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

Dongwon Lee, Dongil Kim, and Thomas E. Borcherding

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 efficient 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 significant 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 confirm these hypotheses. Our findings imply that the demand for government spending markedly influences 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 efficiency costs. Accordingly, increased usage of VATs during the 20th century should be understood as a collective choice to accommodate growing demands for public expenditure.

Citation

Dongwon Lee, Dongil Kim, and Thomas E. Borcherding (2013), Tax Structure and Government Spending: Does the Value-Added Tax Increase the Size of Government?, National Tax Journal, 66:3, pp. 541-570

DOI: dx.doi.org/10.17310/ntj.2013.3.02