Fiscal Illusion in State and Local Finances

Abstract

There is increasing pressure on state and local governments to be transparent. The ultimate goal of increased transparency is to improve the accountability and the efficiency of government through greater citizen awareness. However, despite the abundance of data now available at the click of a button, citizens are still distrustful and dissatisfied with government policies. Fiscal illusion may be at the root of the disconnect. Fiscal illusion suggests that the citizens systematically misperceive their tax burdens and subsequently the cost of government. These issues are discussed with an emphasis on the relationship between fiscal illusion and transparency in this essay.

Keywords

fiscal illusion intergovernmental local finance local revenues

Introduction

The Great Recession has put a spotlight on many aspects of government, causing both public officials and taxpayers to reconsider the role of transparency and accountability in public finance. For example, a growing amount of attention has been given to public debt, tax burdens, and public expenditures, and simultaneously there is a growing demand for more transparent reporting of revenues and spending at every level of government (Dell’Anno and Dollery 2014). In fact, transparency has been an important facet of President Obama’s administration: “[o]penness will strengthen our democracy and promote efficiency and effectiveness in Government…Transparency promotes accountability and provides information for citizens about what their Government is doing” (Obama 2009). Transparency is a result of a government providing information and data about its operation, policies, and management. Providing access to data has become a critical role of the federal government and is working its way through the states and to local governments.

States like Texas (www.texastransparency.org), Kentucky (opendoor.ky.gov), and Indiana (www.in.gov/itp) are leading the charge toward transparency, and many others are making active moves toward transparent data that are accessible, searchable, and highly detailed. However, this is not yet universal, and four states not only lack data that enable citizens to monitor public spending but do not even provide checkbook-level information (Davis, Baxandall, and Pierannunzi 2012). While, local governments have not been as fast to make the transition, there is momentum in this direction. For example, Asheville, North Carolina, has created a website that allows citizens to easily navigate through budget and revenue data; not only is the information available, but it is presented in an easy-to-understand format (avlbudget.org/expenses). For other examples of municipal governments increasing their transparency efforts, see the Sunlight Foundation that highlights municipalities with open data policies (sunlightfoundation.com/policy/local/).

Despite there being more data available to citizens on government activities than any other period in history—trust in government is at a record low (19 percent),¹ citizens believe their government spends too much (76 percent), and they believe that the tax system needs a major overhaul (72 percent).² Citizens’ distrust and frustration in government is exacerbated because citizens neither understand the cost of government nor where their tax dollars are going—providing information that citizens will actually process and absorb may be the best hope to rebuild this trust. This lack of understanding is true even in controlled experimental settings (Sanandaji and Wallace 2010; Sausgruber and Tyran 2011). For example, one study finds that the transparency of citizens’ tax burden had a strong impact on their demand for redistributive policies. Ninety percent of the citizens supported the policy when the tax was opaque versus only 10 percent when the same tax burden was transparent (Sausgruber and Tyran 2005). Results like these have troubling implications for democratic values under the current revenue structure because they imply that government is systematically providing a level of services that is not in keeping with citizens’ preferences.

There are many potential explanations for these disturbing trends, but one factor may be fiscal illusion. Fiscal illusion is the hypothesis that citizens systematically misperceive their true tax burdens and the benefit they receive from services provided by government. Fiscal illusion has been a popular topic for academics since Buchanan introduced the works of Puviani in 1967. The majority of empirical analyses have found evidence that fiscal illusion causes citizens to underestimate their tax burdens and demand a greater amount of public services than they would with complete information. This leads to an inefficiently high level of government expenditures (Misiolek and Elder 1988). The systematic misperception is key to understanding fiscal illusion. It is not that citizens are irrational or have behavior that is random and sporadic. What is observed is repeated, consistent behaviors—suggesting that there is an illusion in place creating a situation where citizens are rationally making choices based on a lower-than-actual perceived price of government. In fact, it has been suggested that fiscal illusion is an explanation for the dramatic increase in the size of the public sector during the twentieth century (Sausgruber and Tyran 2005; Mourao 2010).

Three reasons why fiscal illusion exists have been identified (Pommerehne 1978). First, the cost to a citizen of getting accurate information on tax burdens and public spending is high. Second, a citizen’s tax burden is spread out through the entire year (i.e., temporal spacing), making it more difficult to keep track of the costs. Third, citizens are taxed using many different revenue instruments (i.e., spatial spacing), which further obscure their true burden. This may be especially problematic at the local level because of the overlapping jurisdictions, or what is referred to as vertical fragmentation, that often rely on the same revenue sources, like the dependence on property taxes by county, municipal, and special district governments (Maher and Johnson 2008; Hendrick, Jimenez, and Lal 2011).

This article proceeds with a discussion of the foundational concepts involved in fiscal illusion. Once the fiscal illusion hypothesis is laid out, the five primary forms of fiscal illusion are explained with examples of modern applications of these hypotheses. The remainder of the article discusses how the fiscal illusion literature can better inform decision making related to revenues and citizen engagement.

Foundations of Fiscal Illusion

There are three authors who are considered the originators of fiscal illusion: John Ramsay McCulloch (1845), John Stuart Mill (1848), and the economist who coined the term, Amilcare Puviani (1903). Puviani is treated as the father of fiscal illusion; he posited that the ruling class designs public tax and expenditure policies to minimize resistance from the dominated class (Mourao 2008). To do this, the ruling class intentionally overestimates the benefits that the dominated class receives and tries to obscure the tax burden, so that they will underestimate it. In the case of democracies, the ruling class is the elected and public officials and the ruled are the citizens. Thus, the goal of public officials is to make tax burdens appear lower than they are and this may motivate the choice of tax instruments that are in place (Wagner 2001). Puviani asserted that taxpayers do not understand many aspects of public revenues including the number of taxes and fees and the subsequent revenue generated. This lack of understanding is complemented by a lack of awareness about aspects of public spending such as the amounts involved, the scope of services, and both the short-term and mid-term benefits (or effects) of those expenditures (Ferrari and Randisi 2013). The majority of research has been done on the revenue side of the fiscal illusion coin, which will be the focus of this essay.³

Embedded in the fiscal illusion hypothesis is that citizens will not be well informed about the cost of government. Many scholars explain this widespread phenomenon by rational ignorance. Downs (1957) argues that voters are (rationally) ignorant of happenings in the public sector which allows the public sector to rely on deceptive revenue portfolios. Similar to the revenue diversification argument—if the revenues (and budget documents) are sufficiently complicated, it will make the cost to taxpayers too high for them to monitor making it rational to “minimize…investment in political information” (Downs 1957, 148). A lack of information leads to inaccurate perceptions of tax burdens and the costs of government, that is, fiscal illusion.

A primary way in which fiscal illusions are created is through the use of less visible and less direct tax instruments. An often-used example is income taxes versus excise taxes. Income taxes, when not being automatically withheld, are extremely transparent. The amount that must be remitted is clear and citizens are able to easily, and with minimal cost, understand their burden. In contrast, excise taxes are included in the cost of the good, and taxpayers may not know what portion of the price is the tax or even that they are being taxed. Furthermore, excise taxes (e.g., on cigarettes or gasoline) are paid over time (temporally spaced). Instead of one bill being paid, there are many small opaque bills, making the information cost of knowing their burden very high (Buchanan 1967). Income tax became a less visible tax once withholding from wages became commonplace. Wagner (1976) highlights that a taxpayer being confronted with a bill versus a taxpayer being reminded of the tax through withholding will lead to different perceptions of the burden.

The mechanism behind fiscal illusion to a suboptimal demand for government services is frequently explained using a simple graph developed by Wagner (1976), here presented in Figure 1. In Figure 1, the line D is the demand for public services, as with all normal goods—demand increases as price decreases. P ₁ represents the actual price of government and P ₂ represents the perceived price of government. P ₂ is lower than P ₁ because of fiscal illusion. At the actual price, the optimal provision of government services is at X₁. Thus, with complete information, government services would be provided at point a. However, since citizens perceive their price to be lower (P ₂), they demand a higher level of services, represented here by X₂. Citizens believe that they are at point c, but in reality they are at point d. Allocation of government services at point b would occur if the costs were actually P ₂ and they perceived it to be P ₁.

Figure 1.

Fiscal illusion and oversupply of government services.

There is further evidence that transparency in the budget process can combat fiscal illusion. Transparency may lead to a smaller gap between the perceived price and the actual price (Alt and Lassen 2003; Benito and Bastida 2009; Hameed 2005; Sedmihradská and Haas 2012). This would lead to outcomes that are closer to the optimal.

Types of Fiscal Illusion

While the clearest instance of fiscal illusion arises through the use of less visible revenue instruments, scholars have identified five distinct fiscal illusion hypotheses. These five are well presented and described by Wagner (1976) and Oates (1988) and they are as follows: revenue complexity, revenue elasticity, renter illusion, debt illusion, and the flypaper effect.

Revenue Complexity

Fiscal illusion is not merely a question of how visible taxes are; it is also a question of how complex the revenue portfolio is. Complexity refers to how many taxes and revenue instruments are being used by a government. It is less costly for a taxpayer to understand their burden when there is only one tax instrument in place; however, “let a government levy simultaneously a sales tax with various exemptions, a variety of excise taxes, some perhaps collected at the wholesale level, sundry license fees bearing little or no relation to services rendered, and a tax on the profits of business corporations. The formation of an accurate perception regarding the price of public output would be vastly more difficult under this more complex revenue structure” (Wagner 1976, 51). As the number of instruments grow, the tax system becomes more opaque. This spatial spacing can be exacerbated by relying more heavily on less visible revenues and temporally spacing them (i.e., spreading the collection of them out over a long period). The bottom line is that the more complex a revenue system is, the larger the budget will be and the more fiscal illusion will be in place (Oates 1988). This is an important topic that has been studied a great deal, especially at the local level as there has been movement away from exclusively relying on the property tax to increased the use of sales taxes and fees (Hendrick 2002; Carroll 2009; Carroll and Johnson 2010).

Revenue Elasticity

The second fiscal illusion hypothesis regards the income elasticity of revenues. Income elasticity refers to the percentage change in revenue generated as a proportion of the percentage change in wealth.⁴ The more income elastic the revenue instrument, the more revenue it will generate as wealth in the community rises. This means that revenues will grow faster than wealth, without public officials having to change the rate. In theory, public officials should lower the rate to adjust for the additional revenue. However, the fiscal illusion literature suggests that they will not and that this additional revenue will be used to grow public sector spending but citizens will perceive this as a decrease in the price of government. Modern applications of this hypothesis have turned to property taxes studying whether, after property reassessments, the millage rate decreases to keep the property tax revenue neutral or whether governments take advantage of this growth. They have found that the millage rate is not kept revenue neutral (Ladd 1991; Ross and Yan 2013).

Two additional points are worth discussing here. First, this presumes that citizens care more about their rates than their burdens. This may seem farfetched; though consider the example of sales taxes. Citizens are more likely to know their sales tax rates than their actual burdens. Sales taxes are an income elastic tax, so as the wealth of a jurisdiction increases the revenue generated will increase even faster. A caution though, income elastic revenues grow faster than wealth, but also decrease faster than wealth when it falls (Hou and Seligman 2010; Afonso 2013). Citizens are unlikely to realize that their burdens have grown if the rate has not changed. Second, Wagner (1976) notes that public officials may select income elastic revenues that will grow with the economy, rather than having to readjust rates frequently. This is a reasonable choice, but it does not remove the threat of fiscal illusion for these income elastic revenues.

Renter Illusion

The third fiscal illusion hypothesis is referred to as renter illusion. Renter illusion refers to a phenomenon that, all else being equal, a jurisdiction with a greater proportion of renters will demand a higher level of public services. The rationale behind renter illusion is that renters will not fully understand their property tax burden because it is indirect (paid through their rent), so they will demand a higher level of services. While many studies have found support for this hypothesis (e.g., Dollery and Worthington 1996; Blom-Hansen 2005), Oates (2005) estimates the magnitude of the renter illusion and finds that if a jurisdiction was composed of exclusively homeowners, government would be 10 percent smaller. While many of the fiscal illusion hypotheses have competing explanations, the renter illusion hypothesis has one of the more salient alternative explanations: that renters consume less land, which translates into having lower property tax burdens than “like” homeowners—therefore, it is a rational choice to demand more government services and not the result of an illusion.

Debt Illusion

The fourth fiscal illusion hypothesis regards the balance of debt and current revenues. We know that citizens prefer debt to current revenues (Banzhaf and Oates 2012). Under debt illusion however, the hypothesis is that citizens are more likely to perceive the costs of public spending if it is being financed by current revenues rather than debt. Theory and evidence point out that debt and current revenues should produce the same burdens because debt should be capitalized into property values. Even still, citizens may not realize the true costs of current and future debt. This is a powerful fiscal illusion, and a ranking of European countries finds that the nations with the highest levels of debt are also the nations with the highest level of fiscal illusion (Dell’Anno and Dollery 2014). Additionally, this is one place where there is a massive amount of support for greater transparency and accountability (Tirole 2011).

Flypaper Effect

The final fiscal illusion hypothesis is the flypaper effect. Economic theory suggests that lump sum intergovernmental transfers or grants should be treated like increases in private income. However, there is evidence that this is not the case and that taxpayers are more willing to accept increases in public sector expenditures when the jurisdiction’s wealth increases due to intergovernmental transfers than with private wealth increases. The public perceives this “new revenue” as a reduction in the cost of services instead of a grant and thus erroneously supports higher levels of spending. This has serious ramifications for both the receiver and provider institutions. First, flypaper effect suggests a failure of democracy according to Oates (1994): that “representatives of the populace in state and local government do not follow, in budgetary terms at least, the will of the electorate” (p. 135). Second, Hewitt (1986) finds that while there are positive effects for the receiver government and demand for public sector service increases, there are negative effects for the provider government. Citizens perceive the loss in revenue as inefficient, and this results in a decrease in demand for the provider government’s services.

The flypaper effect literature has grown quite a bit and taken on interesting directions, including measuring the effects of earmarked revenues. In the case of earmarking, the theory suggests that if the earmark is less than the recipient program has spent on it (i.e., a partial earmark), then the new revenue should be treated as an increase in revenue for the jurisdiction. This would result in a modest increase in overall spending on the recipient program. However, the literature has found that the money tends to “stick,” so that the support for the program from the general fund revenue will not decrease by as much as expected. A broad analysis of the literature on earmarking estimates that about $0.45 of every earmarked dollar sticks to the recipient program (Sobel and Crowley 2010). Examining state-level earmarks, Nesbit and Kreft (2009) find that every dollar of earmarked revenue increases recipient program spending by an amount that is not statistically different from a dollar. Their finding holds for both intergovernmental transfers and state-earmarked revenues. These findings have implications for intergovernmental grants and should help shape how money is transferred.

For an in-depth review of the fiscal illusion literature, please see Dollery and Worthington (1996).

Application to Practice

Fiscal illusion presents numerous challenges for governing. Looking at current revenue streams and structures in place (e.g., reliance on sales taxes, continued use of tax withholding, and the growing use of intergovernmental grants) as well as potential revenue streams on the horizon, it is conceivable that fiscal illusions will rise. Additionally, as more levels of government share a tax base, it will become increasingly difficult for taxpayers to track what money is going where and to hold the appropriate level of government accountable (Weingast 2009; Boetti, Piacenza, and Turati 2012; Liberati and Sacchi 2013). Examples of shared tax bases are the federal government and state governments taxing income, and state and local governments taxing the sales of goods.

One example of a revenue change on the horizon that is likely to increase the level of fiscal illusion is increased consideration of hydraulic fracturing or “fracking.” The issue of fracking is complicated and outside the scope of this essay, but it is considered “windfall” revenue and its potential for state revenue is substantial (Pless 2012). The fiscal illusions created by windfall revenues are large and can be harmful to accountability due to their unexpected (and nonrecurring) nature—they are mostly as a result of natural resource extraction (Ross 2001; Jensen and Wantchekon 2004; Ramsay 2011; Paler 2013). Another example of a new potential revenue source is value-added taxes (VATs). VATs, like excise taxes, tend to be opaque. It is difficult for citizens to understand their burdens because they are included in the price of the good. Also like excise and sales taxes, they are temporally spaced, making the possibility of a fiscal illusion even greater.

In the face of all this illusion, what can governments do? First, they can recognize that the most palatable taxes to citizens may also be the most illusionary and choose to rely on more visible, as opposed to opaque, revenue instruments. The literature provides evidence that more transparent tax structures (in terms of the visibility) leads to increased rationality of policy outcomes (Sausgruber and Tyran 2005). Wagner (2001) expresses a number of frustrations with the current system and its lack of transparency.

The most direct and truthful way of taxing people is to send them monthly bills, much as we pay for our utilities. Politicians never do this. We don’t get a monthly bill for government. Income taxes are withheld even before we receive our paychecks. Moreover, we don’t pay one tax. We pay dozens of individual smaller taxes, and in many different ways. We pay income taxes, Social Security taxes, Medicare taxes, death taxes, business taxes, tobacco taxes, sales taxes, and excise taxes, just to name some of the more prominent categories. The only tax that is paid in similar fashion to a utility bill is the real property tax, and many people pay this tax through an escrow account. That the property tax generally ranks low in popularity is an observation that Puviani would have understood. (Wagner 2001, 1)

Such a suggestion may not be feasible due to electoral disincentives and legal constraints, but there are other opportunities to better serve citizens and decrease fiscal illusions. Governments can continue to increase their transparency. If more opaque burdens harm the legitimacy of government (Mourao 2010; Payton and Kennedy 2013), the public sector needs to intentionally and proactively inform the public, who need to understand the ramifications of different revenue policies including what the respective burdens actually are (Payton and Kennedy 2013).

Transparency and citizen education are not simple tasks and there are no universal solutions. The difficulty in reaching citizens (Downs 1957) is why many governments are going beyond just a “data dump” to innovating and experimenting with how to best relay information and engage taxpayers. Citizen academies (International City/County Management Association 2014), taxpayer receipts (Kendall and Kessler 2010; Santacroce and Gibson 2012; Afonso 2014), partnerships with Code for America (codeforamerica.org), and interactive tools like Budget Hero (American Public Media 2012) are ways that governments are engaging and educating their citizens to promote actual transparency despite citizens’ perceived “aversion to fiscal issues” (Cooper 2011).

In order for public officials to achieve their objectives of engaging citizens in a productive and meaningful way, increased transparency is a critical step toward rebuilding trust.⁵ Government must take steps to inform citizens as to (1) the scope of government activities, (2) why the government provides those services and what their benefits are, and (3) how much those services cost and how they are financed. Such knowledge will allow citizens to make well-informed decisions about their desired level of taxes and services.

Footnotes

Declaration of Conflicting Interests

The author declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.

Funding

The author received no financial support for the research, authorship, and/or publication of this article.

Notes

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