Ukraine's Long March Against Illicit Tobacco Trade

According to the Corruption Perception Index 2022 of Transparency International, an NGO working in over 100 countries to end the injustice of corruption, Ukraine is one of the few countries tracked that became less corrupt last year – writes Tetiana Koshchuk, Ph. D. (Economics), expert on taxation at the Growford Institute.

For the first time, Kyiv is reaping the benefits of its fight against endemic corruption. Compared to ten years ago, Ukraine now scores 8 points more. That brings the total to 33, a historic high for a country fighting a defensive war.

The country has a long tradition and a poor record of corruption. Corruption practicesand organised crime are deeply rooted in the Ukrainian society, where the oligarchs are in charge. Law enforcement agencies have notoriously bad reputation. The country’s border with the European Union spanning over 1 500 kilometers has traditionally been a green flield for illicit  trade, with cigarettes – topping the list of goods in both profitability and ease of transportation.   Things are fast changing today. 

Since 2019, the government of President Zelensky has been working hard to crack down on the illicit tobacco trade. In recent years, commendable and at the same time, ambitious steps have been taken in tackling those practices. 

Zelensky's reform agenda leaves little doubt about his intention to eradicate illegal practices and step up the fight against corruption. The Ukrainian president recently fired a dozen advisers, deputy ministers, prosecutors and regional administrators involved in various scandals. 

Since taking office, Zelensky has stressed to the international community that he will make fighting corruption in his country a major policy priority. An essential part of Zelensky's anti-corruption policy is the fight against the illicit tobacco trade because of its close links to criminal activities, organised crime and black market trade.  

Closures of illegal tobacco factories and confiscation of their equipment and products, arrests of corrupt officials,  show that the fight against corruption is not just a matter of window dressing, it is walking the talk. 

To tackle that fight, Zelensky enjoys a lot of credit among his people. His popularity rose to 84 per cent at the end of last year. 

Zelensky knows that his anti-corruption policies are decisive for the country's continued international support. This was reflected in his speech on 24 January, which was largely devoted to this issue. 

His speech did not miss its effect, as both Germany and the US almost immediately announced they would send battle tanks to Ukraine. 

Ukraine had long been the leading transit country of illegal cigarettes to Europe. But in recent years, unlawful production for the domestic market has increased dramatically. As a result, the illicit tobacco trade has reached its highest share since the country gained independence in 1991.

One would think that, the Russian invasion puts on pause anti-corruption policies. Nevertheless, fighting corruption, organized crime and illicit tobacco trade play a role in resolving the current war. It also determines the speed with which Ukraine can obtain a ticket to EU membership.

The introduction in 2018 of the seven-year plan of Kyiv, that included increasing excise duties on tobacco by 20 per cent annually until 2025 – to reach the minimum excise rate prevailing in the EU – has undeniably accelerated Ukraine's illicit cigarette trade to an unprecedented high.  

In the first year of the agreement, excise duties immediately increased by 30 per cent. As a result, by 2021, the market share of the illicit tobacco trade reached 20.4 per cent. That was double in comparison with the year before. 

In 2017, illicit tobacco represented only 2 per cent of total tobacco consumption. In 2022, this percentage rose further to 21.9 per cent. 

There is an undeniable link between the boom in illicit trade and the steady increase in excise taxes. Historically, Ukraine always had low tobacco prices, which meant that the illegal trade did not stand a chance. In 2016, the illicit cigarette market was estimated at only 1.1 per cent.

It would be a tragedy if Ukraine is forced to endure the financial drain that the same ill thought measures have produced for instance in France, where following an accelerated and exaggerated tobacco excise increase almost trebled the illicit share of market with, according to KPMG numbers, mean an overall 6 billion € loss to the French state.

After the outbreak of war in February 2022, the situation worsened and the illicit tobacco trade reached new record highs. Among other factors, the deteriorating economic situation, disruption of logistical channels, lower purchasing power due to inflation (nearly 24 per cent in August 2022) and a simultaneous increase in excise duties on tobacco products drove more and more people, in their search for cheaper alternatives, into the arms of illicit tobacco producers.

The impact on Ukraine's treasury was evident. Kyiv lost more than 375 million euros in converted tax revenue in 2021 due to the illegal cigarette trade. In 2022, the revenue loss was estimated to reach almost half a billion euros. Revenue that the country desperately needs to finance the war against Russia. 

The introduction of the excise increases did not bring more revenue to the treasury, but somewhat less, and the illegal tobacco trade became more attractive as prices in the regular tobacco market rise. 

The Zelensky’s administration has not been an idle spectator watching illicit trade grow. On the contrary. The administration pushed law enforcement to crack down at least six sites where cigarettes destined for domestic and international markets were manufactured. And if you visualize a “garage handrolling” – you are wrong! These were well equipped enterprises with decent machinery. Allegedly, offciails and even local law enforcement stood behind to protect them from closure.

Closing the production sites is a vital first step. Going further, if Ukraine wants to reverse that situation and win the war against the booming illicit trade, it will have to continue and intensify its efforts. However, finding that balance between tobacco excise duty increases on the one hand - and the fight against the illegal cigarette trade on the other is a challenging and complex exercise requiring necessary measures and efforts. 

For example, central coordination at the highest administrative level, intensified cooperation with EU member states, strengthening regional and international collaboration, vetting of the civil service, control of customs and border inspectors, strengthening of police forces and legislation, awareness campaigns, etc. 

As a result of the war and the deteriorating economic situation, combined with an annual increase in the excise duty on cigarettes, Zelensky's anti-corruption policy sets the stage for a long and sustained march in the fight against the illicit tobacco trade.

Tetiana Koshchuk, Ph. D. (Economics), is an expert on taxation at the Growford Institute

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