Fiscal Illusion as an Explanation of Institutional Choice in a Federation

Abstract

"The fiscal 'illusion' hypothesis may be interpreted, following West and Winer (1978), as an assertion that utility maximizing public managers will invest resources to induce underestimation of tax-prices. They do so in order to maximize the size of government, subject to the controlling influence of the (median) voter under majority rule. Unfortunately for the voter, they will in general succeed if information about government activity is costly to acquire, and if political competition is imperfect. In this note, we use the fiscal illusion hypothesis to explain the choice of institutional arrangements in certain federations since 1945. In particular, we are interested in the growth of conditional or tied grants from federal to state or provincial governments."