On Fiscal Illusion and Ricardian Equivalence in Local Public Finance

37 Pages Posted: 19 May 2012 Last revised: 16 Jun 2012

See all articles by H. Spencer Banzhaf

H. Spencer Banzhaf

Georgia State University - Department of Economics; PERC - Property and Environment Research Center; National Bureau of Economic Research (NBER)

Wallace E. Oates

University of Maryland - Department of Economics; Resources for the Future

Multiple version iconThere are 2 versions of this paper

Date Written: April 1, 2012

Abstract

We re-evaluate two forms of fiscal illusion in local public finance: debt illusion and renter illusion. The Ricardian Equivalence Theorem for local governments suggests the form of finance of a public program (tax or debt finance) has no effects on substantive outcomes. For the local case, this results from the capitalization of local fiscal differentials into property values. We show that this version of the model is quite restrictive. In particular, in the U.S, context, where state and local interest is exempt from federal taxation, rational behavior may be inconsistent with Ricardian equivalence if local governments can borrow on more favorable terms than individuals. We also suggest a new test for renter illusion (or the renter effect). In particular, whether or not renters are more likely to support public investments in general, the renter effect suggests that renters are more likely to support them when financed with property taxes than with sales taxes. Using data from hundreds of open space referenda in the U.S. using a variety of finance mechanisms, we find evidence that households do prefer debt financing to tax financing, but find no evidence of the renter effect.

Keywords: Fiscal Illusion, Debt Illusion, Renter Illusion, Ricardian Equivalence, Local Public Goods, Open Space

JEL Classification: H3, H4, H7, Q2, R2, R5

Suggested Citation

Banzhaf, H. Spencer and Oates, Wallace, On Fiscal Illusion and Ricardian Equivalence in Local Public Finance (April 1, 2012). Andrew Young School of Policy Studies Research Paper Series No. 12-15. Available at SSRN: https://ssrn.com/abstract=2062473 or http://dx.doi.org/10.2139/ssrn.2062473

H. Spencer Banzhaf (Contact Author)

Georgia State University - Department of Economics ( email )

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Wallace Oates

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