An Optimal-Tax Approach to Alcohol Policy

Abstract

This paper deals with optimal income and commodity taxation in an economy, where alcohol is an externality-generating consumption good. In our model, alcohol can be bought domestically, imported, or produced illegally. Border trade alone implies an incentive to set the domestic alcohol tax below the marginal social damage of alcohol, and to tax (subsidize) commodities that are complementary with (substitutable for) alcohol. The income tax will also be used as a corrective instrument. Furthermore, although the effects of adding illegal production are ambiguous in general, a realistic outcome is, nevertheless, that it reduces both the optimal alcohol tax and the marginal income tax rate.