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On Fiscal Illusion and Ricardian Equivalence in Local Public Finance

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  • H. Spencer Banzhaf
  • Wallace E. Oates

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.

Suggested Citation

  • H. Spencer Banzhaf & Wallace E. Oates, 2012. "On Fiscal Illusion and Ricardian Equivalence in Local Public Finance," NBER Working Papers 18040, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:18040
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    References listed on IDEAS

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    Cited by:

    1. David Stadelmann & Reiner Eichenberger, 2014. "Public debts capitalize into property prices: empirical evidence for a new perspective on debt incidence," International Tax and Public Finance, Springer;International Institute of Public Finance, vol. 21(3), pages 498-529, June.
    2. Salma Slimani, 2016. "Threshold Effects of Fiscal Policy on Economic Activity in Developing Countries," International Journal of Business and Social Research, MIR Center for Socio-Economic Research, vol. 6(3), pages 20-37, March.
    3. Schnellenbach, Jan & Schubert, Christian, 2015. "Behavioral political economy: A survey," European Journal of Political Economy, Elsevier, vol. 40(PB), pages 395-417.
    4. Schnellenbach, Jan & Schubert, Christian, 2014. "Behavioral public choice: A survey," Freiburg Discussion Papers on Constitutional Economics 14/03, Walter Eucken Institut e.V..
    5. Brunner, Eric J. & Ross, Stephen L. & Simonsen, Becky K., 2015. "Homeowners, renters and the political economy of property taxation," Regional Science and Urban Economics, Elsevier, vol. 53(C), pages 38-49.
    6. Dashle Kelley, 2014. "The political economy of unfunded public pension liabilities," Public Choice, Springer, vol. 158(1), pages 21-38, January.
    7. Lewis Evans & Neil Quigley, 2013. "Intergenerational Contracts and Time Consistency: Implications for Policy Settings and Governance in the Social Welfare System," Treasury Working Paper Series 13/25, New Zealand Treasury.
    8. Roberto Dell’Anno & Jorge Martinez-Vazquez, 2013. "A Behavioral Local Public Finance Perspective on the Renter’s Illusion Hypothesis," International Center for Public Policy Working Paper Series, at AYSPS, GSU paper1303, International Center for Public Policy, Andrew Young School of Policy Studies, Georgia State University.

    More about this item

    JEL classification:

    • H3 - Public Economics - - Fiscal Policies and Behavior of Economic Agents
    • H4 - Public Economics - - Publicly Provided Goods
    • H7 - Public Economics - - State and Local Government; Intergovernmental Relations
    • Q2 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Renewable Resources and Conservation
    • R2 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Household Analysis
    • R5 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Regional Government Analysis

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