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On Fiscal Illusion and Ricardian Equivalence in Local Public Finance

Spencer Banzhaf () and Wallace Oates

No 18040, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: H3 H4 H7 Q2 R2 R5 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-geo, nep-pbe and nep-ure
Date: 2012-05
Note: EEE PE
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Published as "On Fiscal Illusion in Local Public Finance: Re-examining Ricardian Equivalence and the Renter Effect," National Tax Journal 66(3), 2013, pp. 511-40 (with W.E. Oates).

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