Special communication Box 1 Ad valorem and speciﬁc taxes Source: Adapted from Gilmore et al.14 Note: Many countries, including the countries of the European Union, have a mix of speciﬁc and ad valorem taxes. are more widely known24 but differ signiﬁcantly by focusing on retail rather than manufacturers’ prices and fail to deal with the market failure and proﬁt issue. Furthermore, a new (albeit contested) ruling suggests that minimum prices, in some instances at least, may be illegal under EU law.25 PRICE CAP REGULATION: THE BASIC MODEL AND ITS APPLICATION IN THE UK Price cap regulation has been heavily utilised in the British utilities sector (and elsewhere) as a means of protecting society from the monopoly power of companies which face little or no competition given the nature of the market in question.21 22 As such, there are signiﬁcant parallels to the tobacco industry where a strong case exists for further action to protect society from the effects of market failure. As this market failure applies to cigarette manufacturers rather than retailers, we envisage the system only applying to those manufacturing (rather than retailing) cigarettes for the UK market. The system works by establishing an independent regulatory agencydThe Ofﬁce for Smoked Tobacco Regulation (OFSMOKE), for exampledwhich would carry out periodic reviews of what cigarette companies are allowed to charge, setting maximum prices allowed for each product. The prices set would be based on how prices in the economy have generally changed (the retail price index (RPI) element), an assessment of the genuine costs each ﬁrm faces in its production and opera- tions and an assumption about the productivity improvements it would be expected to make (the X element). 426 For the sake of simplicity, we can illustrate this solution by imagining how the system might work in practice. Let us assume that after some research on the industry’s current costs the regulator sets the maximum price a manufacturer can charge, before any taxes or retailer ’s margin are added. This manufacturer ’s price would undoubtedly be less than the industry would wish to charge, thus curtailing proﬁts. How much less would be judged by the regulator based upon its assessment of the legitimate costs the industry faces. This is illustrated in table 3 using a hypothetical example: the regulator caps the manufacturer ’s price at 50 pence per pack of 20 ciga- rettes, a 40 pence reduction from the baseline situation. The retailers would then add their mark-up as at present such that their proﬁts would therefore be unaffected and the government also adds its various taxes and duties. When implementing a policy of RPI-X type price controls, government would need to use tax policy to ensure that the ﬁnal price the consumer pays does not fall. Again this is illustrated in table 3, where the Table 3 Hypothetical example of RPI-X regulation as applied to a pack of 20 cigarettes in the UK market (prices in pounds sterling (£)) Taxes* Retailer takey Manufacturers takey Retail price *Includes tobacco excise tax and VAT (sales tax). yIncludes costs and proﬁt. Current situation 4.2 0.4 0.9 5.5 RPI-X 4.2 0.4 0.5 5.1 RPI-X plus government response (ie, tax increase) 4.6 0.4 0.5 5.5 Tobacco Control 2010;19:423e430. doi:10.1136/tc.2009.034470