1% 10.0% 6.7% 7.5% 10% other cost increase 14.3% 12.5% 11.1% 15.0% 10.0% 7.5% 30% duty increase 0% other cost increase 14.3% 12.5% 11.1% 20.0% 10.0% 7.5% 8% other cost increase 28.7% 25.1% 22.3% 25.0% 16.7% 12.5% 10% other cost increase 28.7% 25.1% 22.3% 25.0% 16.7% 15.0% Source: Europe Economics estimation 4.45 Comparing the percentage total cost increases in Table 4.2 to the modelled increases in retail prices in Table 4.3 indicates the importance and possible impact of price points as opposed to marginal cost pass through In almost all cases the impact on retail price is substantially higher than the underlying percentage increase in total costs. The effect arises because, even in cases where there is some absorption, the cost increase is just high enough to push prices to the next price point. However, the results imply that the price impact on most expensive spirits would be slightly lower than the total cost increase in some tax scenarios. As discussed above, consumers of wine typically buy wine at specific price points as they see price as an indication of quality. The industry would aim to keep wines at specific price points for many duty increases in a row, rather than increase them incrementally. However, eventually when this becomes unsustainable, as the model suggests is the case now, the price of would be taken to the next sustainable price point The impact on prices from a 10 per cent tax increase on wine is the same from the optimistic cost scenario through to pessimistic cost scenario, as there the total cost increase is just too low to imply a breach of the next price point. There are some exceptions to this pattern for example under the optimistic scenario for the higher margin products there might be no effect on retail prices if the duty is increased in line with inflation, as the total cost increases might not breach the minimum sustainable retail margin. 11 However, in the base line scenario an increase in the 11 Again, the retail margin referred to throughout this report relates to the gross retail margin, from which the retailer is required to cover all costs relating to the retail business. The minimum 25

53 4. Impact of a Rise in the Duty on Wine and Spirits duty in line with RPI inflation would move prices to the next price point or beyond. Similarly, a 30 per cent increase in tax would have different price impacts on wine and spirits depending on the cost scenario used In the baseline scenarios the increase in retail price is estimated to be 12.5 per cent for wine (using 3.99 bottle as a starting point), and 6.7 per cent for spirits (using bottle as a starting point). Both of these impacts are higher than the underlying increase in total costs due to price points. The impact on prices is higher using the lower priced benchmark bottle, and slightly lower using the higher priced one. Conclusions 4.49 We conclude that an increase in the excise duty on wine or spirits in the current situation could potentially lead to a significant increase in the retail prices of both wine and spirits due to existing (and further eroding) retail margins. Further, due to the importance of price points, this increase is likely to be substantially higher than the increase implied simply by the duty as a percentage of overall cost base. Impact on consumption (industry sales and revenue) Method employed 4.50 The extent to which the increase in price affects consumption (or sales) of wine or spirits depends on customers' responsiveness to price changes, or on their so called price elasticity of demand. Price elasticity measures a percentage change in the consumption of a product following a percentage change in the price. Not all drinkers respond to price changes in similar ways. Sufferers of alcohol dependency, or other heavy drinkers, are likely to reduce their drinking less as a result of a price increase than are people who drink more modestly Available estimates of the price elasticity of wine and spirits consumption can vary depending on the time period, demographic and geographic coverage, product coverage and the methodology employed, as well as the type of consumers included within the sample. The Breakthrough Britain: Addictions (2007) study quotes several estimates from different studies in the 15 years prior to 2007, providing an overall range and an average estimate for wine and spirits, as reproduced in the below table. Table 4.4: Price elasticity of demand for wine and spirits Average Maximum Minimum Wine Spirits Source: Table 2 of Breakthrough Britain: Ending the costs of social breakdown, Volume 4, Addictions (2007) sustainable retail margin relates to the level of gross margin at which, in the medium term, a retailer can still just cover the costs of business (i.e. leaving a zero net margin). 26

54 4. Impact of a Rise in the Duty on Wine and Spirits 4.52 We have used the average elasticities quoted there as the basis of our estimate of the overall impact on consumption: for wine and for spirits. This implies that a 1 per cent increase in price of wine leads to a 0.69 per cent decrease in the overall sales of wine. It also means that demand for wine is assumed to be relatively inelastic that there is less than one-for-one response between price and sales. Such an assumption is relatively conservative for this modelling exercise, as some studies (not quoted in the Breakdown Britain (2006) report) report elasticities as high as for wine. 12 The higher the elasticity, the more the increase in taxation will affect consumption, and (therefore) the less the additional tax revenue raised. This becomes more important below where we discuss the effects of an increase in the excise duty on the overall tax revenue raised We have not considered the relative reliability of the different available price elasticity estimates. We use the average of elasticity estimates (quoted above), at and , as these are the elasticity estimates put forward by proponents of an increase in the duty. Results and implications 4.54 The elasticity estimates above imply that the price increases postulated above following a 10 per cent duty increase will lead to a reduction of 7.8 per cent in the consumption of wine and an 8.3 per cent reduction in the consumption of spirits in the baseline scenario (taking 3.99 and 9.99 bottles of wine and spirits to be representative of overall sales, and including a 8 per cent increase in production costs) The impacts are slightly higher if the lower price points are taken as representative of all sales, and slightly lower if the higher price points are taken instead. The impacts are similar or higher in the scenarios modelling a 30 per cent increase in the duty, and similar or lower in the scenarios modelling RPI tracking increase in the duty, depending on the cost assumptions and movement of the price points. These impacts show the effect of the price points coming into play, as discussed above In 2006/07 UK wine consumption was equivalent to 1,970 million 75cl bottles, and the UK consumption of spirits was the equivalent to 413 million 70cl bottles of 40 per cent abv (Beer & Pub Association Statistical Handbook 2007). Therefore, the above falls in demand imply a fall in sales of 153 million and 34 million bottles of wine and spirits respectively. Alternatively, the household expenditure (not including corporate expenditure) on wine and spirits was 10,323m and 7,878m respectively. On these estimates, the above fall in demand would lead to a fall of 802m in household expenditure on wine, and 644m in household expenditure on spirits. These are also the estimates of the reduction in revenue by the wine and spirits sectors respectively The impacts relate to reductions due to the own price elasticity of wine and spirits. 27

55 4. Impact of a Rise in the Duty on Wine and Spirits Impact on consumption by problem users 4.57 We have so far discussed the impact of a duty increase on overall consumption based on the average consumer. One of the possible objectives of an increase in tax could be to reduce the consumption of wine and spirits by heavy users and thereby to reduce alcohol related public health and other social costs. However, the responsiveness of problems users to price changes can be very different from that of a non-problem user. Several studies suggest that the demand of the heaviest users can be less elastic than that of the average consumer. 14 Also Manning (1995), as reported in Breakthrough Britain (2007), found that among the heaviest drinkers demand for alcohol is nearly perfectly inelastic (not affected by price). The same paper found that, even at the 80 th percentile (i.e. the heaviest drinking 20 per cent), drinkers are still significantly responsive to price. However, as we noted above, only 4 per cent of drinkers in England would be classified as heavy drinkers. So the implication is that almost everyone is quite responsive to price except for the heavy drinkers that are the object of the policy concern. A rise in taxation would raise prices and so damage the innocent enjoyment of non-problem drinkers, whilst at the same time having no or little effect on the amount of alcohol consumed by the heavy drinkers Therefore, to gain a view on the impact of an increase in alcohol duty on consumption by the problem user groups, we used the minimum price elasticity estimates quoted in Breakthrough Britain (2007) report for wine and spirits, i.e and respectively. We note that particularly the price elasticity of spirits is still quite high, and as such may overestimate the actual reduction in consumption by the heaviest drinkers If we use these elasticity estimates, the results imply a 1.9 per cent reduction in consumption of wine and 4.8 per cent reduction in consumption of spirits in the base line scenario. For the average drinker the equivalent figures were 7.8 and 8.3 per cent respectively. This means that, if most of the harmful effects of alcohol are associated with heavy use, the welfare of up to 96 per cent of drinkers (all non-heavy drinkers), as well as the sector and the economy (see below), would be significantly reduced on the account of achieving a relatively minor impact on problem use of alcohol. It would also imply that the effect of a duty increase would be much less upon heavy drinkers than on moderate drinkers the reverse (presumably) of the policy objective. Conclusions 4.60 We conclude that an increase in the excise duty on wine or spirits in the current situation could potentially lead to a significant reduction in consumption, and therefore industry sales of either product, whilst having little effect on heavy drinking. 14 See for instance Raistrick, D., Hodgson, R. and Ritson, B. (1999) Tackling Alcohol Together: The Evidence Base for UK Alcohol Policy (London, Free Association Books), and: Sinclair, JD and Sillanaukee, P (1993): Comments on The prevention paradox: a critical examination. Addiction, 88,

56 4. Impact of a Rise in the Duty on Wine and Spirits The reduction in sales of wine and spirits is a direct measure of the fall in revenue that the industry would experience. We estimate that this fall in revenue could be 802m from household expenditure on wine, and 644m from household expenditure on spirits, per annum Such a fall in annual sales would be expected to have also an effect on the employment in the industry. The fall in consumption has also important implications for both total tax revenue raised after the excise duty increase, and the welfare of consumers. These effects are further explored in the following two subsections. Impact on industry employment Method employed 4.62 We have explored the effect of the fall in industry output on industry employment using output-employment ratios. The use of the concept assumes that there is a constant ratio of industry output to employment that is maintained through a fall in output We do not have data directly on employment in the wine and spirit sectors of the economy. Instead, we have used the output and employment of the alcoholic drinks sector as an approximation for it. This approximation is valid if the wine and spirits sectors have roughly the same labour intensity as the alcohol sector as a whole. Results and implications 4.64 Consumer expenditure on alcoholic drinks in 2006 was 41.3bn, and alcohol and associated industries are estimated to employ 1.5 million people. Using these figures as the basis of the output-employment ratio implies that there are approximately 36 people employed for each million of sales. On this basis, a fall in sales of wine by 802m per annum as a result of a 10 per cent increase in the duty in the baseline scenario might lead to loss of 28,000 jobs from the industry. Similarly, a 10 per cent increase in the duty on spirits might lead to a loss of 23,000 jobs from the industry, as implied by the baseline scenario The way in which the impact on employment is distributed throughout the industry would depend on the relative labour intensity (the amount of labour input relative to other inputs such as machinery) of different companies at various parts of the supply chain. For example, it could be reasonable to assume that smaller companies in the industry use relatively more labour per unit of output than do larger companies. That would imply that the employment impact is felt more by small companies We note that in practice it is likely that at least some firms might choose to reduce their investment rather than cutting employment, and so to that extent the methodology above is likely to exaggerate the effect on employment. However, we note also that the employment estimate here is for employment impacts just on the wine and spirits industry, and neglects potential losses in other industries from 29

57 4. Impact of a Rise in the Duty on Wine and Spirits linkage effects (such losses could potentially be highly material), and so to this extent is an under-estimate of total UK employment impacts. 15 Direct impact on tax revenue raised Method employed 4.67 An increase in the excise duty on wine and spirits will impact the overall tax revenue raised via several different taxes. (a) Excise duty receipts The amount of the duty would be higher, leading to higher receipts per bottle sold. However, the quantity sold is likely to decline as the price increases, as modelled above. Therefore, the net effect on revenue raised could be negative as well as positive, depending on the consumption impact of the duty rise. (b) VAT receipts VAT on alcoholic drinks is calculated on top of all other costs, including the excise duty. Therefore, the rise in the duty would lead to a rise in VAT receipts per bottle sold. However, as with the excise duty receipts, the quantity sold is likely to decline as the prices increase and therefore the net effect on revenue raised could be negative as well as positive. (c) Corporation tax receipts An increase in the excise duty is a cost for the industry, that has to be either absorbed, reducing profits and corporation tax receipts directly, or passed on to customers in terms of higher prices. Assuming profit maximisation by the industry prior to the increase in duty, even if an increase in the excise duty is passed completely to the customers, the profits of the industry would be lower than they were before (the industry could have charged the new prices previously also, but chose not to). (d) Income tax receipts One of the ways in which the industry might seek to absorb duty increases could be to limit wage growth of employees, which would have a negative effect on income tax receipts. Further, if there are any permanent or long term reductions in employment as a result of the increase in duty, income tax receipts would also fall We have taken the excise duty receipts and VAT receipts as the direct tax revenue raised from the sector. Results and implications 4.69 The results indicate that taking the 3.99 bottle of wine as a typical bottle sold, a 10 per cent increase in duty on wine would increase the duty revenue by 38m in the 15 Of course, we do not contend that unemployment would rise by the total of the jobs lost calculated here, since many people would switch to other jobs, but the jobs lost figure has its own interest and policy significance. 30

58 4. Impact of a Rise in the Duty on Wine and Spirits baseline scenario. This represents a 1.45 per cent increase in the duty collected. 16 Taking the bottle of spirits as a typical bottle sold, a 10 per cent increase on spirits duty would increase the duty revenue by 21m. This represents a 0.91 per cent increase in the duty revenue collected on spirits from a 10 per cent increase in the headline rate of duty. The same figures are 257m and 71m increases in revenue if the duty were raised by 30 per cent on wine and spirits respectively, and 100m fall and 21m increase from a RPI tracking increase in the duty. These represent respectively 9.8 and 3.13 per cent increases in revenue collected from a 30 per cent, and 3.8 per cent fall and 0.91 per cent increase in revenue collected from a RPI tracking increase in the duty The effect on the revenue from the excise duty is in most scenarios positive, although less in percentage terms than the increase in duty. These results merely reflect the effect of the reduction in demand due to the increase in duty Our results imply that total VAT revenue collected would fall from an increase in the duty. Taking the same bottles as the starting point, a 10 per cent increase in duty would lead to a 140m decrease in VAT revenue from wine, and a 113m decrease in VAT revenue from spirits. A 30 per cent increase in the duty on spirits would lead to a 282m fall in VAT revenue from spirits, and to a 281m decrease for wine as above. The VAT revenue would fall also following an inflation tracking increase in the duty Table 4.5 shows the overall impact on direct tax revenue under the baseline scenario, including excise duty and VAT receipts, from the sale of wine and spirits for the different scenarios of tax increase and typical product. Table 4.5: Overall direct sales tax impact ( million) Wine Spirits Typical bottle retail price RPI tracking increase in duty % increase in duty % increase in duty Source: Europe Economics estimation 4.73 Note that the above estimates do not include the effects on corporation tax or income tax receipts, both of which could be expected to be negative. Loss of consumer welfare 4.74 When people enter freely into a commercial transaction, each party expects to gain (otherwise they wouldn t agree to the transaction). An increase in the excise duty on 16 Our estimate of total wine duty receipts are 2.6bn. 38bn is 1.45 per cent of this. This affect arises because, although the duty per bottle has gone up by 10 per cent, the number of bottles sold falls by 7.8 per cent. 31

59 4. Impact of a Rise in the Duty on Wine and Spirits alcohol will also reduce the gains from trade that accrue to consumers from purchases of alcohol. Method employed 4.75 The gains that consumers, as a whole, expect to make from all their transactions in a market are referred to as consumer surplus. If a market does not work as well as it should, or it is distorted by an increase in tax, then these expected gains from trade are reduced. In the case of a tax, some of this lost consumer surplus is transferred to government through tax revenue, but there is a remaining amount that is simply gone this is called the deadweight loss Chart 4.2 overleaf illustrates the concept, with a downward sloping market demand curve (i.e. as prices rise people buy less) and (for simplicity of exposition) a horizontal supply curve (normally supply curves slope upwards i.e. firms supply less as pre-tax prices fall. A horizontal supply curve means that the industry only supplies at a particular price, as might be the case if, for example, the pre-tax price is set by a world price that is independent of UK demand.). The downward slope of the demand curve arises as, all other things being constant, the lower the price of a product, the more people are willing to consume it. More specifically, at every point along the demand curve there are some consumers willing to pay that price for obtaining the product. As the price falls, more and more people are willing to pay it for the product. In general people are only willing to pay a price for something if that price is less than or equal to the benefit they obtain from the product. Therefore, the demand curve maps out the benefit that the particular consumer just willing to make the purchase receives from the product. This means that at the original market equilibrium A in Chart 4.2, everyone except that particular consumer that entered the market at that price is paying less for the product than the benefit they receive. This benefit represents the gains from trade to the consumers (consumer surplus), and is represented by the area of the triangle PAB in Chart Introduction of a tax T on top of the price P leads to a reduction in consumer surplus. This reduction is represented by the rectangle PCDE plus the triangle CAD in the chart. The rectangle PCDE is not lost but is transferred to another party it represents the tax revenue to the government. In contrast, the consumer surplus represented by the triangle CAD is simply lost as a result of the tax T. This loss is called the deadweight loss. 32

60 4. Impact of a Rise in the Duty on Wine and Spirits Chart 4.2: Loss consumer welfare from tax Price B Demand curve E P D C A }T 4.78 The magnitude of the deadweight loss depends therefore on the amount of tax and the slope of the demand curve around the original market equilibrium, leading to a change in quantity purchased. Both the change in tax and the change in quantity demanded have been previously estimated within our model. We can therefore approximate the associated pure loss by multiplying the two together and dividing by two. This is a reasonable approximation if the demand curve is close to linear around the original market equilibrium The resulting direct fall in consumer surplus is equal to the amount of excise duty revenue raised plus the deadweight loss. However, the excise duty revenue raised is not considered as a loss in gains from trade in conventional tax impact analysis, as it is transferred to the government. The dead weight loss consumer welfare reduction is, however, simply lost. Results and implications Quantity 4.80 Estimated as discussed above, this loss in welfare varies between 9m and 11.6m for wines and between 3.5m and 21m for spirits from a 10 per cent increase in the excise duty on both. The estimates are lower for a RPI tracking increase in duty. For a 30 per cent increase in the duty, the loss varies between 27m and 70m for wines and 32m and 105m for spirits. The total dead weight consumer welfare loss from a 10 per cent increase in the duty on wine and spirits could therefore be worth nearly 33m ( 175m for a 30 per cent increase). 17 It will be an underestimate if the demand curve is strongly concave and overestimate if the curve is strongly convex. 33

61 4. Impact of a Rise in the Duty on Wine and Spirits Estimated Indirect Impacts of a Duty Increase Linkage effect on UK economy 4.81 As discussed above, the fall in output (and employment) of the wine and spirits sectors might also have a ripple effect on the rest of the economy through linkages in the production chain and induced effects in the economy. Method employed 4.82 The method that we consider to be the most suitable for assessing sector level change in this study is to use multipliers derived from Input-Output tables. Input- Output tables provide a complete picture of the flows of products and services within an economy for all sectors in an economy. Specifically, the tables detail the flows between various industries and also between industries and the final demand sector. Such linkages can then be used to estimate the extent to which any given industry contributes to the various final demand sectors The main concept behind the multiplier is the recognition that the various sectors that make up an economy are interdependent. One can manipulate the Input-Output table to estimate different types of multipliers depending on whether there is an interest in output, employment or income effects. The constituent component of the multipliers is the Leontief Inverse matrix. This is derived from the symmetric industryby-industry use matrix and shows how much of each industry s output is required, in terms of direct and indirect requirements, to produce one unit of a given industry s output We have used the multiplier data published by the ONS (2002). 18 This is the latest publication containing an estimate of the output multiplier for the UK alcoholic drinks sector, based on 1995 national accounts. These relate to the so called Type I multipliers, capturing the indirect effect of the demand for inputs of the sector. The multipliers do not, however, include the so called Type II induced. Induced effects arise because when output of a sector is increased there is an increase in compensation of employees and other incomes, which may cause further spending and, in turn, further changes in final demand. Therefore, the multiplier used underestimates the total effect of the duty increase on the economy. Results and implications 4.85 The estimated multiplier for the alcoholic drinks sector is This means that a one pound increase (decrease) in output of the alcoholic drinks sector leads to a 1.97 pounds increase (decrease) in the output of the economy as a whole. Table 4.6 below shows the estimated effect on the output of the economy from the reduction in sales of wine and spirits discussed above, for the baseline scenario based on different price points taken as the starting point of the modelling. (Note that each cell 18 ONS (2002): United Kingdom Input-Output Analytical Tables,

62 4. Impact of a Rise in the Duty on Wine and Spirits within product category (wine and spirits) is a different estimate of the total, and therefore should not be viewed as additive with each other.) Table 4.6: First degree linkage effects on UK economy ( m), baseline scenario Wine Spirits Typical bottle retail price RPI tracking increase in duty -1,797-1,572-1,379-1,893-1, % increase in duty -1,797-1,572-1,379-1,893-1,262-1,419 30% increase in duty -3,595-3,144-2,794-4,731-3,154-2,366 Source: Europe Economics estimation Impact on inflation 4.86 The increase in the price driven by the increase in the duty will also have an impact on general price level and inflation in the UK. Method employed 4.87 A first order approximation of the inflationary impact separately for each scenario requires only the percentage change in wine and spirit prices and the weight of wine and spirits in the HICP. In 2007, the weight of wine in the HICP was 9 parts per thousand (or 0.9 per cent) whilst the weight of spirits was 5 parts per thousand (or 0.5 per cent). Multiplying the percentage rise in the price of a bottle of wine by 0.9 will therefore give the percentage rise in inflation and similarly for spirits. Results and implications 4.88 The baseline results for wine and spirits would imply a combined 0.14 percentage point increase in HICP. The impact of that this increase might have on the economy or other objectives of the government has to be considered in the context of the current general market and policy conditions surrounding the Bank of England s inflation targeting regime The costs of high inflation are numerous and include the fact that if inflation in the UK is higher than in other countries and exchange rates remain constant, there could be an adverse impact on overseas sales as UK exports become relatively more expensive. Greater than anticipated inflation also adversely affects those on fixed incomes and the resulting reduction in expenditure by these individuals can have a non-trivial negative impact on GDP Inflation already exceeded the Bank of England s target of 2 per cent during much of 2007 and is forecast to again be above 2 per cent for much of Contributing further to the amount by which inflation is above target matters (even when it is by apparently modest amounts such as 0.1 per cent, through one-off level effects associated with taxes) for a number of reasons, not the least of which is that inflationary expectations are a crucial determinant of wage and retail price increases; if inflation persistently exceeds its target level, anticipated inflation will also exceed 35

63 4. Impact of a Rise in the Duty on Wine and Spirits target if individuals base their expectations on past experience at least to some extent. This will have the effect of maintaining inflation at a high level According to the Office for National Statistics (ONS), the most important source of inflationary pressure during December 2007 was the rising cost of food. Annual food price inflation is now 7.4 per cent, the highest it has been since records began in The Bank of England Inflation Report of November 2007 found that another important source of current inflationary pressure during 2007 was energy prices; wholesale gas prices rose by 20 per cent between August and November 2007 whilst world oil prices rose by 10 per cent during the same period. Pressure from these sources is expected to continue during In addition to rising fuel prices, it is expected that utility bills will have an impact in the early part of 2008 following the decision of Npower to raise their charges and an expectation that other providers will follow suit. Price rises due to increases in taxation can lead to further increases in inflation, as set out above Clearly there are already existing concerns about high and rising inflation next year, and the Bank of England might expect to face additional challenges in hitting the inflation target 19, since it could be hoping to be able to cut interest rates to address issues arising from the international credit crisis. In such an environment it could seem particularly problematic to introduce measures that would unnecessarily raise inflation further. Summary of Results 4.93 This section summarises the above results as quantified above, for ease of reference. The results presented are from our baseline scenarios, for inflation tracking, 10 and 30 per cent increases in the excise duty on wine and for spirits. 19 Indeed, on January 22 nd, 2008, Mervyn King raised the possibility that inflation might exceed 3 per cent for more than three months, leading him to have to write two letters of explanation to the Chancellor:

64 4. Impact of a Rise in the Duty on Wine and Spirits Table 4.7: Wine Estimated impacts of an increase in the excise duty Estimated impact from an increase in the duty by RPI 10 per cent 30 per cent Total cost impact (% of retail price) 5.7% 7.6% 14.2% Impact on retail price (% of retail price) 12.5% 12.5% 25.1% Impact on consumption by average consumer (%) -7.8% -7.8% -15.5% Impact on consumption by problem user (%) -1.9% -1.9% -3.8% Impact on industry sales to households ( ) - 802m - 802m - 1,604m Impact on industry employment -28,000-28,000-57,000 Impact on duty receipts ( ) - 100m 38m 257m Impact on VAT receipts ( ) - 140m - 140m - 281m Combined impact on VAT and duty receipts ( ) - 240m - 102m - 24m Deadweight loss consumer surplus ( ) - 4.4m - 10m - 61m First degree linkage effect on UK output ( ) - 1,572m - 1,572m - 3,144m Source: Europe Economics estimate 4.94 Our results imply that the impact on the retail price of wine would, under the baseline scenario for costs, be around the same from a RPI tracking and a 10 per cent increase in the duty. This is due to the existence and importance of price points. Once the tax increase is such that it breaches the minimum sustainable retail margin, prices have to be increased all the way up to the next price point. This has the effect that even a modest increase in costs that breaches minimum sustainable retail margin can have a substantial effect on price. Increase in the duty by 30 per cent would push the costs beyond even the next available price point, such that the net negative impacts are further amplified. 37

65 4. Impact of a Rise in the Duty on Wine and Spirits Table 4.8: Spirits Estimated impacts of an increase in the excise duty Estimated impact from an increase in the duty by RPI 10 per cent 30 per cent Total cost impact (% of retail price) 5.5% 7.5% 14.8% Impact on retail price (% of retail price) 6.7% 6.7% 16.7% Impact on consumption by average consumer (%) -8.3% -8.3% -20.7% Impact on consumption by problem user (%) -4.8% -4.8% -12.0% Impact on industry sales to households ( ) - 644m - 644m - 1,609m Impact on industry employment -23,000-23,000-57,000 Impact on duty receipts ( ) 21m 21m 71m Impact on VAT receipts ( ) - 113m - 113m - 282m Combined impact on VAT and duty receipts ( ) - 92m - 92m - 211m Deadweight loss consumer surplus ( ) - 4m - 9m - 70m First degree linkage effect on UK output ( ) - 1,262m - 1,262m - 3,154m Source: Europe Economics estimates 4.95 Table 4.8 summarises the baseline results for spirits. The results are similar to those for wines. However, for spirits the duty increases move prices over several price points, even from on inflation tracking increase. The clear indication from the table is that a 30 per cent increase would have the most severe negative impact on the industry, consumers and the economy as a whole Six key messages can be drawn from the modelling exercise, as summarised in the above tables: (a) Because of the importance of price points in this industry, a rise in costs as a result of any increase in duty could have a disproportionate effect on retail prices; (b) The resulting increase in retail prices could have a significant impact on the consumption and enjoyment of wine and spirits of the average non-problem drinkers, whilst having much less impact on consumption by problem drinkers. This reduced consumption by non-problem drinkers could have an adverse impact on the prospects of the industry. (c) Increases in the excise duty on either spirits or wine could potentially lead to a significant fall in tax revenue collected directly on sales, even before considering possible additional impacts on revenue via falls in corporation and income tax receipts. (d) In addition to a fall in total tax revenue, an increase in the duty could also lead to other major unintended spillover effects on the wider economy, in the first instance from 38

66 4. Impact of a Rise in the Duty on Wine and Spirits reductions in the output and employment of the supply or distribution chain of the industry. (e) Further to the above, rises in alcohol duties at this time would contribute to inflation, adding to an already difficult inflation situation for the Bank of England s Monetary Policy Committee, potentially reducing its scope to cut interest rates in response to slowing economic growth. (f) We estimate the negative GDP impacts from the above effects combined, for some of the more negative scenarios, to be of the order of billions of pounds and that is before considering further ripple effects throughout the economy. Further, an increase in alcohol tax duty may also have an effect on alcohol smuggling or private imports from the continent and elsewhere We do not comment on the value of the potential social and public health benefits from an increase in the duty, expect in so far as to point out the relative bluntness of the tax instrument. However, in deciding whether to increase the excise duty on wine or spirits, it is crucial the government compares the estimated benefits to the likely costs of the increase, as estimated in this study. 39

67 5. Conclusions 5. Conclusions 5.1 This study has considered various impacts that an inflationary, 10 or 30 per cent increase in alcohol duty might have on the alcoholic drinks industry, its customers and the UK economy in general. We undertook this assessment via economic modelling, informed by relevant public and industry data as well as a survey of WSTA members. 5.2 The proponents of an increase in alcohol duty might have two main objectives in mind: to reduce social and public health costs associated with excessive use of alcohol, or to raise additional tax revenue for the Exchequer. However, an increase in the duty would also have an impact the majority of drinkers whose consumption does not lead to adverse effects, whilst at the same time potentially having no or little effect on the amount of alcohol consumed by drinkers most at risk from alcohol. Further, total tax revenue collected might fall as well as rise as a result of an increase in the duty. We offer quantification of both effects. 5.3 We find that an increase in duty at this time could lead to a situation where the industry would not be able to maintain profitability without passing some of the costs on to final consumers. Our analysis implies that, at current prices and costs, the impact of this price-point effect would be that if alcohol duty rose then prices would increase by more than costs, as retailers move prices up to the next price point. This difference between the increase in costs and the triggered increase in price can be surprisingly large. 5.4 How much consumers reduce their consumption in response to a price increase is described, in economic jargon, by the "price elasticity of demand" the greater the price elasticity, the more consumption falls for any given rise in prices. Studies suggest that sufferers of alcohol dependency, or other heavy drinkers, are likely to reduce their drinking less as a result of a price increase than are those who drink more modestly their price elasticity is less. Using estimates of elasticities that are favoured by advocates of alcohol duty rises (particularly in terms of the difference in elasticity between normal and problem drinkers), we find that the effect of tax increase on consumption of wine by normal users would be some four times as great as that of problem users. Given the government estimate that only 4 per cent of drinkers are heavy drinkers, excise duty seems not only a blunt instrument of social policy (a position that the government itself has taken up to now), but also one that unnecessarily harms the vast majority of responsible drinkers. 5.5 The fall in consumption of wine and spirits by consumers as a whole, and the associated negative impacts on the industry output and employment, also have a substantial effect on total tax revenue collected. We find that increases in the excise duty on either spirits or wine could potentially lead to a significant fall in tax revenue collected directly on sales of the product, even before considering likely additional impacts on revenue via falls in corporation and income tax receipts. 40

68 5. Conclusions 5.6 The reduction in the sales of wine and spirits would also lead to linkage effects to the rest of the economy, in the first instance from reductions in the output and employment of the supply or distribution chain of the industry. Using the output multiplier for the alcoholic drinks sector published by the government s National Statistics office, we estimate the negative impact on the UK economy as a result of the first degree linkage effects to be measured in billions. 5.7 We also note that there are various additional effects that we did not attempt to directly quantify. In particular, the reduction in sales of wine and spirits would also lead to an income multiplier effect that arises due to reduction in expenditure by those that have become unemployed. Both the output and income multipliers would lead to further ripple effects through the economy. 5.8 Further, an increase in alcohol duty may also have an effect on alcohol smuggling or private imports from the continent and elsewhere: as the expected benefits increase, because of a larger duty gap between the UK and the rest of the EU, alcohol imparted illegally or privately may enter into the supply chain on a significant scale. 5.9 Indeed, increasing the excise duties on wine and spirits could run the risk of a quintuple whammy leaving heavy drinking unaffected, reducing the enjoyment of innocent drinkers, encouraging illegality through smuggling, losing tax revenue as a direct consequence of a fall in domestic consumptions as well as through encouraging massive cross-border transactions, and reducing GDP by damaging an important British industry. 41

69 APPENDIX 1: ANALYSIS OF QUESTIONNAIRE RESPONSES A1.1 This appendix contains a more detailed and continuous analysis of the questionnaire responses, which were drawn upon at various points in the main body of the report. A1.2 The questionnaire covered a broad range of topics, from the general performance of the firm and sector to more specific questions regarding price points, the source and impact of any anticipated cost changes (including excise duty) and the firms anticipated change in employment levels. A1.3 We received 30 responses covering every section of the supply chain and a wide distribution of company sizes. The main results drawn from these responses are discussed in detail below, but a brief summary is as follows. Respondents have generally negative feelings towards the prospects for the sector and their own firm during the next two years. A large majority of firms believe that sales revenues will have an adverse impact on their profitability in 2008 whilst a slightly smaller majority believe that input costs will have a similar impact. The major source of anticipated increases in costs is widely held to be raw materials and labour. Most respondents believe that a rise in alcohol duty even simply in line with inflation would have a severe adverse impact upon their profitability, a concern that is closely related to the respondents perceived possibility of passing on cost increases to consumers. Respondents believe that it will be necessary to pass cost increases on to consumers within the next twelve months, but many are not certain of their ability to do so. Expected impact of a rise in duty on profitability A1.4 Arguably the most important question for the purposes of this project was the following: Suppose that the government were to increase the level of alcohol duty in line with inflation. What impact do you think this would have on your profitability? A1.5 More than half of respondents were very concerned about such a rise in duty and stated that there would be a significant adverse impact on profitability. The main reason given for this is a belief that retail prices could not rise for reasons discussed below and, given this, there was a feeling that a duty increase would achieve little more than compounding the difficulties already faced by market participants and would not reduce alcohol consumption. The remaining respondents reported that there would be very little or no impact. Reasons for this view varied from an observation that past increases have had little impact to the expectation that duty would be passed on to consumers. A1.6 We acknowledge that the effect of a rise in alcohol duty may not be consistent across the various sections of the supply chain. Indeed, it could be that some sections expect to see a major impact from a rise in alcohol duty whilst other sections expect little effect. Breaking these figures down by company type we see a distinct pattern emerging: those towards the beginning of the supply chain feel that there would be a serious adverse impact on profitability whilst those towards the end are slightly more optimistic.

70 A1.7 Producers are the most negative group of respondents, with 86 per cent believing a rise in duty in line with inflation would reduce their profitability. Importers and distributors are similarly negative, in that almost two thirds stated that increasing alcohol duty in line with inflation would have a significant adverse impact on their profitability. Reasons cited by companies operating within the aforementioned sections of the supply chain included price competition in the retail market and a belief that supermarkets would not allow the duty increase to be passed on. A1.8 Retailers are slightly more optimistic. As many retailers believe that there would be no impact on their profitability as believe there would be an adverse impact. The larger retailers (supermarkets and high-street chains) generally felt that there would be no impact on their profitability. The most optimistic group of companies is agencies since 80 per of these believe that a rise in alcohol duty in line with inflation would have no impact on their profitability. Nonetheless, the general picture is that raising alcohol duty would have an adverse impact on the profitability of companies operating in the wine and spirits sector and that this, in turn, would likely hold consequences for industry employment and growth. Profitability A1.9 As profitability is of paramount importance to all respondents, we asked about actual profitability growth during 2007 and the expected profitability growth for In response, 31 per cent answered that that profitability deteriorated during 2007, 24 per cent reported that it remained about the same and 34 per cent saw an improvement. A1.10 Looking ahead to 2008, 41 per cent of respondents expect their profitability to deteriorate, 24 per cent expect it to remain about the same and 34 per cent expect it to improve. It should be noted that these profitability estimates are made with the assumption of the status quo tax regime. As discussed above, raising the level of alcohol duty could have an additional negative impact on profitability, especially if it proves impossible to pass the duty increase onto consumers. Also, the differences in response could reflect different expectations on ability to pass through costs. A1.11 In Table A1.1, we split WSTA members by the section of the supply chain in which they operate so as to examine whether or not the change in profitability during 2007 and the expected change in 2008 is constant along the supply chain.

71 Table A1.1: Expected profitability of firms by company type without duty increase Distributor Percentage of companies that expect profitability to Improve(d) About the same Deteriorate(d) % 21% 36% % 36% 36% Retailer % 14% 29% % 14% 29% Producer % 29% 43% % 0% 57% Import/Export % 67% 0% % 33% 33% Agency % 20% 20% % 20% 80% Wholesaler % 0% 50% % 25% 50% A1.12 It appears that those towards the beginning of the supply chain producers, wholesalers and distributors have found times the hardest during 2007 and expect further deterioration in profitability during A small majority of retailers, by contrast, state that their profitability has risen during 2007 and expect it to rise further during A1.13 The optimism of the sample of retailers about their own prospects could be taken to be, at face value, in contrast with some of the other evidence presented to us, including on cost trends, outlook for the sector in general as well data on the current retail margins on some products. However, note again that this question was asked within the status quo tax regime. Also, it is possible that retailers expect their profitability to improve if they are currently rebuilding their margins from being below sustainable levels previously the questionnaire does not shed light on the quantity of the expected movements, nor the starting level for it. Finally, the sample size per category is too small to draw a reliable inference from for the categories in general: for example, the survey respondents include only seven companies that were classified primarily as retailers. A1.14 To gain a deeper insight into the profitability forecasts, we asked WSTA members what they expect to be the main factors impacting on their profitability in The majority of respondents are greatly concerned about their sales revenues; 79 per cent feel this will have an impact on profitability and 51 per cent of all respondents feel it will be the most important factor. A1.15 Amongst other factors, respondents believe that input costs will be the most important with 66 per cent stating that they will have an effect on profitability in 2008 and 31 per cent believe this to be the most important influence. It is interesting that even having considered the cost increases from other sources that respondents will incur during 2008,

72 5 per cent believe that taxes other than alcohol duty will be the most important factor affecting their profitability in 2008 and 41 per cent believe they will impact on their profitability. A1.16 In Table A1.2, we show the factors that respondents believe will impact on their profitability in 2008, split by the section of the supply chain within which they operate. Table A1.2: Factors affecting the profitability of respondents in 2008 Main factors affecting profitability in 2008 Sales revenues Input costs Taxes other than duty Distributor Percentage mentioning factor 93% 85% 46% Percentage for whom most important 58% 47% 0% Retailer Percentage mentioning factor 86% 57% 43% Percentage for whom most important 71% 14% 0% Producer Percentage mentioning factor 86% 86% 57% Percentage for whom most important 43% 43% 0% Import/Export Percentage mentioning factor 100% 66% 66% Percentage for whom most important 67% 33% 0% Agency Percentage mentioning factor 60% 40% 40% Percentage for whom most important 60% 20% 20% Wholesaler Percentage mentioning factor 75% 50% 50% Percentage for whom most important 25% 50% 0% Note: The percentage for whom most important may sum to less than 100 as some companies mentioned factors other than those in the table and may sum to more than 100 as some companies felt two or more factors to be of equal importance. A1.17 The picture that emerges from Table A1.2 is that whilst sales revenues are an important factor for all types of company, they are relatively more important for retailers and agencies than they are for wholesalers and producers. Similarly, input costs appear to be relatively more important for producers, wholesalers and distributors. However, as above, the sample size of respondents per category could well be too small to draw reliable inference from, and as such the brake down of results should be interpreted with caution. A1.18 In addition to sales revenues, input costs and taxes other than alcohol duty, several other factors thought likely to affect profitability were mentioned by respondents. These include alcohol duty, the state of the economy, business rationalisation, supermarket power, consumer confidence and distribution costs. Finally, one distributor mentioned that they must pay fees to major supermarkets in order to supply them and that these supermarkets would not accept any price increases, leading inevitably to a margin squeeze for suppliers.

73 Retail margins and price points A1.19 To gain a further insight into the market conditions faced by retailers in the wine and spirits sector we asked respondents to indicate as a percentage of retail price the current retail margin earned by retailers and the minimum margin they believe to be sustainable. A1.20 The estimates of current margins varied between both different products sold by the same retailer and between different retailers selling the same product. The minimum reported margin was 5 per cent on some varieties of port and the maximum was 45 per cent on some varieties of wine sold by specialist retailers. Margins are generally reported to be higher on wines than on spirits; the mean (median) margin on wine is 31 per cent (31 per cent) whilst that on spirits is 23 per cent (20 per cent). A1.21 Asked about the minimum sustainable retail margin as a percentage of retail price, the median response was 30 per cent and the mean 27 per cent. In respect of current retail margins all but one respondent stated that retailers earn more than the minimum sustainable retail margin they had previously stated but many estimates placed current margins only slightly above that minimum sustainable margin. A1.22 One important aspect of the margins earned is the retail price at which the product is sold. The pricing in the wine and spirits sector is characterised by a series of price points. Acknowledging the importance of price points, we asked WSTA members what they believe to be the percentage increment between the current price point and the price point immediately above. For spirits, respondents generally reported the increment to be 3-7 per cent, although some mentioned 10 per cent for malt whisky and one distributor reported an increment of 12.5 per cent for spirits generally. The increment between price points seems to be slightly higher for wines, with a range of 5 to12 per cent and a maximum reported value of 20 per cent for white wine. Cost expectations for 2008 A1.23 We asked respondents to go into more detail about what the source of any expected 2008 cost pressures would be. In response, 81 per cent felt that raw materials would lead to cost pressures and, of these, 96 per cent felt that it would be the most important influence on costs. A1.24 Another important impact on costs is expected to be labour, with 67 per cent citing this factor, whilst exactly the same proportion stated that the cost of finance would affect their level of costs during A1.25 In addition to these widely mentioned cost influences, one respondent foresaw rising costs due to an increased legal/regulatory burden and another because of increased logistics and retailer charges. A1.26 In addition to providing a general assessment as above, we asked respondents to quantify the cost increases they expected for raw materials, labour, finance and any other factors mentioned. A1.27 Table A1.3 shows that the majority expect the cost of labour to rise by between 3-6 per cent in 2008 and the cost of finance by less than 10 per cent. The range of estimates for the rise in the cost of raw materials was far greater with some companies expecting zero impact whilst one respondent expects them to double. The median anticipated rise is almost 8 per cent whilst the mean is approximately 14 per cent.

74 A1.28 In addition, several respondents expected there to be further cost increases from a variety of sources. One respondent estimated that his costs would rise by 5 per cent due to exchange rate movements, another that there would be an increase of10 per cent due to the price of fuel, and a third company that there would be a rise of 10 per cent because of additional logistics charges. Table A1.3: Anticipated cost increases during 2008 Anticipated 2008 cost Percentage of respondents expecting such an increase increase (%) Labour Finance Raw Materials Note: Figures do not sum to 100 due to rounding A1.29 Asked to go into more detail about the source of cost influences, respondents that mentioned the importance of the rising cost of raw materials generally saw rising fuel and energy prices as having a major impact on the costs of glass production and transportation. A1.30 Another widely mentioned factor was the poor harvest that had taken place this year. Many respondents felt that this, coupled in the case of wine with high demand for grapes, would push up the cost of the major ingredients of both wines and spirits. Associated with this, two companies stated that the strengthening euro would have an impact because wines would cost more to purchase in sterling terms. A1.31 Those respondents that mentioned labour costs as important gave several contrasting reasons for this. First, the rising cost of labour in wine-growing regions such as California was mentioned, as was the cost of dealing with unsatisfactory staff after the one-year employment point had passed and the costs associated with hiring replacements. The cost of finance is expected to rise because base interest rates are expected to rise and there is an expectation that this will cause a credit crunch leading to banks becoming risk averse and pushing up borrowing costs further. A1.32 Amongst other factors, respondents mentioned that packaging costs would rise because of the waste package tax and the need to use a greater proportion of recycled/recyclable materials. Finally, it was mentioned by one company that major wholesalers charge a large amount of money in listing fees for the privilege of supplying them and that these could rise during A1.33 Of those that answered the question, all felt that it would be necessary to pass on cost increases to consumers over the next 12 months. Of these, 64 per cent felt that it would be necessary and possible to pass on at least some cost increases whilst 46 per cent felt that it would be necessary but impossible (note that the percentages sum to more than 100 because some retailers answered that it would be possible to pass on costs increases for some of their products but not for others, whilst some distributors stated that they could pass on cost increases to some clients but not to others).

75 A1.34 To enhance our understanding of the forces determining whether it would be possible, if necessary, for a company to pass on a price increase to consumers we asked WSTA members to give the three main factors affecting their ability to pass on costs. No clear pattern emerged but some of the most common were resistance from retail buyers (especially the supermarkets), the actions taken by competitors, and the customer and consumer fixation with set price points. Capital expenditure and employment A1.35 We also asked WSTA members to inform us of their plans for capital expenditure and employment during the next twelve months. With regard to capital expenditure, 22 per cent of respondents said they plan to decrease capital expenditure in 2008, 48 per cent are planning to spend approximately the same amount and 30 per cent plan increase spending. A1.36 For employment, 14 per cent of respondents are planning to decrease employment in 2008, 52 per cent plan to leave employment levels unchanged and 34 per cent are planning to hire more staff. When asked about the reasons for changing employment levels, those that plan to hire additional staff gave reasons such as company growth, opening new retail outlets, increased demand and the demographic profile of current staff. Amongst those planning to lay off staff during 2008, the reason given was the need to improve efficiency in order to remain competitive and grow. Expectations for the sector A1.37 One of the most general questions was designed to provide us with an insight into the expectations of WSTA members with regards to how the sector will perform during 2008 and 2009 and how their expectations for the coming twelve months compare with the expectations they had held a year ago. A1.38 Few respondents have any optimism for the sector over the next two years. Overall, 76 per cent are less optimistic about prospects over the next 12 months than they had been a year ago, whilst 14 per cent feel about the same and only 10 per cent feel more optimistic. For 2009, 52 per cent feel that the prospects for the sector are worse than in 2008, 34 per cent believe they are about the same and only 14 per cent believe they are better. A1.39 In Table A1.4 we again split the supply chain into six major sections and present the expectations for 2008 of the respondents that operate within each of these sections.

76 Table A1.4: Expectations for the Sector during 2008 and 2009 by type of company Distributor Percentage of companies that are More optimistic About the same Less optimistic 2008 (compared to 2007) (compared to 2008) Retailer 2008 (compared to 2007) (compared to 2008) Producer 2008 (compared to 2007) (compared to 2008) Import/Export 2008 (compared to 2007) (compared to 2008) Agency 2008 (compared to 2007) (compared to 2008) Wholesaler 2008 (compared to 2007) (compared to 2008) Note: A very small number of respondents have been excluded from this and similar tables because they do not fit conveniently into any of the above categories. They have, however, been included in the aggregate figures given in the text. A1.40 The general pattern that emerges from Table A1.4 is that companies operating in most sections of the supply chain expect the sector to perform poorly in 2008 compared with 2007 but expect things to pick up in Retailers expectations for 2007 are particularly divided 71 per cent are less optimistic about the sector, whereas 29 per cent are more optimistic. This might be a reflection of different retailers beliefs regarding their own performance, possibly also linked with different expectations of being able to pass on cost increases to consumers. Further, again, the breakdown is based on very small sample of respondents per category the results might not be representative of the category as a whole, and should be interpreted with caution. Lessons from the Questionnaire Responses A1.41 From the main questionnaire responses, it is not difficult to see how a rise in alcohol duty might have a significant adverse impact on the wine and spirits industry. A1.42 Firstly, more than half of respondents expect that a rise in alcohol duty would have an adverse impact on their profitability, either because of a reduction in margins if the retail price fails to rise in line with tax duty or through a reduction in sales volumes if the retail price were to rise. All respondents believed it would be necessary to pass on cost increases to consumers even in the absence of a duty increase, but almost 50 per cent believed this would not be possible for at least some of their products. A1.43 Since retail in the wine and spirits sector is characterised by a series of price points, any increase in prices resulting from the rise in alcohol duty would involve a movement to the

77 next price point. Respondents indicated that the increment between price points generally lies between 3-7 per cent for spirits and 5-12 per cent for wine. A1.44 More than half of respondents believe that a rise in alcohol duty would have a serious impact upon their profitability. This conjecture is supported by responses to other questions, not least the idea that some retail prices will not rise and hence the duty would be absorbed by market participants. Furthermore, there would be reduced sales volumes for those products for which the price does increase as consumers substitute towards lower quality products in order to remain at their price points. This pattern of substitution would imply that despite the major adverse impact on the industry, a rise in alcohol duty would not have a major impact on alcohol consumption levels, or only a minor impact on consumption of the very cheapest brands. A1.45 Adverse impacts on profitability seem likely to have further negative impacts on growth and employment within the industry. Employment costs themselves are expected to rise by an average of 4 per cent in 2008 and this is one of the factors that has led some firms to plan to lay off staff during 2008 in order to remain competitive and grow. Therefore, any additional negative impact on profitability can only increase the likelihood of employment reductions being required by a greater number of WSTA members.

78

79 WSTA Budget Submission 2008 ANNEX 2 PROJECT TO ASSESS THE AVERAGE ALCOHOL CONTENT OF WINES SOLD IN THE UK A report prepared by the WSA, 2005

80 PROJECT TO ASSESS THE AVERAGE ALCOHOL CONTENT OF WINES SOLD IN THE UK The project In 2004, the Beer and Pub Association, in its Budget Submission, questioned whether wine duty had fallen behind the equivalent rate of beer, taking into account the strength of wine, which they asserted had risen over the years (with no equivalent increase in duty. since all still wine in the range % pays the same rate of duty per litre. In order to test this statement, the WSA wished to ascertain the average strength of wine. However, no hard evidence exists as to average alcohol levels of wines sold in the UK. Sainsbury s and the WSA therefore decided to carry out a project to evaluate the average strength of wine in Sainsbury s stores (which were considered to be representative of the whole UK market). This was carried out in December Outline of procedure An electronic version of the wine aspects of Sainsbury s December BWS catalogue was supplied to the WSA A WSA representative, by prior arrangement, audited all the wines on the list in Nine Elms store, taking the strength from the label Following the initial sort of the data, key omissions were added following visits to South Ruislip & Uxbridge stores 52 week sales figures (ending 4/12/04) were added to the table for all wines. Sales volumes were converted to litreage respecting the different packaging formats, i.e. 25, 37.5, 75 cl plus 1.5 and 3 litres Using the declared alcohol levels, litreage figures of pure alcohol were calculated for all wines Sorts were done initially for the total market, EU and non-eu components and subsequently for the key producing countries within the different sectors o EU included all the current member states; so Hungarian wine was considered Exclusions o Sparkling wine having its own special duty regime o Lambrusco being Partially Grape Must and paying lower duty Results 707 wines were included in the survey listed in the catalogue Data was available on 615 wines (86.74%) The main reasons for lack of data were regionally stocked UK wines, fine wines in limited distribution or wines not available in store at the time of the survey All major sales lines were captured for inclusion and the volume of wine included in the survey exceeded 99% of the total volume actually sold Results for the specific regions and key countries were as follows:-

81 Region or country Average % vol Region or country Average % vol Global Non-EU Countries Europe Australia Non EU New Zealand Chile EU Countries Argentina France USA Italy S Africa Spain Germany 9.80 Count 86.74% of lines Portugal Volume 99.15% of volume Comments The alcoholic strength of European wines is 9.3% below the 13% equivalence figure, so arguably there could actually be a duty decrease for wine if the BBPA s argument were to be followed Even the global figure remains well below the 13% equivalence value The country analysis is interesting: Europe o France as expected, with Chaptalisation in the northern parts of the country and higher alcohols achieved naturally in the hotter south o Italy surprisingly low; however this is affected by the huge volumes sold from the cooler northern Veneto region o Spain, warmer than France with mainly red wine achieving greater grape ripeness o Germany as expected for a country whose wines are dominated by Hock & Liebfraumilch with typical alcoholic strength 9-9.5%vol o Portugal dominated by the lighter alcoholic Portuguese Rose and Vinho Verde markets Non-EU o Little to choose between Australia, Chile, South Africa and Argentina with hot climates, ripe grapes and a winemaking mentality that looks for full physiological maturity of the grapes before harvest leading to higher alcoholic levels in the resultant wine o New Zealand, again best grape ripeness is always sought in even this the most southerly of the Southern hemisphere s wine growing countries o USA, a surprisingly low result however the average is affected by the massive volumes of lighter alcohol blush type wines sold Relating wine and beer duty

82 Conclusions updated in 2008 to reflect current duty rates EU wine: The ECJ Judgement states that wine duty should be no higher than beer, taking account of the different strength. o The current rate of duty for beer is 13.71/Hl for each 1%abv. Hence the equivalent duty if beer were at the average strength of EU wine (11.79%abv) would be x = /Hl. o However, duty on still light wine is currently /Hl, /Hl higher. o So wine duty is 10.1% higher than beer; to make them equivalent; wine duty would have to be cut by 16.35/Hl, or 9.2% of the current rate. Non-EU wine: There is no requirement to equate new world wine duty with beer. However, a similar calculation can be made as follows: o At 13.71/Hl per 1% abv, the beer equivalent at 13.10%abv (the average strength of non-eu wines) is x = /Hl o However, non-eu wine pays /Hl plus Combined Community Tariff of 15.40/Hl (equivalent to 1.00 = 0.744), making /Hl in all, 9.79/Hl higher. o So wine duty is 5.4% higher than beer; to make them equivalent, wine duty (excluding CCT) would have to be cut by 9.79/Hl, or 5.4% of the current rate.

83 WSTA Budget Submission 2008 ANNEX 3 WINE DUTY ADMINISTRATION REMOVING A SIGNIFICANT ADMINISTRATIVE BURDEN A report prepared by Ernst & Young, 2007

84 WINE DUTY ADMINISTRATION REMOVING A SIGNIFICANT ADMINISTRATIVE BURDEN A report prepared by Ernst & Young, 2007 EXECUTIVE SUMMARY The timing of announcements for changes in wine duty imposes unnecessary administrative burdens on the wine supply chain reducing productivity and increasing administration. This paper argues that any changes in wine duty should be announced at the time of the Pre-Budget report, in common with the announcement of the personal allowance and National Insurance Contribution levels, which are announced at the Pre-Budget Report for administrative reasons. Currently, the duty on wine is set by the Chancellor in the Budget and applies to all wine sold after the Budget Resolution, in a similar way to other duties such as fuel and tobacco duty. However, in contrast to the other duties, the wine buying process has long lead times and lag times and must fit with the Northern and Southern hemisphere harvests. The current process gives rise to an abrupt change in duty that imposes a significant administrative burden on the industry. There is an immediate change in the economics of the contract between the (numerous) suppliers and the (few) retailers, which will result in reductions to margins across the supply chain from those previously negotiated. From an administrative perspective, an individual retailer can be faced with the need to renegotiate contracts for up to a thousand different wines with potentially hundreds of suppliers. This renegotiation process is cumbersome and disruptive and could be avoided if the increase was known sufficiently in advance. Given the buying cycle, publication of the duty rate at the Pre-Budget Report stage, for implementation following Budget Day, would remove a significant amount of uncertainty and unnecessary administration. Pre-announcement of rates and limits is already accepted practice in the area of income tax and social security. 1. INTRODUCTION This paper considers the administrative issues that arise from a combination of long lead times, annual contracts and virtually immediate changes in duty rate. Section 2 explains the purchasing cycle and how this is not within the control of the wine retailers or suppliers, and then shows how this combines adversely with the Budget cycle. Section 3 explores the potential policy responses, concluding that change is recommended. Section 4 explores the change in detail and examines (and dismisses) potential concerns that the policy could create, and outlines existing precedents. 2. WINE CONTRACTING This section explores the contracting process for wine and contrasts it with the Budget timetable. Vintages and purchasing cycle The purchasing cycle for a retailer in the UK is broadly determined by the agricultural process and follows the time when the vintage can be tasted and quality judged. The vintage release for the Northern Hemisphere is between January and March following the harvest whilst the Southern Hemisphere release is between July and September. Differences will

85 arise between particular branded wines and out of season buying will occur, but a retailer will generally need to contract as early as possible in order to secure supply. In seeking to secure such supply, the UK retailer is competing not only with other UK retailers but also with overseas buyers who are not exposed to the same duty cycle. Given the above, the two key contracting times are as follows: Southern Hemisphere: July to November Northern Hemisphere: November to January Depending on the nature of the wine, the wine may be received up to four months later. This is shown in the diagram below. Sales through this period are clustered around the Christmas period. The Budget timetable The level of wine taxation is determined following an assessment by the Treasury on a year by year basis. In determining the appropriate level of duty the Treasury has stated two key aims: 1. To secure an attractive but sustainable revenue stream for the Exchequer; and 2. To ensure that markets are not distorted or damaged. 20 Wine duty for the coming 12 months are announced in the Budget and take effect a few days later, once the appropriate Budget Resolutions have been passed. This combines adversely with the vintage purchasing cycle, as shown in the diagram below, such that the bulk of sales occur in a future, unknown duty regime. (In the diagram below, the Budget has been assumed to be 1 March.) 20 HM Treasury, discussions with the Wine and Spirit Trade Association, 13 September 2005 (as reported by the WSTA).

86 Price Points The wine consumer market is dominated by distinct price points (e.g. 3.99, 4.49). There is clear evidence of demand elasticity across the key prices. Recent attempts to move away from price points have typically met with severe reductions in purchases. This is in part caused by the strong substitutability between wines in the same regions, particularly amongst branded wines. Negotiations Contract negotiations are complicated by the relative numbers of the suppliers (many) and the purchasers (few) and the large number of different wines. Any agreement between a supplier and a purchaser will normally cover multiple product lines and will be a complex negotiation designed to accommodate, where possible, price points. Responding to the mid-year changes in costs As discussed above, the wine industry is unable to adjust its own contracting timetable to fit with the scheduled duty increase and is left with the need to adapt to the change mid-year. In theory, faced with a mid-year duty increase, importers could respond in one of two ways either to change their own contract negotiation timetables to fit with the Budget timetable, or seek to change prices to accommodate the change in duty levels mid year. The first option causes significant administrative burdens as each wine will need to be renegotiated between supplier and purchaser. Given the complex nature of the discussion, this can take considerable time and places further strain on the relationships between suppliers and retailers. The second option can have a negative impact on sales, which may harm future negotiations. Predicting changes in advance It has been argued that the recent changes have been predictable and therefore could be included in the contract, providing no surprises to either party. However, in practice this does not occur as the negotiations will only take into account the information available at the time. Furthermore, as the repricing will occur differently across the wines supplied, the work involved in identifying the price movements is significant and will depend critically on the precise extent of the rise. 3. POSSIBLE POLICY RESPONSES Based on the arguments in the preceding sections, it is clear that the current timing of duty changes for alcohol is having a disruptive and administratively costly effect on the contracting between importers and retailers of wine. Despite this outcome, it is right to question whether this should justify a policy response or whether this should remain a complication that the industry will need to accept. These options are considered below. Do nothing The first possible policy response is to retain the status quo ie, to leave the industry to bear the uncertainty and adapt commercially. This clearly retains the large administrative burden. In the past, comparison has been made to contracts for VAT which adjust the contract price should VAT ultimately be chargeable. However, this is fundamentally different from the VAT situation, which arises out of a lack of certainty as to whether the law applies to a particular circumstance. Furthermore, in the VAT case, such a provision between taxable entities serves to retain the purchase price should VAT become chargeable without leaving either side in a worse position. In contrast, in this situation if the price does not rise then there is reduced margin on the product. Move timing of both announcement and implementation

87 The second possibility is to keep the close proximity of announcement and implementation, but to shift this to the Pre-Budget Report rather than the Budget. This would result in a sudden and immediate price increase prior to the largest period of sales of wine (the approach to Christmas). This is therefore not recommended and would be strongly opposed by the industry. The resulting negative impact on sales volumes would be unacceptably severe. Split timing of announcement and implementation The favoured proposal is to change the dates of announcement of tax changes, to bring announcement forward to the Pre-Budget Report so that at that time the duty rate for the next 17 months is known (or twelve months from Year Two onwards). The duty increase would still be implemented after the Budget. This should allow time for the contract negotiation process to be completed, from a position of certainty. The result would be that there would be more scope for duty increases to be incorporated into wholesale, and ultimately retail, prices (for example, given sufficient lead time, by marketing affected wines at the next higher price point). It should also allow for catalogues and promotional material to be produced to reflect the impact of the new duty level. Although this still leaves some exposure to unknown duty rates during the contract period, this is much reduced. Also the crucial Christmas trading period occurs within the known duty regime. 4. THE PROPOSAL The key elements of the proposal are as follows: announcements of duty changes should be made at the time of the Pre-Budget Report; the duty changes would come into effect immediately following the Budget. The benefits of the proposal would be as follows: a simple and straightforward change annual supply contracts can be negotiated in more certain knowledge of the level of duty that will apply; reduction in wasted time and cost in re-negotiation; reduction in the need for wasted printing of promotional materials, since these can be produced in full knowledge of the applicable duty; a more harmonious and stable relationship between the suppliers and retailers in the industry which will contribute to the sustainability of the industry The proposal raises the following concerns which are not considered insurmountable: potential for taxpayers to pre-order to avoid the forthcoming increase in duties on the preordered product ( forestalling )

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