Excise duties harmonisation and smoking in a model with cross-border arbitrage

We use the 2007–2018 monthly data for five Western Balkan (WB) countries to estimate the impact of harmonisation of excise duties with the EU rules on the demand for cigarettes and tax revenues by taking into account the cross-border shopping effect. Both in time series and panel regressions we find strong evidence on cross-border arbitrage. The price elasticity of demand for cigarettes in WB countries is close to − 1, while the cross-border elasticity is 0.24. Full harmonisation of taxes with the EU directives would trigger a substantial decline in the demand for cigarettes on the legal market in the WB of 25.5% (approx. 931,000 smoker equivalents). In spite of a considerable behavioural reaction, harmonisation would still have positive effects on tax revenues of almost a half percent of GDP. The impact on cigarette consumption and tax revenues in a particular country depends on the relative magnitude of its own and cross-border price elasticity and the relative size of its tax rate gap compared to neighbouring countries. Failing to account for cross-border arbitrage in evaluating the impact of an increase in cigarette taxes leads to the results on demand effects being significantly overestimated and tax revenue effects underestimated.