Optimal e-cigarette policy when preferences and internalities are correlated

Abstract

This paper studies the policy implications of correlation between preferences and internalities in the context of tobacco products. Using novel survey data, I show that cigarette smokers who misperceive the relative health harms of cigarettes and e-cigarettes—and thus for whom internalities associated with imperfect information are potentially large—are also significantly less likely to respond to changes in relative prices. I build this heterogeneity into a model of cigarette and e-cigarette taxation to show that the relationship between the optimal e-cigarette tax and the mean elasticity of substitution is relatively flat. This is policy relevant because evidence of substitution is thought to suggest low (or even negative) e-cigarette taxes. Even at implausibly large degrees of substitution, simulated optimal e-cigarette taxes are positive and large.