Among the manufacturing sectors suffering the worst of decline in recent months is the tobacco industry. In July 2019, when production was expected to pick up as per seasonality, the output had declined by 40 percent over July 2018 to come down to 2.73 billion sticks, as per latest PBS data. It's quite a fall since January, when production crossed 6 billion-stick mark and sustained a high level until April.

What is going on? Are consumers starting to smoke less? In the seven months ended July 2019, cigarette production was down 6 percent year-on-year. But the decline is concentrated in the three months ended July 2019, when production fell 27 percent year-on-year. In May-Jul period, monthly average production was 3 billion sticks, down from 4 billion seen in the same period in 2018 and 2017.

The production decline is likely a consequence of higher cigarette prices in recent months for the formal industry. Just in 2019 so far, the FED on cigarettes has been raised twice. As a result, a double-digit increase in prices has occurred in both value and premium brands. But the tobacco industry is not taking the windfall home, as evident in latest financials of Pakistan Tobacco (PSX: PAKT) and Philip Morris (PSX: PMPK), the dominant duo in the formal market.

Latest quarterly results suggest a significant rise in the effective FED rate (amount of FED collected in terms of gross turnover) despite high growth in the two companies' gross turnover. As a result, the duo retained less of the top line as net turnover. In 2QCY19, the FED rate had jumped for PAKT to 50 percent (44% in 2QCY18) and for PMPK to 44 percent (37% in 2QCY18).

In this scenario, the regulated sector may not have much incentive for achieving growth in production. In fact, the industry is again complaining about the threat of “illicit cigarette" sales. Managements of both PAKT and PMPK claim that the duty-non-paid (DNP) brands – which undercut the competitiveness of the regulated sector by evading taxes and duties – had a market share of 33 percent in June 2019!

The formal industry maintains that three rounds of FED hikes in 2018 and 2019 had once again widened the margins for DNP brands vis-à-vis regulated brands. As per PAKT management, the average pack price of a DNP brand is Rs26, as opposed to average pack price of Rs78 for PAKT. If that is true, it is remarkable as DNP brand is selling at a price lower than the minimum tax paid by a regulated brand. PAKT has claimed that the DNP sector is causing a tax loss to the government of Rs50 billion per annum.

The government will have less reason to worry at this stage. In the first half ended June 2019, industry's tax contribution was substantially higher. For instance, PAKT collected Rs55 billion on account of FED, sales tax and corporate income tax – a growth of 37 percent year-on-year. For PMPK, tax collection on those three counts stood at Rs15 billion, a 64 percent increase over same period last year.

However, if the trend in production decline continued, the government will feel the pinch, too, and lose some billions down the year. However, a typical response that lowers the effective FED rate to accommodate the formal industry will also make cigarettes cheaper and lead to a rising incidence of smoking. The status quo demands effective enforcement across the tobacco value chain.