November 17, 2014

Fiscal Illusions in Municipal Finance: The Latest Research

Mark J. Warshawsky

Former Senior Research Fellow
Summary

Economists call a fiscal illusion a systematic misperception of key fiscal parameters, often leading to distorted behavior by citizens and governments. In particular, the failure to perceive the full extent of tax burdens can lead taxpayers to misunderstand and underestimate the true cost of public goods and services and redistribution activities by the government.

Contact us
To speak with a scholar or learn more on this topic, visit our contact page.

Economists call a fiscal illusion a systematic misperception of key fiscal parameters, often leading to distorted behavior by citizens and governments. In particular, the failure to perceive the full extent of tax burdens can lead taxpayers to misunderstand and underestimate the true cost of public goods and services and redistribution activities by the government. Examples of fiscal illusion include debt illusion, which causes citizens to prefer bond issues over current taxes, and renter illusion, which causes renters to believe they do not effectively pay any property taxes.

In the context of the finances of the federal government, fiscal illusion is the negative of Ricardian equivalence, an economic theory under which taxpayers are indifferent to whether the government uses debt financing or tax financing because individuals would increase their savings and intended bequests to future generations to offset any increase in future taxes needed to pay for higher federal borrowing. At the state and especially local government levels, there is an added and more realistic mechanism at work to support Ricardian equivalence — the normal operation of local land markets, with aware and mobile citizenhomeowners, which capitalizes fiscal differentials into local property values. Hence, debt finance, paid by future taxes, would be capitalized into reduced current property values, thereby producing indifference among households between current taxation and borrowing by the government.

For many analysts, the assumption that citizens, even if mobile, are aware of government finances and that the state of those finances is embedded in property values is not a reasonable one, and therefore fiscal illusion should be considered the natural condition and behavioral framework. H. Spencer Banzhaf and Wallace E. Oates, professors of economics at Georgia State University and the University of Maryland, respectively, take a different approach. In their article,1 they argue that even with rational and fully aware citizens, Ricardian equivalence will fail, and effective fiscal illusion (debt and renter effects in particular) should operate because of other real economic considerations and not on illusory grounds.

Continue reading