Fiscal Illusion and Progressive Taxation with Retrospective Voting

We consider the tax progressivity decision of a rent‐maximizing government when voters’ perceptions of the tax price of public goods are biased by cognitive anomalies (i.e., fiscal illusion), and the electorate opts for re‐appointing or for dismissing the incumbent according to a retrospective voting logic. Given electoral and constitutional constraints, we show that the design of the tax system can be sensibly affected by fiscal illusion within the population of voters. Specifically, we find that (i) the tax system is more (less) progressive when taxes and public expenditures are perceived less (more), and (ii) an increase in the median voter’s income may positively or negatively affect tax progressivity depending on the nature (pessimistic or optimistic) of fiscal illusion. The impact of fiscal illusion on tax progressivity is validated by econometric analysis.