Do governments grow when they become more efficient? Evidence from tax withholding

The paper examines the claim that more efficient taxes lead to bigger government by studying the effects of income tax withholding, a particular technological shock to tax efficiency. I exploit the variation in the timing of the adoption of withholding by state governments in the USA during the 1940's through 1970's. Due to better compliance and other factors, withholding immediately and permanently increased income tax collections by 22 percent at given tax rates which corresponds to 2.7 percent reduction in deadweight costs. I find strong evidence that governments did respond to this efficiency shock; however, the major response was a shift in the composition of revenues towards a heavier reliance on the income tax. States sharply increased revenues from other taxes as they implemented withholding, which indicates that a need to raise more revenue was an important motive for the adoption of withholding. Withholding increased total tax revenues by 8.3 percent, but I find that the causal relationship from more efficient taxes to a bigger government accounts for at most 3.4 percent, while at least 4.9 percent should be attributed to a higher demand for spending that stimulated the adoption. Contrary to claims that withholding was the thing that enabled the post-war explosion of income taxation, I find that it did accounts for approximately 9 percent of the growth of state income taxes during the period in question.