(b) Legislative Objective

438. The European Communities maintains that the tax distinctions in dispute do not serve any legitimate purpose. They are simply a subterfuge to replicate the protective effects of the preceding system. Alcohol content has been chosen as a taxation criterion merely because it allows Chile to distinguish indirectly between the majority of pisco, on the one hand, and the majority of imported spirits, on the other hand, and not because the ILA purports to discourage the consumption of alcohol.
439. In support, the European Communities goes on to state that the New Chilean System is a rather unusual method of taxing alcoholic beverages. In fact, that method does not correspond to any of the three methods commonly applied by most countries, and which are: a) specific taxes based on the alcohol content (e.g., x pesos per litre of pure alcohol or per degree of alcohol); b) specific taxes based on the volume of beverage (e.g., x pesos per litre of pisco); and c) ad valorem taxes on the price of the beverage.
440. According to the European Communities, instead, the method devised by Chile is a hybrid one in which ad valorem rates vary according to alcohol content. The rationality of that method in terms of fiscal policy is questionable. The price of distilled spirits is not correlated to their alcohol content. Indeed, if there was such a direct correlation, high strength ethyl alcohol would be more expensive than any other distilled spirit. The absence of a direct correlation between price and alcohol content means that the goal of ad valorem taxation (imposing a higher burden on the more valuable products) and the goal of taxing alcohol content (discouraging the consumption of alcohol) may conflict and ultimately cancel each other.
441. The European Communities also argues that the absence of any legitimate policy purpose is further evidenced by the lack of internal coherence of the ILA, and in particular by the following aspects of its "design, structure and architecture".
442. First, the European Communities points out that all liquors of 35° or less are taxed at the same ad valorem rate. As a result, low strength liquors (e.g., light liqueurs) are taxed more heavily per degree of alcohol than pisco of 35° . Thus, contrary to Chile's claims, the ILA actually encourages the consumption of alcohol, rather than discourages it.
443. Second, the European Communities notes that there is no objective reason that can explain why the ad valorem rate starts to increase from precisely 35° . The only reason for choosing that strength level as the starting point is simply that 35° is the most usual alcohol content of pisco especial, which together with pisco corriente of less than 35° accounts for 90 % of the sales of pisco.
444. The European Communities explains that if the rate had started to increase from 0° instead of 35° , the applicable rate on pisco of 35° would have been much higher (140 %) unless, of course, the rate increased by smaller increments than the current 4 percentage points per degree of alcohol. But if Chile had applied a smaller increment per degree of alcohol, the applicable ad valorem rate on spirits of 40° would have also been lower, a result unacceptable to Chile's pisco industry.
445. Third, the European Communities notes that between 35° and 40° , the tax rate increases very rapidly, by no less than 4 percentage points for each additional degree of alcohol. As a result, a difference of merely 5 degrees of alcohol content leads to the application of a tax on spirits of 40° which is 74 % higher than the tax on spirits of 35° . Such a tax differential is disproportionate to the additional damage to human health or other undesirable social effects (if any at all) which may result from drinking spirits of 40° instead of spirits of 35° . The magnitude of that tax differential is even more arbitrary in view of the fact that similar differences in alcohol content outside the 35° - 40° bracket do not entail any difference in taxation at all. For instance, pisco corriente is typically bottled at 30° , five degrees less than pisco especial. Yet, both pisco especial and pisco corriente are taxed at the same rate.
446. Fourth, the European Communities states that all spirits above 39° are taxed at the same rate. Again, this has the paradoxical result that the alcohol contained in very high strength liquors such as gran pisco of 46° or even 50° is taxed less than the alcohol contained in spirits of 40° .
447. The European Communities adds that in the 1995 Proposal, the rate continued to increase until 42° . As shown in Table 5, all the main types of imported spirits can be legally sold in Chile (and are usually bottled in their countries of origin) at 40° . Thus, in practice the imposition of higher tax rates above 40° would have had little impact on imports. For instance, the exporters of whisky would have reacted to the imposition of a much higher tax on whisky of 43° than on whisky of 40° simply by replacing current exports of whisky of 43° by shipments of whisky of 40° . This development was anticipated by the pisco industry, which explains its quiet acquiescence to what in practice was but a purely "cosmetic" amendment of the 1995 Proposal. Thus, according to press reports, when presenting the 1996 Gemines study, Mr Peñafiel (general manager of Capel) noted that:

[A]lthough nowadays, the largest part of [whisky] imported [into Chile] has 43° , so that the tax will decrease only to 65 %, in the future the product will arrive at 40° , something which, [Mr Peñafiel] underlined, is already a characteristic of all whisky sold in Europe. ²³¹

448. In rebuttal, Chile points out that it has explained to the European Communities that the Chilean tax system serves legitimate revenue, health and social purposes, primarily by taxing more heavily products that are more costly and higher in alcohol content. It is not for the European Communities to second guess those purposes. While there are trade-offs in fulfilling these objectives, the relevant point is that the system is indeed neutral and objective. One might indeed question the motivation and effectiveness of countless internal measures of the European Communities or any other WTO Member, but Article III was not established so that the WTO could sit in judgement on the "legitimacy" of the policy objectives of its Members, so long as the measures themselves objectively conform with the WTO Agreement.
449. Chile alleges that in amending its laws, it had had in mind several objectives, including:

1. maintaining fiscal revenue;
2. eliminating type distinctions such as those that had existed in Japan (which also would eliminate the alleged discrimination against whisky in the previous system);
3. discouraging alcohol consumption; and
4. minimizing the potential regressive aspects of reforming the tax system.

450. Chile points out that because the New Chilean System will change the rate of tax paid with respect to various products, there is the Transition System, under which the whisky tax is phased down immediately, but the remainder of the system takes full effect on 1 December 2000. In the intervening time, whisky producers will enjoy continuing tax reductions, while other producers can decide how they wish to approach the Chilean market under the New Chilean System.
451. Chile argues that the new Chilean law completely reforms Chilean taxation of alcoholic beverages and advances the objectives noted above, while conforming to Article III.
452. Chile goes on to explain that in November 1997 it enacted new legislation substantially reforming the Chilean system of taxation of distilled spirits. Within this new system, spirits of 35� or less will be taxed at 27% ad valorem. The ad valorem tax will rise 4 percentage points for each additional degree of alcohol content above 35�, but with the rate capped at 47% for spirits above 39� of alcohol content. Therefore, lower alcohol content products have a lower tax rate, while those having a higher alcohol content have a higher tax rate. The new Chilean system will make no tax distinction by type of distilled beverage or origin. (i.e., domestic or imported). The same ad valorem tax rate is applied to all distilled spirits having the same alcohol content.
453. Chile further argues that, concerning tax differentials, there is no difference in that all distilled spirits of the same alcohol strength are subject to an identical ad valorem tax. The European system is the same, in that all distilled spirits of the same alcohol strength face the same rate of tax, except that the EC tax is a specific one, which, of course, falls more heavily on lower priced products than on higher priced products. Both tax systems use identical scales for all distilled spirits (except beer and wine, which are taxed less in the European Communities and more in Chile), but the EC's system is more distortive because of the use of specific taxes per degree of alcohol.
454. Chile further explains that within this context, the new system is built around objective and non-discriminatory criteria has the effect inter alia of reducing the present tax rate applied to some products, as is the case for whisky, and of increasing it for others, as is the case for pisco in all its categories (i.e., pisco of high and low alcohol content).
455. According to Chile, the new Chilean System is based on two objective criteria: alcohol content and price (i.e., ad valorem) of the product, regardless of its type, origin and labeling. Taxation based on alcohol content and on an ad valorem basis is not against Article III of GATT or any other provision of the multilateral trading system and both are widely used.
456. Chile notes that the ad valorem taxation system does not distort competitive attributes of products (i.e., price relationships), as opposed to those which an absolute value is imposed according to alcohol content. Such specific tax systems introduce a distortion biased in favor of products of higher price since a fixed tax will be a smaller percentage of the value of a high priced product.
457. Chile poses a question: why did the European Communities insist on pursuing the WTO challenge against the New Chilean System? Chile considers that is not so hard to understand. The major exporters of distilled spirits want to minimize their tax burdens in all markets, and such exporters would prefer not to have to adapt their products to individual markets. Chilean exporters, similarly would prefer not to have to adapt their products to individual markets.
458. Chile goes on to state that, in this sense, it can understand why European exporters of distilled spirits would be willing to take a chance on continuing their old GATT challenge against the Chilean system even after its reform, since failure would leave them no worse off while the possibility of success might reduce their taxes.
459. Chile further notes that the European Communities continues its attacks on the motivations for Chile's tax laws. For example, Chile is accused both of hiding its motivations and failing to achieve the objectives in a fashion that the European Communities finds sufficiently coherent. Chile has freely conceded that its objectives required a measure of compromise between different objectives, but not a compromise on GATT compliance.
460. Further, Chile claims that it is not revealing a secret that WTO member governments all over the world tax alcoholic beverages at higher rates than most products, partly for revenue reasons that contradict to some extent the health reasons. If that establishes a violation of GATT obligations, then the European Communities will have much policing and self-policing to do in the world and at home.
461. Chile indicates that it is not critical of the European Communities for having their system, because a multiplicity of motivations is common for all kinds of taxes in every country. It is not Chile who is attacking objective systems that have differential results. Nevertheless, the European Communities should see that objective tax systems can have uneven results when measured by a subjective categorization system. Chile also cannot help being bemused by the EC's diligent efforts to find a justification for its specific tax on ethyl alcohol. Neither the Chilean nor the EC system appears to qualify under the Article XX exception. At least, Chile believes that the European Communities would have a difficult time explaining the necessity of this tax to discourage consumption of ethyl alcohol in distilled spirits (does wine or beer alcohol not impair the senses?). Chile also wonders what scientific analysis produced the varying scales of taxation, and how the EC's health goals are reconciled with the EC's minimum alcohol requirements for various spirits and with its socialisation objectives for distilled spirits.
462. In the view of Chile, like nearly all tax measures in nearly all countries, the New Chilean System serves various objectives, and to some extent is a compromise among these objectives. Chile understands that the issue before this Panel is the conformity of the New Chilean System with Article III:2 rather than the various policy objectives that may have been considered by different legislators and government agencies involved in developing that law. Nevertheless, Chile provided some explanations in order to understand the Chilean legislation.
463. Chile explains that in Chile, as in many countries, the Finance Ministry has a significant role in tax policy. In providing its input into the development of the New Chilean System, the Chilean Finance Ministry sought to achieve two broad objectives: tax revenues that would be approximately equivalent to those obtained under the Old Chilean System; and a distribution of the burden of the taxes that would not be more regressive than that of the Old Chilean System, i.e., that would not increase the relative tax burden on the poorer income-earners relative to the wealthier income-earners.

In its support, Chile puts forward Tables 36 and 37 below.

Table 36 ²³²

Weighting Factors for Expenditure on Alcoholic Beverages Per Quintile

	Overall	Q1 (<Income)	Q2	Q3	Q4	Q5 (>Income)
Total	100.000	100.000	100.000	100.000	100.000	100.000
Alcoholic Beverages	0.930	0.985	1.124	1.107	1.061	0.781
Wine	0.301	0.362	0.350	0.328	0.318	0.269
Champagne	0.025	0.033	0.017	0.019	0.035	0.023
Chicha	0.010	0.005	0.024	0.020	0.010	0.006
Beer	0.295	0.384	0.488	0.467	0.352	0.172
Pisco	0.172	0.166	0.185	0.194	0.213	0.147
Whisky	0.050	0.000	0.011	0.026	0.050	0.072
Other spirits	0.077	0.035	0.049	0.053	0.083	0.092
Number of households	1,363,706	272,741	272,741	272,741	272,741	272,741
Total expenditure	607,718	38,728	60,757	83,591	123,755	300,888

Percentage Distribution of Expenditure Per Quintile

	Overall	Q1 (<Income)	Q2	Q3	Q4	Q5 (>Income)
Alcoholic beverages	100%	6.7%	12.1%	16.4%	23.2%	41.6%
Wine	100%	7.7%	11.6%	15.0%	21.5%	44.2%
Champagne	100%	8.4%	6.8%	10.5%	28.5%	45.6%
Chicha	100%	3.2%	24.0%	27.5%	20.4%	29.7%
Beer	100%	8.3%	16.5%	21.8%	24.3%	28.9%
Pisco	100%	6.2%	10.8%	15.5%	25.2%	42.3%
Whisky	100%	0.0%	2.2%	7.2%	20.4%	71.3%
Other liqueurs	100%	2.9%	6.4%	9.5%	22.0%	59.2%

Source: Survey of household budgets 1996/1997 (National Institute of Statistics) (to be published).

Q = Quintile.

Table 37 ²³³

Distribution of Revenue by Income Quintile

Additional Tax on Alcoholic Beverages

Millions of Chilean Pesos ($), May 1997 ²³⁴

Case 1: Former System vs. Law No. 19,534 (1997)

	Weighting factors for expenditure		Revenue	Revenue under new system
	Q: I, II, III	Q: IV, V	1996	e=0	e=1
Pisco	32.4%	67.5%	12,012	14,512	13,799
Whisky	9.4%	91.7%	7,090	4,760	5,505
Spirits	18.7%	81.1%	4,844	5,998	5,617
Burden 1996	5,464	18,540	24,004
Burden under new system e=0	6,273	19,028	25,301
Burden under new system e= 1	6,040	18,920	24,960
Change e=0	14.8%	2.6%	5.4%
Change e=1	10.5%	2.1%	4.0%

Case 2: Former System vs. Uniform Ad Valorem Rate (34%)

	Weighting factors for expenditure		Revenue	Revenue under new system
	Q: I, II, III	Q: IV, V	1996	e=0	e=1
Pisco	32.4%	67.5%	12,012	16,337	15,240
Whisky	9.4%	91.7%	7,090	3,444	4,369
Spirits	18.7%	81.1%	4,844	5,490	5,326
Burden 1996	5,464	18,540	24,004
Burden under new system e=0	6,646	18,642	25,289
Burden under new system e= 1	6,346	18,616	24,963
Change e=0	21.6%	0.6%	5.4%
Change e=1	16.1%	0.4%	4.0%

Source: Survey of household budgets 1996/1997 (National Institute of Statistics) Ministry of Finance model.

Q = Quintile

464. Chile indicates that Table 36 sets forth the weighting factors for expenditure by the different income quintiles of the population on the most commonly consumed alcoholic beverages. By analysing the distribution of expenditure on each type of beverage according to income quintile, it is easy to appreciate that in the case of both whisky and the other non-pisco beverages, it is the higher income groups that account proportionally for the greatest consumption. Whisky, in particular, has always been considered as a luxury good consumed for the most part (92 per cent) by the high income groups. The source of this information is the Survey of Household Budgets 1996/1997 by the National Institute of Statistics.
465. Chile further claims that Table 37 shows the impact of different tax structures on different socio-economic groups. Quintiles I, II and III (lower income), and quintiles IV and V (higher income), have been grouped together. With the revenue obtained from the model described above (Section I) and the distribution of expenditure according to the above table it is possible to estimate the change in the tax burden on the different socio-economic groups, for the products concerned, under the new tax structure and under the flat structure (both having the same effect on aggregate revenue). The results show that the flat structure involves a greater change in the tax burden (16-22 per cent) than under the new structure (11-15 per cent) for the lower income groups. For the higher income groups, the tax burden under the flat rate remains practically unchanged (<1 per cent) in relation to the new structure (2-3 per cent).
466. According to Chile, the first of these Finance Ministry objectives -- approximate equality of tax revenues -- could have been achieved through a flat ad valorem tax. However, such a tax would have been materially more regressive in its effects than the Old Chilean System in terms of income distribution. In Chile, with the exception of certain specialty liqueurs primarily imported from Europe (such as Campari), there tends to be a correlation between higher prices and higher alcohol strength. Thus, by having the ad valorem tax rise with alcohol content, the progressive distribution of tax revenues is enhanced.
467. Chile states that two further points should be noted in this regard. First, notwithstanding the objective not to have a more regressive incidence of taxation on the different quintiles of the population, the New Chilean System is slightly more regressive than the Old Chilean System. That is primarily because of the drastic reduction in tax on whisky, which is a relative luxury good in Chile, and the increase in tax on the cheapest grades of pisco, the most common drink for poorer Chileans. (Ironically, in light of Europe's current complaint, the only motivation for this regressive step of reducing the tax on whisky was to respond to the trade complaint of the European Communities).
468. Chile further notes that the second point that should be noted is that the Finance Ministry assessment was a static analysis, based on two arbitrary assumptions:

1. that there would be no adjustment by consumers in their spending patterns as a result of the changed tax system; and
2. that there would be no adjustment of the alcohol strength of their products by producers to try to take advantage of the lower ad valorem rates applied to lower alcohol strength products.

469. Chile also notes that as to whether producers will adjust the alcohol strength of their products, that is difficult to tell. Chile would guess that, if the United States adopted the Chilean Tax System tomorrow, within weeks Chile would see distilled spirits producers of the world undertaking the simple dilution that is required to qualify for lower taxes. Thus would be born "Johnny Walker Light," "Beef Eaters Lean," etc., all marketed at lower alcohol strength. The highest quality producers (like producers of gran pisco) might not wish to adjust their products, but those wishing to compete on price at the low end of the market might well decide to adapt their products.

To continue with Legislative Objective

²³¹ El Diario, 2 July 1996, (EC Exhibit 30).

²³² Chile Response to Questions asked at the First Substantive Meeting, p. 35.

²³³ Chile Response to Questions asked at the First Substantive Meeting, p. 36.

²³⁴ Chile explains that the measurement can be made under two hypothetical elasticity scenarios: e=0: constant consumption, and e=1: constant expenditure.