Optimal e-cigarette policy when preferences and internalities are correlated

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.