The Theory of Optimal Seigniorage – A State-Level Analysis for India

This paper examines the relevance of the inflation tax as a source of revenue within India's federal fiscal framework, by assessing the applicability of the optimal inflation tax theory proposed by Mankiw (1987) at the subnational level. The subnational focus is crucial in the Indian context due to significant inter-state variations in economic structure, fiscal capacity, tax composition, and institutional efficiency, which can influence the inflation-tax relationship in ways obscured by national aggregates. Departing from traditional time-series analyses, the study employs second generation panel data techniques – panel unit root (CIPS) and cointegration tests – to account for cross-sectional dependence and heterogeneity across Indian states. The analysis finds that inflation is stationary while the tax rate is trend stationary, justifying the use of the ARDL framework. Estimations using Mean Group and Pooled Mean Group methods reveal a long-run cointegration relationship, with a negative and statistically significant coefficient – contradicting the theoretical expectations of a positive link. This reflects India's institutional shift towards central bank independence and reduced reliance on seigniorage, after the implementation of the FRBM Act (2003). In contrast, the short-run dynamics exhibit a positive and significant relationship, indicating temporary inflationary pressures from tax increases. JEL Classifications: H21; H71; H77; E31; C23