tax structure and government spending: does … · tax structure and government spending: does the...

National Tax Journal, September 2013, 66 (3), 541–570

TAX STRUCTURE AND GOVERNMENT SPENDING: DOES THE VALUE-ADDED TAX INCREASE

THE SIZE OF GOVERNMENT?

Dongwon Lee, Dongil Kim, and Thomas E. Borcherding

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.

Keywords: VAT, tax structure, government size, tax effi ciency

JEL Codes: H20, H21, H60

The political danger of a value-added tax is that it is so effi cient at raising money (Barro, 2011).

I. INTRODUCTION

The fi rst value-added tax (VAT) was introduced in France in 1968; since then, over 150 countries worldwide have adopted some form of a VAT. On average, countries

from the Organisation for Economic Co-operation and Development (OECD) collect

Dongwon Lee: Department of Economics, Sungkyunkwan University, Seoul, Korea ([email protected])

Dongil Kim: Ministry of Strategy and Finance, Sejong, Korea ([email protected])

Thomas E. Borcherding: Department of Economics, Claremont Graduate University, Claremont, CA, USA ([email protected])

bicgen

Typewritten Text

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

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

National Tax Journal542

about 32 percent of their total revenue from VATs and 27 percent from personal income taxes. This relatively new tax has become a crucial revenue source among OECD mem-ber countries. The only exception is the United States, which has not adopted a VAT and instead relies on the personal income tax for over 70 percent of its total revenue.1

Since Congressman Al Ullman (of Oregon) proposed a VAT in 1979 to partially replace U.S. federal income taxes, there has been an ongoing debate over introducing more effi cient taxes, such as a VAT, a fl at tax, or a general sales tax. Much of the debate has focused on the proposed advantages of a VAT as a relatively effi cient instrument to achieve fi scal reform, including reducing defi cits, fi nancing social security, and enhanc-ing the competitiveness of U.S. industry (McLure, 1987; Bird and Gendron, 2007; Toder and Rosenberg, 2010; Gale and Harris, 2011). The opposition claims that VATs increase regressivity, intrude on the taxation authority of state and local governments, and expand the size of government because they act as a “money machine” (Gravelle, 2011; Holtz-Eakin, 2011).

Indeed, the main argument against VATs arises from the fear that they lead to larger government. The money machine hypothesis has helped to defeat several attempts to introduce a VAT in the United States. Recently, the President’s Advisory Panel on Fed-eral Tax Reform (2005) refused to recommend the “Partial Replacement Value-Added Tax (VAT)” advocated by Graetz (2002), which proposes a 15 percent VAT, coupled with the lowering of top individual and corporation income tax rates to 15 percent. The Panel sided with opponents who criticized the VAT for being an easy way of collecting large amounts of revenue with regressive distributional effects.

Similarly, some recent literature (e.g., Becker and Mulligan, 2003) suggests that more effi cient tax instruments cause government expenditures to increase. Moreover, if the VAT’s “budget-push effect” leads to an ineffi ciently large level of government services, the VAT can be described as a money machine.2 Keen and Lockwood (hereafter referred to as K&L) (2006, 2010) have examined and supported the money machine hypothesis.

These fi ndings contrast with a conventional approach to political economy. This literature (e.g., Meltzer and Richard, 1981,1983) explains the growth of government by demand-side activities of various interest groups, including budget-maximizing government agencies and well-organized interest groups. Contrary to the Becker and Mulligan framework, the orthodox literature implies causality running from an increased demand for government services to adoption of relatively more effi cient taxes. Accord-ing to this view, the use of effi cient taxes increases social welfare by reducing the costs of an (ineffi cient) expansion of public services.

This paper investigates the effi ciency effects of the VAT on both the size of government and social welfare. We present a simple model in which the government seeks voter support through public spending and taxation. This political optimization problem helps to differentiate the effects of demand-side and supply-side factors that affect government

1 Data refer to the federal government. The United States relies on the corporate income tax for over 10 percent of its total revenue.

2 In other words, simple Pigovian tax improvements are swamped by the VAT’s money-machine tendencies.

Does the Value-Added Tax Increase the Size of Government? 543

growth. Our theoretical model indicates that the extent to which the introduction of a VAT increases the size of government is limited by two factors: (1) the substitution of the VAT for other tax sources, and (2) the low price elasticity of demand for public goods, which suggests that reducing the cost of taxation at the margin may not necessarily increase government size. In contrast, an increased demand for government services can lead to a signifi cant increase in government size. Our results suggest that government growth is primarily attributable to changes on the demand side of the public sector.

To test the propositions suggested by our political economy model of the equilibrium level of government expenditures, we perform a panel study of the revenues of 29 OECD countries from 1970 to 2007. Our empirical methodology examines the effect of adopt-ing the VAT on the level of expenditures using a structural equation model of a causal relation. The empirical results confi rm that the VAT has little impact on government size.

This study’s broader concept of tax costs implies that the VAT may be relatively more effi cient than traditional theories assume. We suggest that the introduction of VATs improves social welfare, despite the presence of any rent-seeking activities on the demand side of government spending. In fact, the popularity of the VAT around the world may refl ect its welfare superiority to other taxes. The introduction of the VAT is also politically viable when opposition to the VAT is mitigated by progressive spending and special provisions for the poor, as has been the case with European VATs. These mitigating actions provide another reason why one may expect government expenditures to increase, even in the absence of the money machine effect.

This paper is organized as follows. Section II briefl y reviews the money machine argument and the orthodox public choice approach to tax effi ciency. Section III presents a model of political equilibrium that examines the causal effect of the adoption of a VAT on the size of government and on the welfare of taxpayers. Section IV presents empirical evidence for the propositions suggested by our model. Section V summarizes the conclusions of our paper for the debate on tax effi ciency.

II. EFFICIENCY OF A VAT

Some contemporary literature posits that an effi cient tax is a major source of larger governments (Becker and Mulligan, 2003; Dušek, 2002). The argument centers around the ease and ability of a government to collect a tax — that is, an effi cient tax such as the VAT reduces opposition to taxation and leads to larger government. For example, Becker and Mulligan (2003) developed a model of competition for political power between taxpayers and benefi ciaries. They argued that an effi cient tax system changes the balance of political pressure in favor of the subsidy recipient group, because lower deadweight costs dissuade taxpayers from opposing additional government spending. Nellor (1987) and Ebrill et al. (2001) showed that the adoption of a VAT signifi cantly increased the size of government as measured by the tax-to-GDP ratio. These studies suggested that the VAT is a money machine, as they argue that the use of VATs results in a movement to an ineffi ciently large level of government spending.


The revenue-raising feature of the VAT is desirable, however, if the increase in revenue is used as an effi cient means of lowering defi cits or fi nancing an effi cient expansion of government services — that is, an increase in effi ciently-provided public services attributable to a decline in the marginal cost of public funds (Gale and Harris, 2011).

More recently, K&L (2006) identifi ed two versions of the money machine hypothesis. The weak form of the hypothesis (a positive association between VAT revenue and government size) is a necessary condition for the strong form of the hypothesis (that the adoption of a VAT leads to government growth). They empirically tested the weak form by adding a VAT dummy to tax ratio (total tax revenue as a share of GDP) equa-tions, and the strong form by assessing whether revenue raised by the VAT is mitigated by reductions in revenue from other taxes. They concluded that the VAT is a money machine in both senses. The increase in government growth under the strong form of the hypothesis, however, was quite modest as they found that VAT revenue substitutes to a signifi cant extent for revenue previously raised from other taxes. This conclusion suggests that, even with Leviathan policy makers who are mainly concerned with their own interests, it is possible that introducing a VAT may increase taxpayer welfare.3

The money machine perspective contrasts with a large volume of scholarly work that attempts to explain the sources of government growth using conventional public choice theories. The public choice approach mainly focuses on the demand side of public goods. As discussed by Borcherding (1985), ineffi cient government expansion can be explained by the rent-seeking activities of budget-maximizing government agencies (Niskanen, 1971; Brennan and Buchanan, 1980; Mackay and Weaver, 1981), income-based interest groups focused on redistribution (Meltzer and Richard, 1981, 1983; Peltzman, 1980; Husted and Kenny, 1997), or well-organized special interest groups (Demsetz, 1982; Olson, 1982). This public choice literature implies that an increase in the demand for government spending causes the adoption of effi cient taxes, such as VATs.

We argue that tax effi ciency, for all taxes including the VAT, should be assessed on the basis of the total costs that a tax imposes. Traditional optimal tax theory focuses only on deadweight costs, implying that a tax system should be designed to minimize the excess burdens of taxation for a given amount of revenue. Slemrod and Yitzhaki (1996) and Holcombe (2004) suggested, however, that a more complete analysis of the welfare impact of taxation should include compliance costs and rent-seeking costs, in addition to the deadweight costs of taxation. A tax is effi cient when it minimizes the full costs of taxation.

From a political perspective, a progressive income tax causes unnecessarily large rent-seeking costs. Taxpayers in lower income brackets support more progressive rates and special provisions, while those at the top lobby to reduce progressivity.

On the other hand, the broad base and fl at tax rate of well-designed VATs present fewer incentives for interest groups to fi ne-tune tax rates and to search for special treatments. A broad tax base enables the marginal tax rate to be low, which dissuades

3 The income effect of tax innovation — a more effi cient tax system leaves taxpayers better off at a given level of resources — could dominate the substitution effect — an increase in tax effi ciency allows Leviathan to extract more tax revenue for private benefi ts.


interest groups from attempting to lower tax rates. Even though exemptions and fraud can increase political costs in VAT systems, we believe that the total costs of VATs are smaller than those of the income tax system.

Table A1 shows some of the basic characteristics of the VATs in the OECD countries, including the year of adoption, the standard rates, revenue from the VAT as a share of GDP, and the VAT revenue ratio (VRR).4 On average, the standard VAT rate of 17.7 percent collects about 6.5 percent of GDP. In the last column, the VRR varies substan-tially across the OECD countries, ranging from 0.35 in Mexico to 0.98 in New Zealand. This refl ects differences in actual VAT systems in terms of exemptions, reduced rates, and poor tax administration (OECD, 2010).

III. VAT, GOVERNMENT SIZE, AND WELFARE EFFECTS

At the center of the debate about taxes and large government is whether the VAT is a money machine. We fi rst defi ne the “positive” version of the money machine hypothesis as a situation in which the use of a VAT itself leads to a larger government (i.e., what K&L (2006) termed the strong form of the money machine hypothesis). However, this increase in government size alone should not be treated as evidence that the VAT is a money machine, as the increase may instead represent an effi ciency-enhancing expan-sion of public services. The key issue of the money machine argument is not whether the VAT raises more revenue, but whether the increase in government size results in a movement toward an ineffi ciently large level of government services. In this sense, the “normative” version of the money machine argument is that the adoption of a VAT results in an ineffi cient overexpansion of government expenditures. Thus, we investigate both the causal and welfare effects of VAT adoption.

A complete analysis of the causality issue requires accurate modeling of collec-tive decision making. From the perspective of public choice theory, government size can alternatively be modeled as a result of competition between interest groups, the optimization behavior of a social planner, or the choice of an autonomous Leviathan. This study employs a simple social planner model in a competitive political system under which the government acts as a vote maximizer, because this approach easily incorporates the standard supply and demand analysis of public goods in examining the relationship between variables.

A. A Political Equilibrium Model of Government Size

Consider a government whose policy choices are largely decided by the expected support of taxpayers. We assume that the government seeks to maximize political sup-port from voters by choosing government expenditures and the taxes to fi nance them.

4 The VRR measures the gap between the actual VAT revenue collected and the revenues that would be collected if the standard rates were applied to all fi nal consumption. A pure VAT system would achieve a VRR (with only consumption goods subject to tax) close to one, which indicates that a VAT is applied uniformly on a broad consumption base with effective tax collection.


In general, the net effects of these two policies determine the support of voters. Govern-ment spending is modeled the same as tax revenue, with consumption smoothing (i.e., debt fi nancing) being a short-run deviation from this identity. The assumption of vote maximization follows theories developed and extended by Downs (1957), Denzau and Munger (1986), Hettich and Winer (1988, 1999), and K&L (2006).

We posit a government that maximizes the sum of political support from N voters, given the budget constraint:

(1) ∑∑ +==

U f∑= ∑ G T C(f ) (∑) (∑∑− ( )T )]iffffij ij ij

j

J

i

N

11

subject to ∑∑==

G T∑∑= ,ij

j

J

i

N

11

where fi(·) is a policy benefi t function for taxpayer i that depends on government expen-diture G; T ij is the tax revenue raised from revenue source j and taxpayer i; and C ij is the additional “tax costs” of the ith taxpayer from the jth tax, consisting of compliance, rent-seeking, and effi ciency costs.5

The objective function assumes that the level of political support for public spending depends on the difference between the benefi t and income loss of the voter. The size of the difference matters, rather than just whether the net benefi t is positive, because the government maximizes voters’ support. Note that income losses imply political opposition to taxation, and that they depend on the sums across J taxes of tax revenue, T i, and tax costs, C i. These tax costs differ according to tax bases and tax rates.6 Also, note that, to simplify the analysis, we ignore everything else that goes into taxpayer welfare and that affects voting, including the distribution of income.

For expositional simplicity, we assume a tax system with two tax bases: A and B. We also suppress the summation sign (ΣN) because we can easily recognize aggregate impacts.

The fi rst order condition for this simplifi ed model is

(2) f ′(T ) = 1 + Cj(T j ) j = A,B,

where f ′ and Cj denote derivatives, and T = T A + T B. The left side of (2) represents the aggregate marginal benefi ts per dollar of additional spending for N individuals. The right side is the aggregate marginal income loss that results from either tax A or B.

B. Ef ects of a VAT on Government Size

Suppose that the government decides to introduce a more effi cient tax instrument (e.g., a VAT), replacing the tax base A. Such a tax replacement reduces CA by assump-

5 Standard assumptions are that the benefi t function is concave, and the tax costs function is convex and non-decreasing in T; that is, ∂f /∂G > 0, ∂2f /∂G2 < 0, ∂C /∂T > 0, and ∂2C /∂T 2 > 0.

6 In the model, differences in progressivity across taxes are implicitly embedded in differences in tax costs — including deadweight costs. We assume that a more progressive tax results in greater deadweight cost than a less progressive tax for a given size of government, other things equal.


tion regarding C, and substitution reduces overall costs because access to a VAT means access to a more effi cient tax (K&L, 2006). First, this change in tax structure leads to a shift toward tax source A and away from the other tax source B. The substitution of tax sources results in increased government reliance on the more effi cient tax mix in order to reduce political opposition. Second, because of the change in tax structure, the (upward sloping) total marginal tax cost curve shifts down. When such a shift is set against a downward sloping marginal benefi t curve, the result is an increase in government size (T ) (Hettich and Winer, 1999; Kenny and Winer, 2006). Tax effi ciency appears to have a one-sided positive effect on government size.

However, the substitution effect between A and B restricts the overall impact of tax effi ciency on revenue growth. Moreover, if the demand for public goods is price inelastic, then the impact of an effi cient tax on the size of government would be smaller than if demand were more elastic.7

Following K&L (2006) and Hettich and Winer (1999), (2) can be solved for the impact of the exogenous change in CA on T A, T B and T

(3)

= ′′ <

= − ′′ >

= − <

dT dC w

dT dC f w′′

dT dC C w

)( f C′′ − 0

0

0,

AA BC f( f C BBB

BAC

A BC C BBB

where w = CAACBB –f ″(CAA + CBB) > 0.8 Note that, due to the substitution effect, the increase in total revenue induced by an exogenous reduction in CA (shown in the last equation in (3)) is smaller than the increase in tax A (shown in the fi rst equation in (3)) by the amount represented by the term –f ″/w (shown in the second equation in (3)).

Additionally, if the marginal benefi t of the public spending curve is very inelastic, there will only be a shift in revenue composition. A low price elasticity of demand implies a much larger value of │f ″│. Since w is increasing in │f ″│, a low price elasticity means a much smaller value of │dT/dCA│ in the last equation in (3).9 If the demand is perfectly price inelastic (i.e., │f ″│ → ∞), then the impact of tax reform on revenue size would be zero.

The existing public fi nance literature suggests a fairly low price elasticity of demand for public goods. A large number of studies that provide econometric estimates of demand functions for public services have found the price elasticity to be in the range of –0.3 to –0.5 (Oates, 1996, 2006; Brasington, 2002; Borcherding, 1985; Reiter and Weichenrieder, 1997; Holsey and Borcherding, 1997). These studies estimated price elasticities of demand for public services, such as education, health and highways

7 The low price elasticity of demand is a market condition that can reduce (unless demand is perfectly inelastic) the impact of any supply-side effi ciency on government size, even in a single tax regime that does not substitute between taxes.

8 See the Appendix for a detailed derivation. 9 We assume that CB is independent of │f ″│.


(mainly at the U.S. state and local levels), by employing the models derived from a median voter theorem or contingent valuation approach. Accordingly, our study predicts that supply-side effi ciencies play a limited role in determining the size of government under the assumption of a low price elasticity. Note that, due to higher degree of pub-licness, demands for national services (e.g., defense and redistributive expenditures) are likely to be more price inelastic than the demands for local public services. The path from the introduction of an effi cient tax to government growth is very narrow. A rough calculation suggests that the elasticity of T with respect to CA is about –0.04. That is, a 1 percent increase in tax effi ciency leads to an increase in government size of approximately 0.04 percent.10

In contrast, increases in the demand for public goods (i.e., the exogenous change in f ′) result in relatively large changes in government size.11 Various factors can increase the demand for public goods, including changes in income, demographic variables, and preferences toward public goods. The public choice theory of political competition also regards rent seeking as a major source of variation in the demand for public goods.

Our theoretical approach follows and extends K&L (2006) but with markedly dif-ferent implications. It is similar in that, in the case of tax substitution, a more effi cient tax leads to some increase in government spending simply because the marginal cost of public funds has declined. We extend this result by noting that the size of government expansion is determined by the size of the demand elasticity for public services. Previ-ous studies on government size (e.g., Tridimas and Winer, 2005) have recognized that the price elasticity of demand for public services may infl uence the size of the budget, but the point has been largely ignored in the tax effi ciency literature (e.g., Becker and Mulligan, 2003; K&L, 2006). Further, the main point of our theoretical model is that government growth is largely attributable to an increase in demand for public goods. This proposition contrasts with the views asserted by Becker and Mulligan (2003) and K&L (2006, 2010) who emphasize the tax structure as a determinant of government size.

C. Ef ects of a VAT on Welfare

Of central interest to this study is whether the use of a relatively effi cient VAT brings about desirable economic effects. The key issue is then whether an increase in govern-ment size, induced by a VAT, reduces general welfare due to a money machine effect.

From (1)–(3), we can derive the impact of adopting a more effi cient tax on the gen-eral welfare of taxpayers (we again suppress the summation sign and assume two tax bases A and B)

(4) = ′′dU dC f w′′( )C C− .A BC (C AC

10 This calculation assumes CA = 0.27 (Jorgenson and Yun, 2001), and a price elasticity of demand = – 0.3. Given a constant elasticity demand curve, this implies f ″ = –3.3. Other variables (CAA, CBB, T) are set equal to 1.

11 See the Appendix for a derivation.


Thus, the introduction of a more effi cient tax to replace tax A will increase the welfare of taxpayers if CA < CB after the tax replacement, i.e., if the new tax (e.g., the VAT) is more effi cient than tax B (e.g., the corporate tax). In most OECD countries, the VAT was substituted for less effi cient taxes, such as sales (turnover) and specifi c goods taxes (an issue that is further discussed in Section IV).

Could an increase in government size induced by a more effi cient tax structure result in a reduction in welfare? Equation (4) shows that the welfare gain from adopting a VAT depends on the difference in marginal tax costs (CB – CA) and the substitution effect between tax sources ( f ″/w). This implies that, even when the existing level of public spending is ineffi ciently large, the welfare gain from adopting an effi cient tax would be larger than the welfare loss from an increase in government spending induced by lower marginal costs (dT/dCA). Indeed, the derivation of (4) reveals that the dT/dCA terms cancel. Note that this result would also hold when the government is a pure Leviathan. A budget-maximizing Leviathan chooses revenue subject to the constraint that total income losses not be above total benefi ts. Even at such an initially exces-sive level of government, however, adoption of a VAT will result in a welfare gain for taxpayers.12

IV. EMPIRICAL EVIDENCE

This section provides an empirical analysis of two hypotheses: (1) the introduction of an effi cient tax leads to a tax substitution toward the effi cient, and (2) the causal effect of a tax structure on government size is small compared to the impact of demand-side variables.

A. Variables and Data

We used a panel of data collected over 38 years (1970–2007) in 29 OECD countries, not including the United States. The dependent variables include total tax revenue and revenues of VATs, income taxes, sales taxes, customs, and property taxes.13 These tax revenues are collected by central or federal governments. The social security contribu-tion (payroll tax) is excluded from calculations of total revenue; thus, our analysis does not consider substitution between VATs and payroll taxes.14

Government size is determined through a political process, which inevitably includes actions for income redistribution. We use three proxy variables to capture the activities

12 This result is driven by the fact that marginal benefi ts are less than marginal income losses at the budget-maximizing level of government output. More specifi cally, dU/dCA can be written as ( f ′ – 1)dT/dCA – dC/dCA, where C is the sum of tax costs. Since f ′ < 1 + dC/dT, this implies dU/dCA < 0.

13 All the revenue data were obtained from OECD iLibrary Revenue Statistics, http://www.oecdilibrary.org/content/datacollection/ctpa-rev-data-en.

14 With few exceptions, social security funds in OECD countries are run separately from other government revenues by an independent administration and fi nanced with payroll taxes. Typically, this separation leads to the claim that the payroll tax is not actually a tax.


on the demand side of public goods. The proxy variables are central government debt relative to GDP, social expenditure relative to GDP, and compensation of government employees relative to general expenditure.15 First, central government debt gauges the demand-side push for increased revenue. Government debt represents the accumula-tion of demand for government expenditures beyond currently available resources. Larger government debt forces governments to opt for increased revenues in order to reduce the costs of debt.16 Second, social expenditure refers to the total amount of public spending for social insurance and welfare programs, measured as a share of GDP. Inclusion of social expenditure was motivated by Tanzi and Schuknecht (2000), who designated transfers and subsidies as signifi cant sources of government growth. However, social expenditure data are only available for the 1980–2005 period, and the data include social security and Medicare spending, of which the revenue source (i.e., payroll tax) is excluded from the total revenue in this paper. Accordingly, the social expenditure variable may not accurately represent the exact distributional demand. Third, compensation of government employees is the share of general government expenditures dedicated to paying salaries in the public sector. This variable captures two phenomena, bureaucratic budget-maximizing and the general demand for public goods, which presumably require more government employees. The employee com-pensation data, however, cover a relatively short period of time and refl ect only general government.

The socioeconomic control variables are similar to those used in previous research on government growth and tax structure. Standard variables include income, agriculture, openness, education, urbanization, energy production, federal structure, the presence of a socialist government, and the nature of political rights and civil liberties, as well as fi ve demographic variables, including population, population density, percentage of elderly (over age 65), percentage of youth (under age 14), and percentage of female labor force (Tridimas and Winer, 2005; Kenny and Winer, 2006; Ferris, Park, and Winer, 2008). All these variables determine the nature of the tax structure in a com-petitive political equilibrium, which is determined based on the size of the potential tax base, administration costs, and political opposition to taxation (Kenny and Winer, 2006).17 Table A2 shows summary statistics for all the variables described in this subsection.

15 Government debt and employee compensation data were taken from World Bank, World Development Indicators, http://data.worldbank.org/data-catalog/world-development-indicators, and social expenditure data were obtained from OECD iLibrary Revenue Statistics.

16 Some costs of government debt are irresponsible fi scal systems, high infl ation, low private investment, and generational inequality in tax burdens. High government debt restricts a government’s fi nancial capability in that it increases interest payments for the debt and shatters confi dence in government bonds issued for borrowing.

17 Most of the socioeconomic data were collected from the World Bank’s World Development Indicators; the political rights and civil liberties data were collected from the Gastil index of democracy from Freedom House, http://www.freedomhouse.org/report-types/freedom-world. Education is measured by secondary school enrollment (% of the population of offi cial secondary education age).


B. General Trend

The average total revenue of OECD countries as a share of GDP has gradually increased. Figure 1 shows that average total revenue of OECD countries has grown from 17.8 percent of GDP in 1973 to 22.2 percent in 2007. Meanwhile, taxes as shares of total revenue have also changed, as shown in Figure 2. The tax ratio of VATs has increased, while the tax ratios of “older” taxes, such as excise, sales, customs, and specifi c goods taxes, have decreased. The average VAT revenue as a share of total revenue in OECD countries increased from 18.6 percent in 1973 to 29.8 percent in 2007.18 In contrast, excise tax revenue decreased from 16.9 percent to 12.8 percent of total revenue, sales tax revenue decreased drastically from 4.2 percent to 0.03 percent, customs revenue decreased from 4.3 percent to 0.7 percent, and specifi c goods tax revenue decreased from 24.4 percent to 16.4 percent during the same period.19 The difference between the revenue trends of VATs and the older, indirect taxes provides broad evidence of the substitution effect.

Note that the decrease in income taxes (paid by individuals and corporations) is rela-tively small. That is, the percentage of revenues from income taxes as a share of total

35

30

25

20

15

10

5

01973 1978 1983 1988 1993 1998 2003

Total Revenue I / GDP

Total Revenue II / GDP

VAT / GDP

Per

cent

18 Corporate tax revenue as a share of total revenue also increased from 11.1 percent to 16.1 percent.19 Tax revenues as shares of GDP display a similar pattern of change over time.

Notes: Total Revenue I is total revenue plus social security contributions; Total Revenue II is total revenue.

Figure 1Average Total Revenue and VAT Revenue


revenue decreases from 45.5 percent to 43.8 percent within the time frame. Combined income taxes remain the largest source of government revenue.20

C. Substitution Ef ects

The substitution effect is estimated as follows:

(5) δ φ μ ε= δ + +μT GDP Xφ (or )T RrjitT itPP jitT it it itX i iμ εμμ t j = 1, 2,…, J – 1,

where Tjit /GDPit is the tax revenue of tax j relative to GDP, and Tjit /Rit is the tax ratio of jth tax; Vit is a dummy variable for the presence of a VAT for the ith country and in year t; Xit is a vector of socioeconomic control variables; μi is the country fi xed effect; and εit is the error term. The sign of δ is predicted to be negative. If the substitution effect is valid, adoption of the VAT reduces reliance on other taxes. Note that the regression model given in (5) is similar to K&L’s (2006) model of VAT revenue substitution, as well as Kenny and Winer’s (2006) tax structure model.

40

35

30

25

20

15

10

5

01973 1978 1983 1988 1993 1998 2003

Income (individual)

Excise

Per

cent

Corporate

Sales Property Customs

VAT

Specific Goods

Figure 2Average Tax Ratio (A Tax Revenue/Total Revenue)

20 A prominent explanation for why this is the case hinges on the consideration of “fairness.” Income is accepted as a good measure of both a taxpayer’s ability to pay and of the taxpayer’s eligibility to receive welfare benefi ts. The sustainability of income taxes in the 20th century may in part be due to their percep-tion as fair taxes.


Table 1 presents the regression estimates of (5). Each row in Table 1 shows the effects of an explanatory variable on tax revenues relative to GDP for eight taxes listed. The coeffi cients in the fi rst row show that the VAT mainly replaces four old taxes (sales, specifi c goods, customs, and property taxes). The sharpest reduction is in the turnover or gross-receipts tax, which has commonly been replaced by VATs in OECD countries. After Iceland adopted the VAT, for example, sales tax revenue decreased from 12 percent of GDP to near zero.

Panel A of Table 2 shows the results of estimating (5) using the tax revenue/total rev-enue ratio as the dependent variable. The results are similar in that adoption of a VAT has a negative effect on each tax ratio. In particular, the signs of the four indirect taxes are all negative and highly signifi cant. Panels B and C include Total Revenue/GDP among the control variables. Total Revenue/GDP indicates the scale effect because an increase in total revenue leads to an increase in revenue from each tax source (Kenny and Winer, 2006). Note in Panel B that the sum of the coeffi cients across regressions (0.9) is close to 1, thereby satisfying the condition that an increase in total revenue should be equal to the sum of the increases from the individual taxes (Kenny and Winer, 2006). In both panels, the signs of the four indirect taxes are all negative and statistically signifi cant.

The results shown in Table 1 and Table 2 provide evidence supporting the substitu-tion effect of a VAT adoption. Since the VAT substitutes for less effi cient old taxes, Equation (4) in Section III implies that increases in the size of government due to VAT adoption improve taxpayer welfare (at least for OECD countries). In addition, note that the evidence in this section describes the exact nature of the substitution between taxes, and is not evidence that it will occur. In the next section, we show that the causal effect of VATs on government size is more complicated.

D. Causal Ef ects

This paper uses a structural equation model to determine whether VATs are a direct cause of large government.21 The specifi cation is an augmented dummy endogenous variable model

(6) β β β ω ζ= β +TR D β+ βit it it i iζ+ t0 1β ββββ

2ββββ

(7) γ γ θ+ γD Zγ= +γ uθ +it it it i iu+ t*

0 1γγ

2

(8) =>

≤

⎧⎨⎪⎧⎧⎨⎨⎩⎪⎨⎨⎩⎩

DD

D

1 if 0

0 if 0

,itit

it

*

*

where TRit is total revenue relative to GDP, and Dit is a dummy variable for the pres-ence of a VAT. Equation (7) indicates a latent index formulation, which implies that

21 Even though the treatment effect method has been popular since the infl uential paper by LaLonde (1986), an econometric model is more suitable than a nonparametric method for the current study because the data set in this paper has a small N (number of countries) and a long T (years in time series).

National Tax Journal554Ta

ble

1Su

bstit

utio

n Ef

ect

s (D

epen

dent

Var

iabl

e: T

ax R

even

ue/G

DP)

VAT

Rev

enue

Inco

me

Cor

pora

teEx

cise

Sale

sSp

ecifi

c G

oods

Cus

tom

sPr

oper

ty

VAT

0.49

1–0

.300

0.31

3–3

.581

***

–0.6

74–0

.788

**–0

.146

(0.4

87)

(0.2

36)

(0.3

88)

(0.8

94)

(0.5

80)

(0.3

05)

(0.0

94)

Ln(Y

PC)

–1.9

01*

–0.6

29–0

.552

–0.6

690.

143

–0.8

64–0

.388

0.6

50**

*(1

.047

)(1

.529

)(0

.514

)(0

.655

)(0

.517

)(0

.732

)(0

.367

)(0

.217

)

AG

R–0

.270

*–0

.212

–0.1

78**

0.11

6–0

.040

0.14

3–0

.016

–0.0

01(0

.145

)(0

.132

)(0

.078

)(0

.084

)(0

.087

)(0

.085

)(0

.035

)(0

.024

)

Ope

n–0

.051

**–0

.029

**–0

.001

–0.0

080.

008

–0.0

15–0

.011

–0.0

05(0

.021

)(0

.013

)(0

.005

)(0

.006

)(0

.007

)(0

.011

)(0

.007

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.003

)

Elde

rly0.

017

–0.1

92–0

.209

–0.0

070.

093

0.10

60.

085

–0.0

76(0

.164

)(0

.218

)(0

.141

)(0

.106

)(0

.081

)(0

.113

)(0

.050

)(0

.046

)

Yout

h–0

.092

–0.2

600.

099

–0.1

180.

008

–0.0

610.

049

–0.0

20(0

.174

)(0

.154

)(0

.075

)(0

.078

)(0

.095

)(0

.067

)(0

.032

)(0

.023

)

Fem

ale

0.05

9–0

.121

0.10

9**

–0.1

56*

0.13

2–0

.074

0.09

0**

0.00

6(0

.118

)(0

.111

)(0

.051

)(0

.080

)(0

.081

)(0

.091

)(0

.035

)(0

.019

)

Ln(d

ensi

ty)

8.22

8–5

.628

1.94

3–0

.088

–2.4

361.

418

1.61

9–0

.199

(8.5

30)

(6.8

85)

(2.9

49)

(3.6

06)

(4.3

76)

(4.7

80)

(2.2

96)

(1.0

21)

Educ

atio

n0.

002

–0.0

33**

–0.0

040.

011

0.00

20.

009

–0.0

05*

–0.0

02(0

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)(0

.013

)(0

.008

)(0

.008

)(0

.004

)(0

.010

)(0

.003

)(0

.003

)


Urb

an–0

.207

**–0

.120

–0.0

520.

080

0.00

10.

108*

0.02

30.

0004

(0.0

92)

(0.0

79)

(0.0

65)

(0.0

70)

(0.0

35)

(0.0

62)

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29)

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16)

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gy

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120.

016*

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005

–0.0

09**

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010

–0.0

080.

003

–0.0

007

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10)

(0.0

07)

(0.0

30)

(0.0

03)

(0.0

06)

(0.0

05)

(0.0

03)

(0.0

01)

No

right

s–0

.325

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23–0

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–0.0

14–0

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–0.0

270.

073

0.13

4***

(0.2

08)

(0.2

02)

(0.1

09)

(0.1

07)

(0.1

09)

(0.1

04)

(0.0

47)

(0.0

48)

Tim

e0.

126*

0.02

80.

065

0.02

2–0

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–0.0

22–0

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0.00

8(0

.070

)(0

.086

)(0

.045

)(0

.029

)(0

.043

)(0

.043

)(0

.026

)(0

.020

)

Con

stan

t–3

.889

59.3

0*–3

.566

8.14

97.

209

–1.9

51–9

.950

0.06

7(3

4.78

0)(3

1.81

0)(1

3.76

0)(1

5.11

0)(1

7.88

0)(1

9.77

0)(8

.420

)(4

.904

)

Obs

erva

tions

645

604

604

636

622

636

636

635

R2

0.43

90.

232

0.30

00.

257

0.53

50.

328

0.42

30.

115

Not

es: V

AT is

a d

umm

y va

riabl

e th

at is

1 if

a V

AT is

pre

sent

and

0 o

ther

wis

e. C

lust

er-r

obus

t sta

ndar

d er

rors

are

in p

aren

thes

es. A

ster

isks

den

ote

sign

ifi ca

nce

at th

e 1%

(***

), 5%

(**)

, and

10%

(*) l

evel

s.

National Tax Journal556Ta

ble

2Su

bstit

utio

n Ef

ect

s w

ith A

ltern

ativ

e Sp

ecif

catio

ns

VAT

Rev

enue

Inco

me

Cor

pora

teEx

cise

Sale

sSp

ecifi

c G

oods

Cus

tom

sPr

oper

ty

Pane

l A: D

epen

dent

Var

iabl

e: T

ax R

even

ue/T

otal

Rev

enue

VAT

0.04

8–1

.967

*–0

.499

–20.

00**

*–5

.861

*–4

.033

***

–1.2

56**

(2.1

52)

(1.0

99)

(2.2

64)

(3.8

38)

(2.8

99)

(1.1

78)

(0.5

11)

Obs

erva

tions

642

604

604

636

622

636

636

636

Adj

uste

d R

20.

403

0.33

00.

359

0.28

10.

626

0.41

90.

546

0.13

8

Pane

l B: D

epen

dent

Var

iabl

e: T

ax R

even

ue/G

DP

VAT

0.19

2–0

.507

**0.

254

–3.6

79**

*–0

.723

–0.7

84**

–0.1

81*

(0.3

81)

(0.2

13)

(0.3

95)

(0.8

95)

(0.5

93)

(0.3

06)

(0.0

98)

Tota

l rev

enue

/GD

P0.

164*

*0.

338*

**0.

233*

*0.

049

0.04

80.

041

–0.0

030.

030

(0.0

77)

(0.0

86)

(0.0

85)

(0.0

46)

(0.0

34)

(0.0

57)

(0.0

12)

(0.0

24)

Obs

erva

tions

636

604

604

636

622

636

636

635

Adj

uste

d R

20.

429

0.45

70.

497

0.27

50.

542

0.33

50.

423

0.13

6

Pane

l C: D

epen

dent

Var

iabl

e: T

ax R

even

ue/T

otal

Rev

enue

VAT

–0.3

31–2

.316

*–0

.219

–20.

53**

*–5

.400

*–3

.934

***

–1.2

27**

(2.1

15)

(1.1

41)

(2.5

09)

(3.7

27)

(3.1

63)

(1.1

81)

(0.4

63)

Tota

l rev

enue

/GD

P–0

.343

0.42

8*0.

394

–0.2

350.

262

–0.3

88–0

.083

–0.0

25(0

.377

)(0

.243

)(0

.235

)(0

.229

)(0

.154

)(0

.261

)(0

.051

)(0

.090

)O

bser

vatio

ns63

360

460

463

662

263

663

663

6A

djus

ted

R2

0.36

40.

359

0.40

50.

295

0.63

40.

441

0.55

10.

139

Not

es: O

nly

the

coeffi c

ient

s on

VAT

and

Tot

al R

ev/G

DP

are

repo

rted

from

the

full

equa

tion.

VAT

is a

dum

my

varia

ble

that

is 1

if a

VAT

is p

rese

nt a

nd 0

ot

herw

ise.

Clu

ster

-rob

ust s

tand

ard

erro

rs a

re in

par

enth

eses

. Ast

eris

ks d

enot

e si

gnifi

canc

e at

the

1% (*

**),

5% (*

*), a

nd 1

0% (*

) lev

els.


the adoption of a VAT is a political decision that depends on the expected support from voters.

In general, Dit is potentially correlated with ζit because the two error terms (ζit and uit) may be correlated. For instance, an upward bias in the estimate of β1 would occur if a country with a larger government is more likely to adopt a VAT (K&L, 2010). In order to solve this problem of endogeneity, the structural equation requires a critical assumption that Zit, an instrumental variable (IV), is independent of the error terms ζit and uit. Note that correlation between Dit and Zit is assumed: cov(Dit · Zit) ≠ 0 . If Zit satisfi es these two assumptions, then any effect of Zit on TRit must be only through an effect of Zit on Dit. In this model, β1 implies the causal effect of Dit on TRit and is analogous to the local average treatment effect (LATE) (Imbens and Angrist, 1994).22

Table 3 presents the estimation results of a dummy endogenous variable model. Since within estimators require a stronger exogeneity assumption on the independent variables in a dynamic panel model, the fi rst-differences estimation method was used for the analysis. All the variables except the VAT are in natural logs. For the latent index function, either a probit model or a linear probability model (LPM) is applicable. A probit model has several advantages over the LPM, but probit models exhibit a serious numerical problem in the statistical package STATA.23 Thus, the current study uses the LPM rather than a probit model.

The index function (7) uses four instrumental variables (Zs), including the current and one-year lagged sales tax revenue of total government, population density, and European Union (EU) membership.24 These instrumental variables are expected to satisfy the requirement of having an impact on the VAT adoption, but they have no direct infl u-ence on total revenue. In particular, in many countries with multi-level governments, sales taxes have been replaced by VATs in order to eliminate “tax cascading” in the tax system. In any case, sales tax revenue has not been essential to central government revenues. For example, two-thirds of OECD countries had only local sales taxes or trivial amounts of central sales taxes during the 1970–2007 period.

Densely populated countries are more likely to adopt a VAT because dense population implies low administration costs and a large potential tax base. For instance, Kenny and Winer (2006) have found that countries rely more on sales taxes, for which the VAT is a main substitute, as population density increases. EU membership can also be an instrument because the adoption of a VAT is a precondition for EU membership, and EU membership is not directly related to revenue size.

The index function is always statistically signifi cant for all variations of the specifi ca-tions in Table 3.25 The fi rst stage F-statistics rule out underidentifi cation of the model,

22 LATE can be defi ned as αz,w = E[Yi(1) –Yi(0)│Di(z) ≠ Di(w)], where Yi(1) is the response with treatment D for individual i, and Yi(0) is the response without treatment.

23 The LPM also has a few theoretical problems: it assumes a constant marginal effect; it does not guarantee 0 < E(D) < 1; and the error term is not homoscedastic (Greene, 2011).

24 Total government refers to multi-level governments (federal, state, and local).25 We present these results in the working paper version of this paper.


Tabl

e 3

Caus

al E

f ect

s of

the

VAT

(Dep

ende

nt V

aria

ble:

Ln

Tota

l Rev

enue

/GD

P)

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

Lagg

ed T

otal

Rev

enue

–0.0

170.

003

–0.0

010.

010

0.07

2(0

.036

)(0

.039

)(0

.043

)(0

.046

)(0

.056

)

VAT

0.07

3**

0.07

0**

0.07

1**

0.07

0**

0.06

10.

061

0.03

20.

032

–0.0

26(0

.033

)(0

.033

)(0

.032

)(0

.032

)(0

.051

)(0

.052

)(0

.047

)(0

.048

)(0

.094

)

YPC

0.04

90.

047

0.03

70.

038

0.09

0*0.

090*

0.10

1*0.

102*

0.14

0*(0

.042

)(0

.043

)(0

.047

)(0

.047

)(0

.054

)(0

.054

)(0

.061

)(0

.061

)(0

.074

)

AG

R–0

.040

*–0

.038

–0.0

50*

–0.0

51*

–0.0

76**

*–0

.077

***

–0.0

70**

–0.0

70**

–0.0

84**

(0.0

24)

(0.0

24)

(0.0

26)

(0.0

26)

(0.0

29)

(0.0

29)

(0.0

32)

(0.0

32)

(0.0

35)

Ope

n0.

028

0.01

90.

023

0.02

20.

036

0.03

50.

039

0.03

80.

045

(0.0

31)

(0.0

33)

(0.0

38)

(0.0

38)

(0.0

42)

(0.0

42)

(0.0

46)

(0.0

46)

(0.0

52)

POP

1.12

70.

944

1.07

11.

095

1.32

91.

358

1.40

31.

384

–0.0

81(0

.764

)(0

.776

)(0

.886

)(0

.888

)(0

.937

)(0

.940

)(1

.102

)(1

.105

)(1

.363

)

Elde

rly–0

.109

–0.0

99–0

.096

–0.0

86–0

.177

–0.1

76–0

.054

(0.1

97)

(0.1

98)

(0.2

17)

(0.2

17)

(0.2

35)

(0.2

35)

(0.2

69)

Yout

h–0

.116

–0.1

230.

022

0.01

4–0

.019

–0.0

160.

522*

(0.2

13)

(0.2

13)

(0.2

35)

(0.2

35)

(0.2

50)

(0.2

50)

(0.2

97)

Fem

ale

–0.0

26–0

.030

0.07

70.

072

0.02

80.

030

–0.1

11(0

.145

)(0

.145

)(0

.156

)(0

.156

)(0

.169

)(0

.170

)(0

.284

)

Lagg

ed D

ebt

0.05

6***

0.05

6***

0.05

2**

0.05

2**

0.03

5(0

.018

)(0

.018

)(0

.022

)(0

.022

)(0

.028

).


Lagg

ed S

ocia

lex

0.03

80.

038

0.03

1(0

.049

)(0

.049

)(0

.062

)

Lagg

ed C

ompe

n0.

002

(0.0

03)

Con

stan

t–0

.002

–0.0

01–0

.003

–0.0

03–0

.008

–0.0

08–0

.007

–0.0

07–0

.002

(0.0

03)

(0.0

03)

(0.0

05)

(0.0

05)

(0.0

05)

(0.0

05)

(0.0

05)

(0.0

05)

(0.0

06)

Obs

erva

tions

775

759

645

644

547

546

480

480

344

1st s

tage

F st

atis

tic91

.11

88.3

276

.84

74.4

134

.54

33.7

452

.49

51.4

513

.18

Sarg

an te

st, p

<0.

323

0.30

40.

359

0.35

70.

538

0.53

70.

359

0.35

40.

658

Not

es: V

AT is

a d

umm

y va

riabl

e th

at is

1 if

a V

AT is

pre

sent

and

0 o

ther

wis

e. A

ll th

e in

depe

nden

t var

iabl

es a

re a

lso

in n

atur

al lo

gs.

Clu

ster

-rob

ust s

tand

ard

erro

rs a

re in

par

enth

eses

. Ast

eris

ks d

enot

e si

gnifi

canc

e at

the

1% (*

**),

5% (*

*), a

nd 1

0% (*

) lev

els.


while the Sargan test for overidentifi cation indicates that the instruments are exogenous. This suggests that the weak instrument problem may not be serious, if relevant at all.

Columns (1) and (2) are the benchmark models, with the one-year lagged dependent variable in (2). Columns (3) and (4) add three demographic variables, including percent-age elderly, percentage youth, and percentage of labor force that is female. Columns (5) through (9) show the infl uence of political variables. All of the political variables are lagged by one year because policy implementation typically requires some time to take effect.

Note that the VAT adoption seems to have causal effects on government revenue if there is no consideration of political variables. Columns (1) through (4) show that the coeffi cients on the VAT are positive and statistically signifi cant at the 5 percent level. The average impact of VAT adoption is about a 7 percent increase of total revenue as a share of GDP. However, when political variables are considered, VAT adoption no longer has a signifi cant effect on government size. Columns (5) through (9) show that the coeffi cients on the VAT are not statistically signifi cant. That is, the impact of an effi cient tax is dominated by the impact of the demand-side variables. This result corresponds with the predictions of our model. The majority of government growth is caused by demand-side factors, such as income classes, organized interest groups, and budget-maximizing bureaucrats.

Three political variables have positive relationships with revenues. Debt is statistically signifi cant in most specifi cations, and a 1 percent increase in debt is associated with a greater than 0.05 percent increase in total revenue/GDP. Thus, we see that demand in excess of available resources, or debt, plays an important role in determining govern-ment size. Social expenditure and the compensation of government employees are not signifi cant. This result is partly attributable to the limitations of our data because the variables contain information that is not relevant for our analysis, such as social security expenditures and the compensation of employees in local governments.

E. Causal Ef ects with Alternative Specif cations

Does altering the specifi cations of the model change the basic conclusion that the adoption of a VAT does not signifi cantly affect the size of government? To examine this, we estimated alternative specifi cations of our empirical model based on the data and methods used by K&L (2010). Like K&L, we used general revenue (i.e., the sum of total revenue and social security contributions) relative to GDP as a dependent variable.

Panel A of Table 4 shows the empirical results of our dummy endogenous model, which adds the major covariates used by K&L (2010). First, we added neighborhood effects and a federal structure dummy to the instrumental variables for the index func-tion (7).26 Neighborhood effects are measured by the proportion of countries in the same

26 Participation in an IMF program is the only variable in K&L (2010) that we did not consider.


Tabl

e 4

Caus

al E

f ect

s w

ith A

ltern

ativ

e Sp

ecif

catio

ns(D

epen

dent

Var

iabl

e: L

n G

ener

al R

even

ue/G

DP)

(1)

(2)

(3)

(4)

(5)

(6)

Pane

l APa

nel B

IV fo

r VAT

= Z

s + N

eigh

bor,

Fed

IV fo

r L. G

ener

al R

ev/G

DP

= 3r

d an

d 4t

h la

gs o

f Gen

eral

Rev

/GD

P

VAT

0.06

3**

0.70

6*–0

.940

0.01

70.

185

–0.6

22(0

.025

)(0

.379

)(0

.981

)(0

.028

)(0

.222

)(0

.566

)Y

PC×V

AT–0

.159

*0.

213

–0.0

280.

140

(0.0

89)

(0.2

22)

(0.0

86)

(0.1

26)

AG

R×V

AT–0

.008

*–0

.007

–0.0

08–0

.008

(0.0

05)

(0.0

11)

(0.0

54)

(0.0

12)

Ope

n×VA

T0.

0002

0.00

030.

0003

0.00

03(0

.000

5)(0

.000

6)(0

.003

)(0

.000

6)

Fed×

VAT

–0.0

21(0

.042

)La

gged

Deb

t0.

040*

*0.

040*

(0.0

18)

(0.0

24)

Lagg

ed S

ocia

lex

0.04

90.

048

(0.0

40)

(0.0

43)

Lagg

ed C

ompe

n0.

0006

0.00

0(0

.002

)(0

.002

)

Not

es: O

ther

inde

pend

ent v

aria

bles

are

not

repo

rted.

VAT

is a

dum

my

varia

ble

that

is 1

if a

VAT

is p

rese

nt a

nd 0

oth

erw

ise.

Clu

ster

-rob

ust s

tand

ard

erro

rs a

re

in p

aren

thes

es. A

ster

isks

den

ote

sign

ifi ca

nce

at th

e 1%

(***

), 5%

(**)

, and

10%

(*) l

evel

s.


geographical region that have implemented VATs. Federal systems are less likely to adopt VATs because lower-level governments often prefer to be the sole user of sales taxes. Second, we considered four interaction terms that vary the impact of the VAT with income, agriculture, openness of the economy, and a federal structure dummy. According to K&L (2010), positive and statistically signifi cant coeffi cients on the inter-action terms in VATs imply that countries that have adopted VATs experience revenue gains. In column (1), our benchmark model, the VAT is positive and signifi cant at the 1 percent level. After adding the interaction terms in the VAT in column (2), the VAT coeffi cient is still positive and signifi cant at the 10 percent level, but the interaction terms are either negative or not statistically signifi cant. In column (3), which introduces the demand-side variables, the effect of the VAT on government size becomes negative and is not signifi cant. In contrast, all the demand-side variables are positive, and debt is statistically signifi cant.

Panel B of Table 4 shows the results of the method used in K&L (2010). Following Maddala (1983), K&L (2010) used a simple two-step estimation procedure with the inverse Mills ratio to deal with the problem of endogeneity (i.e., the possibility that the errors in the VAT adoption and total revenue equations are correlated). Since K&L found that the errors in the VAT adoption and total revenue equations are not correlated, the revenue equation was subsequently estimated by OLS or by GMM. Similar to K&L (2010), we treat our total revenue equation in (6) as exogenous to the VAT dummy. We also instrumented for the lagged dependent variable using the third and fourth lags of General Revenue/GDP. In all three columns, none of the VAT-related variables are statistically signifi cant. In contrast, all the demand-side variables are positive, and debt is still statistically signifi cant at the 10 percent level.

K&L (2010) has the advantage of a large sample of 143 countries that included many types of political regimes. However, including regional dummies may not be suffi cient to deal with heterogeneity, which will be embedded in all the coeffi cients (Islam and Winer, 2004). Similarly, fi xed effects that allow constant terms to vary are not suffi cient to capture all the important differences in political regimes. Thus, the results of K&L (2010) are altered in this study by confi ning the sample to the OECD countries.

Our smaller sample size also makes our results more relevant to the United States. The larger sample size used by K&L (2010) includes many developing countries that adopted the VAT in the face of very low revenues from alternative tax instruments. This suggests that the VAT-induced increases in government spending in those developing countries may have increased government services from very low levels, an effect that would not be relevant in the current U.S. context. Another problem with using a large sample is that the sample may not effectively distinguish between countries that replaced inferior taxes (e.g., a turnover tax) with the VAT and countries that did not. Further, data on key demand-side variables (debt, social expenditure, and compensation of govern-ment employees) are not available for the large sample over 38 years (1970–2007).

Note that our empirical method and results are different from those of K&L (2010). We instrumented for VAT adoption, while K&L (2010) treated the VAT dummy as largely


exogenous to the revenue equation. The VAT adoption equation of K&L, for instance, does not consider the Zs (i.e., the instrumental variables employed in this paper) or demand-side factors. More importantly, we show that the inclusion of demand-side variables signifi cantly alters the fi ndings about the impact of VATs on the size of gov-ernment. Any causal effect model is subject to an omitted variable bias if it does not include demand-side policy variables that affect government expenditure.

V. CONCLUSION

Our conclusion is in line with that of Wallis (2000, p. 80), who argued, “there is no substantial evidence to suggest that tinkering with revenue structure will change the size of government.”

Since the empirical evidence suggests that the causal effect of VAT adoption on the size of government is not statistically signifi cant (at least for OECD countries), we tend to reject the positive version of the money machine hypothesis. This also implies that there is no strong evidence for the normative version — that the adoption of a VAT leads to an ineffi cient overexpansion of government. More effi cient tax systems necessarily improve social welfare.

Our fi ndings have two crucial implications. First, since the growth of government mainly depends on the demand side of government spending, it is plausible that the direction of causality goes from the size of government to the tax structure. Many European countries, such as France and Germany, have reduced the size of central government revenues (excluding social security contributions) since the 1980s, but not because the tax structures of these countries have become less effi cient during the period. Additionally, the diminished size of government in the Reagan-Thatcher period is not primarily explained by less effi cient taxes. On the contrary, a more credible assertion is that greater demand for government spending causes an alteration in the tax structure. Facing growing expenditures, governments have had every reason to fi nd new, effi cient revenue sources. Given the level of revenue, effi cient tax systems enable governments to reduce the political opposition to taxation, as well as to increase revenues, given the social costs of the taxation. Tax structure accommodates the demand-side changes, and the increased usage of VATs in the last several decades of the 20th century should be understood as a collective choice in response to the growing demands for public expenditures.

The second implication is that government growth can be effectively controlled only through demand-side policies. Institutional arrangements are particularly important because rent seeking may be limited by collective-choice mechanisms such as voting, elections, and legislative procedures. The Budget Enforcement Act (1990) pay-go mechanisms in the United States are examples of such demand-control efforts. Persson and Tabellini (1999) and Mueller (2002) have suggested that interest groups more eas-ily increase government transfers in the European parliamentary governments than in the more decentralized presidential system of the United States, and that proportional representation systems are more conducive to large government than are majoritarian


systems. Despite having a presidential and majoritarian system, the problem for the United States is that Congress, with its locally-oriented representatives, focuses on spending for the benefi t of special interests. The problem in the United States is fi scal imbalance, not accommodating taxes.

ACKNOWLEDGEMENTS AND DISCLAIMERS

We wish to thank three anonymous referees, editors George Zodrow and William Gentry, Jinyong Hahn of U.C.L.A. and Byeong-in Im of Chungbuk National Univer-sity, seminar participants at the Seoul National University, and participants at the 2012 meetings of the Korean Association of Public Finance for valuable comments and sug-gestions. Dongwon (Dan) Lee thanks his colleagues at the Sungkyunkwan University for helpful advice. This work was supported by the National Research Foundation of Korea Grant funded by the Korean Government (NRF-2012S1A5A8021942). The views expressed here are those of the authors and do not necessarily refl ect those of their affi liated institutions.

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APPENDIX

To derive (3), use (2) to obtain

(A1) ′′′′

⎡

⎣⎢⎡⎡

⎣⎣

′′′′

⎤

⎦⎥⎤⎤

⎦⎦

⎡

⎣⎢⎡⎡

⎣⎣

⎤

⎦⎥⎤⎤

⎦⎦=

⎡

⎣⎢⎡⎡

⎣⎣

⎤

⎦⎥⎤⎤

⎦⎦

f C′′ −f

ff C′′ −

dTdT

dC0

,AAC

BBC

A

BAC

which imply

(A2) ⎡

⎣⎢⎡⎡

⎣⎣

⎤

⎦⎥⎤⎤

⎦⎦=

′′− ′′

⎡

⎣⎢⎡⎡

⎣⎣

− ′′′′

⎤

⎦⎥⎤⎤

⎦⎦

⎡

⎣⎢⎡⎡

⎣⎣

⎤

⎦⎥⎤⎤

⎦⎦

dTdT w

f C′′ −f

ff C′′ −

dC1

0

,

A

BBBC

AACAC

where w = CAACBB –f ″(CAA + CBB). Using a similar method, obtain

(A3) ⎡

⎣⎢⎡⎡

⎣⎣

⎤

⎦⎥⎤⎤

⎦⎦=

− ′′′′

⎡

⎣⎢⎡⎡

⎣⎣

′′− ′′

⎤

⎦⎥⎤⎤

⎦⎦

′′

⎡

⎣⎢⎡⎡

⎣⎣

⎤

⎦⎥⎤⎤

⎦⎦

dTdT w

f C′′ +f

ff C′′ +

dfdf

1,

A

BBBC

AAC

which imply

(A4) ′ = >dT df w( )C C+ 0.AAC BBC

Thus, dT/df ′ is larger than │dT/dCA│.


Table A1VAT Rates, Revenues, and VAT Revenue Ratio (VRR)

VAT Adopted Standard Rate VAT Revenue VRR (2008)Australia 2000 10.0 3.4 0.49Austria 1973 20.0 7.8 0.61Belgium 1971 21.0 7.0 0.49Canada 1991 5.0 2.7 0.74Czech Republic 1993 19.0 7.1 0.59Denmark 1967 25.0 10.1 0.62Finland 1994 22.0 8.4 0.58France 1968 19.6 7.1 0.49Germany 1968 19.0 7.1 0.55Greece 1987 19.0 7.2 0.46Hungary 1988 20.0 7.8 0.57Iceland 1989 24.5 9.1 0.54Ireland 1972 21.0 7.1 0.55Italy 1973 20.0 6.0 0.41Japan 1989 5.0 2.5 0.67Korea 1977 10.0 4.3 0.65Luxembourg 1970 15.0 5.8 0.93Mexico 1980 15.0 3.8 0.35Netherlands 1969 19.0 7.2 0.60New Zealand 1986 12.5 8.5 0.98Norway 1970 25.0 7.4 0.57Poland 1993 22.0 7.9 0.49Portugal 1986 21.0 8.4 0.51Slovak Republic 1993 19.0 6.9 0.54Spain 1986 16.0 5.2 0.46Sweden 1969 25.0 9.3 0.58Switzerland 1995 7.6 3.7 0.77Turkey 1985 18.0 4.9 0.35United Kingdom 1973 17.5 6.4 0.46Average 17.7 6.5 0.57Source: Organisation for Economic Co-operation and Development, 2010.


Tabl

e A

2Su

mm

ary

Stat

istic

s

Obs

erva

tions

Mea

nSt

anda

rd

Dev

iatio

nO

bser

vatio

nsM

ean

Stan

dard

Dev

iatio

n

Tota

l rev

enue

/GD

P 9

0521

.0 7

.5C

orpo

rate

tax/

tota

l rev

enue

861

11.9

6.4

Per c

apita

GD

P (lo

g)1,

051

4.0

0.5

Exci

se ta

x/G

DP

905

3.1

1.7

Agr

icul

ture

shar

e of

GD

P 9

73 6

.5 6

.0Ex

cise

tax/

tota

l rev

enue

905

14.7

5.9

Ope

nnes

s1,

039

71.1

41.6

Sale

s tax

/GD

P 8

84 0

.5 1

.4Yo

uth

(und

er a

ge 1

4/po

pula

tion)

1,10

222

.3 6

.1Sa

les t

ax/to

tal r

even

ue 8

84 2

.8 7

.8El

derly

(ove

r age

65/

popu

latio

n)1,

102

12.4

0.5

Tax

on sp

ecifi

c go

ods a

nd

905

4.1

1.9

se

rvic

es/G

DP

Popu

latio

n (lo

g)1,

101

7.1

0.6

Tax

on sp

ecifi

c go

ods a

nd

905

20.2

8.7

se

rvic

es/to

tal r

even

ueD

ebt (

cent

ral g

over

nmen

t deb

t/GD

P) 6

7345

.829

.2C

usto

ms a

nd d

utie

s /G

DP

905

0.5

0.7

Com

pens

atio

n of

gov

ernm

ent

542

25.6

5.4

Cus

tom

s and

dut

ies/

905

2.4

3.4

em

ploy

ees

to

tal r

even

ueSh

are

of fe

mal

e la

bor

812

41.4

5.2

Prop

erty

tax/

GD

P 9

04 0

.7 0

.7Po

pula

tion

dens

ity (l

og)

1,10

2 4

.2 1

.4Pr

oper

ty ta

x/to

tal r

even

ue 9

05 3

.5 3

.1To

tal g

over

nmen

t sal

es ta

x/ 9

55 2

.1 5

.2Fe

dera

l stru

ctur

e1,

102

0.3

0.5

to

tal r

even

ueSo

cial

exp

endi

ture

/GD

P 6

5519

.3 6

.4So

cial

ist

1,10

2 0

.1 0

.3VA

T re

venu

e/G

DP

1,06

6 4

.4 3

.6N

eigh

bor

1,10

2 0

.4 0

.2VA

T re

venu

e/to

tal r

even

ue1,

040

20.6

14.1

Educ

atio

n 9

6092

.821

.5In

com

e ta

x/G

DP

861

6.8

3.8

Urb

aniz

atio

n1,

102

70.9

12.7

Inco

me

tax/

tota

l rev

enue

861

32.1

12.6

Ener

gy1,

060

59.9

80.2

Cor

pora

te ta

x/G

DP

861

2.5

1.8

No

right

s 9

84 3

.3 2

.4

tax structure and government spending: does … · tax structure and government spending: does the...

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