Differential Fiscal Policy Induced Innovations in Consumer Markets

Many consumer goods - sugar, cigarettes, alcohol, fossil fuels - are considered sin goods as they cause externalities like CO2 emissions or internalities such as addiction. The standard response is then to appeal to the Pigouvian principle and tax these goods to correct these ex- and internalities. This paper builds on this fundamental Pigouvian insight but argues that the effectiveness of the traditional approach is limited. The main reason is that in many cases, close substitutes are missing, which provide similar benefits to the consumer but are less harmful. As a result behavior does not change and the fiscal intervention is regressive. We then make two points. First, if those substitutes exist, then a differential fiscal policy which directs consumer behavior from the sin good to the less harmful substitute complements the pure Pigouvian approach. We survey the nascent empirical literature on this topic and nd that this differential approach is promising. Second, if those substitutes do not exist, then a commitment to implement a differential fiscal policy (fiscal forward guidance) in the future (not now) will induce innovations today and finally deliver a substitute in the future.