CFO as budget magician: fiscal illusion in public finance.

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