Sweden controls its alcohol market very tightly but the one thing it can't prevent is its inhabitants going to neighbouring EU countries to do their alcohol shopping. With Finland and Estonia soon to join Denmark and Germany as tempting shopping destinations for thirsty Swedes, Ben Cooper asks how long this bastion of alcohol regulation will be able to retain its high tax rates.

When Sweden joined the EU in 1995, it knew there would be pros and cons. Whilst reaping the benefits of free trade with a host of affluent states, the country would receive a harsh lesson in the realities of a Single Market which allows the free movement of goods but does little more than gently suggest the harmonisation of indirect taxation.

This is a harder lesson for some countries than others. And for Sweden, with its tightly regulated and highly taxed alcohol market, the drawbacks are significant. When neighbouring countries offer sustantially lower prices on alcohol, the likelihood that legitimate cross-border shopping along with illicit shopping and smuggling will be commonplace is a virtual certainty.

The higher the tax differential, the greater the levels of cross-border activity - legitimate and illegitimate - and the greater the cash loss in terms of tax revenue. As exactly the same phenomenon was seen in the cross-Channel market after 1993, Sweden must have known what to expect.

And far from improving over time, Sweden's situation in this regard has actually worsened. According to the industry analysts, Euromonitor, unregistered consumption, including smuggling, home production and private importation, accounts for around 30% of Sweden's total alcohol consumption. The Scotch Whisky Association, meanwhile, believes that unrecorded sales represent as much as 50% of total expenditure on spirits in Sweden.

Although some adjustment has been made in Sweden's taxation system since 1995 - along with a certain amount of deregulation of its alcohol market - its taxes have remained higher than its EU neighbours. And recently, two more significant events have taken place which ensure that the situation will become worse still.

In October last year, Denmark reduced its levels of alcohol taxation by 45% and on January 1st, personal duty paid import quotas on alcohol for Swedes returning home were brought into line with EU standards. Exactly what this means is open to some interpretation. Technically the EU quota is defined by what can reasonably be said to be for personal consumption. In other words, how long is a piece of string?

The limits have been set at 10 litres of spirits, 90 litres of wine and 110 litres of beer but when challenged, a traveller can say they have a special occasion to cater for, such as a family wedding, and customs officials tend to observe a degree of flexibility. The consequence of this - as once again has been seen in the cross-Channel market - is that consumers tend to regard any limits put in place as relatively flexible and open to some leeway. Also, if there are good bargains to be had, the level of cross-border shopping escalates to a level which makes policing such limits difficult. Officials tend to concentrate on dealing with the organised smuggling which the disharmony in taxation inevitably fosters.

It is in spirits where the tax differences are the greatest with Sweden's rate coming in at a hefty €15.45 on a 70cl bottle of spirits, the highest excise rate in the EU. While the wine and beer sectors will also be affected, it is in spirits that Sweden's monopoly alcohol retailer, Systembolaget, will most acutely feel the effects of the January 1st changes as it has already felt the impact of Denmark's tax cut. But worse is to come for the state retailer.

In the spring, Finland, which also joined the EU in 1995, will reduce its alcohol taxation, creating another tempting cross-border shopping destination for Swedes in addition to Denmark and Germany. And in July, Estonia, which has very low alcohol taxation, is due to join the EU.

When the personal import allowances were increased in January 2003, Systembolaget, which has annual sales of around SEK23 billion (including VAT) and reckons it accounts for around 50% of total alcohol expenditure, official and unofficial, said cross-border shopping increased by around 6%, while smuggling increased by some 40%.

Systembolaget also said it experienced a drop in sales following Denmark's tax cut in October. Sales were reported to be down by 9.8% in December against 2002. As for how sales may perform in 2004 as a whole, estimates differ significantly. Systembolaget said in its Launch Plan 2004 that spirits sales will be negatively affected by cross-border shopping but did not estimate by how much. "Sweden's high import quotas and reduced taxes in neighbouring countries will probably lead to a reduction in sales for Systembolaget," the retailer said.

With the other factors coming into play, some are predicting a significantly greater drop than seen following the Danish tax cut. "I wouldn't be surprised if total spirits sales at Systembolaget in 2004 were 20% to 25% lower than this year," Peter Kandel, vice president at V&S Distillers, told Just-drinks.

However, Systembolaget spokesperson, Bjorn Rydberg, considered this to be a possibly over-pessimistic prediction. "Of course we know that the sales of spirits have been reduced in December by about 9% but at the same time the sales of beers and wine have gone up," Rydberg said. "We think the decrease in spirits will continue and we don't know what will happen with the other figures. We think that the figures for beer and wine will not decrease. Spirits sales dropped 10% in the autumn and it (the decrease) will not be smaller than that for 2004."

However, Rydberg was at pains to stress that he believes the drop in Danish taxation to be a more significant factor than the January 1st changes in personal import quotas. He also said that while the Finnish tax reduction would encourage cross-border shopping, this would be more of an issue in the north of Sweden which is more sparsely populated in comparison with the south. However, crossing between the two countries by ferry is extremely popular and also a significant alcohol market for returning Swedes.

The degree to which Systembolaget's sales - and with it tax revenues - are affected will be closely watched by the Swedish government. Swedish administrations have traditionally taken a conservative view on liberalising the alcohol market and to a degree public opinion has supported a generally cautious stance. Indeed, in a referendum in 1922, a motion to ban alcohol altogether was only defeated by 1% with the result instead that retail and production monopolies were created.

The Swedish view towards alcohol regulation and the fact that as a nation it has always been prepared to pay for social welfare through relatively high taxation means the government may not be under quite such intense pressure to lower alcohol taxes as might be seen in other European countries.

If popular support for tax cuts is growing, it is as much because people view the current situation as unsupportable and economically damaging as much as coming from a general desire for liberalisation. "I am pretty sure that amongst the people if you go about them and ask, they will understand and support the taxation and the regulation that has existed in Sweden," says Peter Kandel. "They understand that it was a solution we came to years ago and it has helped. What they are seeing now is that the rules have changed, the income for the state is getting lower and lower and the whole idea collapses if the market situation changes so dramatically."

Plummeting tax revenues and an increase in organised smuggling will certainly be more likely to force a change of view among legislators than any amount of lobbying. To a degree, it is this kind of pressure which theorists believe brings about the convergence of levels of indirect taxation in a single market. Where inconsistencies exist and are deemed unsupportable by governments, adjustments occur as a result of market forces.

There is a prevailing view that Sweden will have to cut its alcohol taxes but whether this will happen sooner or later is extremely difficult to second-guess. However, the consensus view appears to suggest it will not happen this year.

"There was a discussion in Parliament before Christmas but there was no indication that there would be a tax cut in the spring," said Rydberg. "It depends how the sales in Systembolaget develop. One did not get the feeling that there would be a tax cut in the spring but it could come later."

However, Rydberg said that if the drop in Systembolaget's sales was closer to the more pessimistic predictions of 25%, this could precipitate an earlier tax cut. "I think they will follow the sales of Systembolaget and if the sales drop very heavily I think the tax cut will come sooner."

The Swedish government is nevertheless likely to resist as long as it can. Although its own state retailer may be suffering declining sales, alcohol consumption is rising in Sweden. According to Systembolaget, in 2002, consumption totalled approximately 10 litres (100% by volume) of alcohol per inhabitant aged 15 years old and above, representing an increase of some 9% from 2001. At a time when governments throughout Europe are concerned about rising alcohol consumption and misuse, cutting taxes would not be an easy step for a Swedish government to take.

But faced with the possibility that consumption will rise anyway and the increase will come from unregulated smuggled or home-produced alcohol, or products purchased quite legally but for which the tax has gone straight into the coffers of the German, Finnish, Danish or Estonian exchequers, it may have little choice.