Optimal Second Best Taxation of Addictive Goods in Dynamic General Equilibrium

In this paper we derive conditions under which optimal tax rates for addictive goods exceed tax rates for non-addictive consumption goods in a rational addiction framework where exogenous government spending cannot be financed with lump sum taxes. We reexamine classic results on optimal commodity taxation and find a rich set of new findings. Our dynamic results imply tax rates on addictive goods which are smaller than those implied by the static framework. This is the case because high current tax rates on addictive goods tend to reduce future tax revenues, by making households less addicted in the future. In general, the optimal tax on addictive goods smooths intertemporal distortions by raising current addictive taxes when elasticities are falling. The rise in future elasticities caused by households which become less addicted offsets the decline in elasticities over time. Classic results on uniform commodity taxation emerge as special cases when elasticities are constant and the addiction function is homogeneous of degree one. Finally, we consider features of addictive goods such as complementarity to leisure that, while unrelated to addiction itself, are nonetheless common among some addictive goods. In general, such effects are weaker in our dynamic setting since if taxing addictive goods has strong positive revenue effects today, then taxing addictive goods has a strong offsetting effect on future tax revenues.