CFO as budget magician: fiscal illusion in public finance.

• Author: Miranda, Rowan A.

The strong economy of the past decade flushed the treasuries of many governments. Public officials who focused on tax cuts or "surplus management" initiatives only a short time ago are now facing budget deficits. Periodic economic downturns make the perennially difficult task of budgeting even more challenging. Yet austerity in public budgeting is more the norm than the exception and most public managers would probably agree that fiscal stress has been a routine feature of administrative life for most of their careers.

How do governments cope?

Experience tells us that under the incentive structure of fiscal federalism, deficits at the top of the food chain will trickle down to the bottom levels. As the federal government struggles with its projected deficits, it is likely that grant funding will be cut and unfunded mandates imposed, adding insult to injury. State and local governments, in turn, ratchet back into a "fixation on short-term gapsmanship" by balancing budgets one year at a time. (1)

The "first wave" of retrenchment steps often involves the use of budgetary reserves, postponement of major capital projects, and cutbacks to some programs and services. The "second wave" of actions-across-the-board cuts; overtime reductions; and freezes in hiring, purchasing, and travel-has more of a symbolic impact than a fiscal one. Former Treasury Secretary Lawrence Summers' statement, "I wouldn't want to skate on a flexibly frozen lake," illustrates this point. As first wave actions are used up, and second wave actions produce disappointing results, it is not uncommon for governments to adopt strategies meant to avoid difficult political decisions and disguise financial condition.

This article is about illusory fiscal practices that governments use in periods of budgetary stress-a topic that is generally referred to as "fiscal illusion" in the public finance literature. (2) In its most direct form, the theory of fiscal illusion suggests that the size of a government's budget will be larger than it would otherwise be because citizens face illusions regarding the tax price of public goods. (3)

Fiscal illusion may seem like an odd topic for an article in the main practitioner publication of the public finance profession, especially if governments use the information provided here as an inventory of steps to balance budgets. While this is not the intention, it also seems rather incomplete to present recommended budget balancing strategies in Government Finance Review, as it so often has through case studies, without discussing practices that are in violation of basic public finance principles. We therefore examine the topic of illusory fiscal practices and point out why such practices can undermine fiscal stability and distort citizen choices. There are many sources of "best practices", such as those developed by GFOA's standing committees and the National Advisory Council on State and Local Budgeting's recommended budget practices. (4) By identifying some "worst practices," we hope governments are steered in the direction of the tougher policy choices that are needed to address situations of budgeta ry stress.

THE THEORY OF FISCAL ILLUSION

"It is true that you may fool all the people some of the time; you can even fool some of the people all the time; but you can't fool all of the people all the time." Whether Abraham Lincoln actually said this is a matter for historians to decide. What is well known, though, is that elected officials and administrators make budgeting decisions strategically by considering citizen reaction to tax and service issues. Fiscal illusion refers to tax and spending mechanisms that distort the citizen's assessment and choices regarding the costs and benefits of government programs.

The original theory has been attributed to the Italian scholar Amilcare Puviani who wrote on the topic at the turn of the last century. (5) Puviani asked the question, "If the ruling group desires to minimize taxpayer resistance for any given level of revenues collected, how will it set out to organize the fiscal system?" (6) Economist James Buchanan synthesizes Puviani's answer:

The ruling group attempts, to the extent that is possible, to create fiscal illusions, and these have the effect of making taxpayers think that the taxes to which they are subjected are less burdensome than they actually are. At the same time, other illusions are created that make beneficiaries consider the values of public goods and services provided them to be larger than may actually be the case. (7)

It is important to distinguish citizen choices under uncertainty and imperfect information from those under an illusion. As Buchanan states, "If the chooser does not possess adequate information about alternatives and if he is uncertain, he conceptualizes the alternatives imperfectly If he is affected by an illusion, he conceptualizes the alternatives falsely." (8)

As odd as it may seem, the major challenge to solving the budget-balancing problem is to convince participants in the policymaking process that there is indeed a relationship between taxes and services. The elected executive may have run on a read my lips, no new taxes" platform. Legislators and governing board members are often "visionaries" concerning new programs but remain hesitant to cut spending in other areas or raise taxes or fees. Department heads, in the understandable drive to secure as much funding as possible to meet their service mission, are often focused on maximizing the size of their agency budgets regardless of the economic situation. Citizens, as surveys have shown repeatedly, can hold inconsistent tax and service preferences--wanting more services without supporting a tax or fee increase to pay for them. It is in these murky waters of conflicting agendas and priorities that finance officers and public managers face the challenging task of getting spending to match revenues. It is in this climate where the norms of professional financial management may be shelved in favor of politically expedient, illusory fiscal practices.

Many years ago, political scientist V.O. Key recognized the challenge facing governments in noting that:

simultaneous support of tax reduction and expansion of welfare activities [can be] entirely consistent for (individuals). For the system as a whole, however, this type of opinion combination is irrational and creates problems in program-making. ... [It] drives policymakers back toward concealed and indirect taxation, which may be regressive in its incidence. (9)

By examining how governments cope in periods of budgetary stress, it is possible to guide the practice of public finance both in terms of what to do...