Tax Structure and Government Spending: Does the Value-Added Tax Increase the Size of Government?

Abstract

This paper examines the claim that the adoption of a value-added tax (VAT) increases the size of government. Our analysis suggests that introducing the VAT, despite the fact that it is a relatively effi cient tax in comparison to the income tax alternative, has little impact on government growth due to two factors: (1) the substitution of the VAT for other tax sources, and (2) the low price elasticity of demand for public goods. In contrast, demand-side changes may have a more signifi cant impact on government size, thus reversing the direction of causality. Using a panel of 29 OECD countries over a period of 38 years (1970-2007), we confi rm these hypotheses. Our fi ndings imply that the demand for government spending markedly infl uences the tax structure of society. Using a broad concept of tax costs, introduction of a VAT increases social welfare because it reduces compliance costs, rent-seeking, and effi ciency costs. Accordingly, increased usage of VATs during the 20th century should be understood as a collective choice to accommodate growing demands for public expenditure.

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