Fiscal illusion is a public choice theory of government expenditure first developed by the Italian economist Amilcare Puviani.[1][2] Fiscal illusion suggests that when government revenues are unobserved or not fully observed by taxpayers then the cost of government is perceived to be less expensive than it actually is. Since some or all taxpayers benefit from government expenditures from these unobserved or hidden revenues the public's demand for government expenditures increases, thus providing politicians incentive to expand the size of government.
Fiscal illusion has been used to explain the flypaper effect often seen when a higher level of government provides a grant to a lower level of government. Here, instead of reducing taxes in order to pass on the benefits of the grant to local taxpayers, the grant-receiving body increases expenditures in order to expand local services in some way. Fiscal illusion is invoked as an explanation because the local taxpayers are under the mistaken perception that the grant is to local government and not, in fact, to them.
Another example of fiscal illusion can be seen in local property tax politics. Here renters, who do not pay local property taxes directly, may vote for an expansion of local government services. Fiscal illusion theory suggests they support this policy because its cost is masked by its roundabout nature (through an increase in their rent payments).
In their book Democracy in Deficit (1977) James M. Buchanan and Richard E. Wagner suggest that the complicated nature of the U.S. tax system causes fiscal illusion and results in greater public expenditure than would be the case in an idealized system in which everyone is aware in detail of what their share of the costs of government is.[3]
Finally, another example of fiscal illusion may be seen in deficit spending. CATO Institute economist William Niskanen (2004), for instance, has noted that the ‘starve the beast’ strategy popular among US conservatives wherein tax cuts now force a future reduction in federal government spending is empirically false. Instead, he has found that there is ‘a strong negative relation between the relative level of federal spending and tax revenues.’ Tax cuts and deficit spending, he argues, makes the cost of government appear to be cheaper than it otherwise would be.
Mourao (2008) shows an empirical attempt to measure fiscal illusion for almost 70 democracies since 1960.[4]