Does VAT Necessarily Lead to Bigger Government Size? The Experience of States in India

Abstract

Many have held that value-added tax (VAT) generates higher revenue which then leads to bigger government spending. They cited the experience of European countries claiming that both the tax rate and the government size have risen over the years. The present study finds that there are exceptions to it based on the state level data of India. The tax was introduced as a replacement for sales tax about a decade ago but an increase in government size was not observed. Instead, higher revenues generated helped in the reduction of budget deficits when introduced along with a number of austerity measures among which was the enactment of the fiscal responsibility law (FRL) placing quantitative restrictions on budget deficits. Some states did witness bigger spending but most of them were observed to be financially weaker states receiving more central transfers. It enabled them to spend more without running into deficits and, hence, meet FRL obligations.JEL Classification: H7, H26, H50