How Does a Welfare State achieves Fiscal Sustainability? A Study of the Impact of Tax Equity

Abstract

This study seeks to identify institutional characteristics of financially sustainable welfare states that focus on tax structure. Using data collected from 17 OECD countries from 1986 to 2013, this study investigates the characteristics of fiscal sustainability of each welfare state. The model of simultaneous equations (three-step least-squares method) is used for treating simultaneousness between fiscal sustainability and welfare expenditures. As a result, increasing the level of tax burden generally has a positive effect on the fiscal sustainability of the welfare state. However, the most important point that should be considered is the manner of raising tax revenue that affects the sustainability of economic, political, and social dimensions for securing fiscal sustainability. Specifically, it is necessary to raise the equity between the sources of taxation in accordance with the ability to pay principle. Improving vertical equity can also make a positive contribution to the fiscal sustainability in order to secure the political legitimacy of the tax and mitigate the regressive burden, which may result from the expansion of a consumption tax. Finally, it is beneficial to fiscal sustainability of the welfare state to diversify the financial base by combining the ability to pay principle and the benefit principle.