Tax Structure, Welfare and Government Spending

This paper examines the claim that the introduction of a more efficient tax, a VAT, increases the relative size of government and, thus, has a negative impact on taxpayers’ welfare. A careful analysis suggests that introducing the VAT has only a limited impact on government growth due to two factors: substitution to the VAT away from other tax sources and the fairly low price elasticity of demand for public goods. Reducing the cost of taxation at the margin will not likely have much effect on the size of government. In contrast, demand shifts of public goods may have a more significant impact on government size. Thus, the causal direction is reversed; demand shifts markedly influence the tax structure. Using a 38 year (1970-2007) panel data for 29 OECD countries, we confirm the hypotheses. With a broader scope placed to judge the tax efficiency, the VAT is more efficient than what conventional theories estimate, and introduction of a VAT increases taxpayer’s welfare because it reduces administration, political, and deadweight costs.