Optimal Taxes on E-Cigarettes

We study a model of optimal taxation on e-cigarettes, a healthier but addictive substitute to cigarettes.  The model we develop has three key features.  First, we account for heterogeneity in the population of smokers in terms of their predilection for nicotine addiction and preferences for e-cigarettes relative to conventional cigarettes.  This allows the population of conventional cigarette smokers, e-cigarette users, and non-nicotine users to emerge endogenously in the model as a function of relative tax-inclusive prices for conventional cigarettes, e-cigarettes, and numeraire consumption.  Moreover, it also allows us to evaluate the distributional impacts of e-cigarette taxation in addition to the direct efficiency costs.  Second, we account for the possibility that smokers may only partly internalize the public health gains from switching from conventional cigarettes to e-cigarettes, reflecting behavioral failures.  This is important because conventional smokers are less likely to switch to e-cigarettes on their own because they only partly internalize the harm caused by conventional cigarette consumption.  Third, our model captures the possibility for e-cigarette consumption by non-smokers to ‘gateway’ to conventional cigarette consumption.  This may offset the potential gains from smokers who switch from conventional cigarettes to e-cigarettes.  To calibrate the model, we plan to estimate key elasticities of conventional and e-cigarette take-up using the Nielsen Homescan Consumer Panel dataset.  While preliminary, the results from the optimal tax model suggest two policy recommendations. First, even under upper bound assumptions for the size of the gateway effect, the optimal size of e-cigarette taxes appears to be modest relative to cigarette taxes, although these results are very preliminary. Second, to the extent that the gateway effect is nontrivial, policy makers should act quickly to increase e-cigarette taxes.