Fiscal Illusion in Public Finance: A Theoretical and Empirical Study

Abstract

This study of fiscal illusion begins by surveying existing studies of its nature and consequences: finding no consensus upon its definition proposes a comprehensive one: "the misperception by one or more individuals of the value of one or more fiscal parameters." No specifications of source, locus, nature, duration, variables affected, or direction of bias are presumed, and none are precluded. The issue of aggregation of individual perceptions, often preempted as definitional, is found to be crucial in interpreting the existing literature. The theoretical portion of the study uses the standard consumer choice model and the median voter model, again finding that the method of aggregating individual choices is crucial. It demonstrates that high average and total levels of fiscal illusion can be consistent with efficient social outcomes and that survey evidence is inappropriate for assessing the importance of fiscal illusion. It further finds that the impact of fiscal illusion on individual welfare provides a source of potential gain for agents who can dispel that illusion in individuals who may be decisive for the outcome of the collective choice process. An examination of the incentives of various agents to dispel illusion concludes that, though the existing literature evinces a recurrent concern that fiscal illusion results in misallocation of resources to and within the public sector, especially through the public officials' manipulation of citizens' perceptions, there exists a considerable array of forces that have significant power to limit the ability of such illusion to impose important burdens upon the electorate. The work concludes with an empirical study of the fiscal illusion hypothesis, in which estimates of the dollar magnitudes of the state tax "windfalls" resulting from the federal Tax Reform Act of 1986 are calculated and, in the estimated model, are found to exert no significant impact upon either the levels of state expenditures or changes in those levels. Because the windfalls are exogenous, this finding is free from the simultaneity issues that have compromised existing empirical studies of fiscal illusion. The results are consistent with the proposition that existing forces effectively limit the sway of fiscal illusion.