Optimal Second Best Taxation of Addictive Goods∗

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. Standard static models that consider a revenue raising motive predict taxing addictive goods at a rate in excess of that observed in the data. In contrast, our dynamic results imply tax rates on addictive goods which are smaller than tax rates 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. 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 goods has a strong offsetting effect on future tax revenues.