1 Introduction
Empirical tax reform analysis for European countries almost without exception
reports on the very high welfare costs involved in marginally raising total tax
revenue through an increase in the VAT or excise rate on alcoholic beverages and
tobacco.1 The coexistence of such a high marginal welfare cost with much lower
values for other commodities and services seemingly points at the possibility of
significant welfare increases by reducing of taxes on alcohol and tobacco, and
raising those on, say, transport. Still, authors of such studies hasten to remark
that their analysis does not take into account the demerit good arguments that
probably motivated these high excise tax levels in the first place.
Although the (de)merit good argument dates back to Musgrave (1959), its
introduction in the optimal taxation literature did not come before Besley’s (1988)
analysis.2 The reason for this delay is that standard second-best analysis of
economic policy takes place in a welfaristic framework, while (de)merit good
arguments drive a wedge between the evaluations of citizens and those of policy
makers.
The strength of Besley’s (1988) model is twofold. First, it incorporates merit
good arguments in an otherwise very standard welfaristic setting, and therefore
allows to demonstrate clearly how putting one foot into non-welfaristic terrain
affects the familiar first- and second-best policy rules. Second, Besley relates the
(de)merit good considerations to where we would expect them to have their root:
the consumption pattern of the individual agent, rather than the aggregate level
of consumption of particular commodities.3
Unfortunately, Besley’s first-best analysis suffers from a deficiency that puts
the framework into question. As I will show below, his model in fact prescribes
to subsidise demerit goods and to tax merit goods whenever the demand for
those goods is inelastic. Keeping in mind the fact that habit formation is often
responsible for an inelastic demand for cigarettes and alcoholic beverages, one
is then led to the paradox that such demand should be encouraged rather than
discouraged.
Although a normative model cannot be subjected to the same kind of falsifi-
cation tests as positive models, if its policy prescriptions go exactly against one’s
gut-feeling, then one should ask whether the framework within which those pre-
scriptions were derived is an appropriate one. I think one can question Besley’s
1 Decoster & Schokkaert (1989) for Belgium, Madden (1995) for Ireland, Kaplanoglou &
Newbery (2002) for Greece, Schroyen & Aasness (2002) for Norway.
2 Several years earlier, Sandmo (1983) outlined for different degrees of market completeness
the policy implications of a divergence between the agent’s beliefs about the future states of
the world, and those of the social planner. Besley’s (1988) model, and the present one, concern
the case of (de)merit wants: the divergence between the agent’s preferences and those of the
social planner.
3See e.g. Pazner (1972).