Unfunded Pension Obligations as a Source of Fiscal Illusion for State Governments
Sneed, Cynthia A, Sneed, John E, Journal of Public Budgeting, Accounting & Financial Management
ABSTRACT. Prior research has examined the relationship between government expenditures and the complexity of a governmental unit to examine the fiscal illusion hypothesis. Fiscal illusion posits that unfunded government obligations lead to rapid government growth because taxpayers perceive the cost of services to be lower than would possible if the services had to be financed with immediate tax increases. This study investigates whether unfunded pension obligations are a source of fiscal illusion for states. The results of the analysis support the fiscal illusion hypothesis that states with unfunded pension obligations have higher levels of spending.
The economics literature offers two competing theories as explanations for the increases in the size of government. Fiscal illusion theory hypothesizes that debt financing allows governments to provide a higher level of services without raising additional taxes, and may encourage citizens to demand more services than they would if the services had to be paid for with immediate tax increases. Fiscal stress theory hypothesizes that governments are larger because of the complexity and diversity of their tax structure. Tax diversity can hedge against revenue variability, smoothing the amount of revenues governments receive. A stable tax structure allows governments to commit to higher levels of services because they are less vulnerable to decreases in revenues than they would be if their tax structure was unstable.
Buchanan and Wagner (1977) extended the fiscal illusion hypothesis by arguing that debt financing is a major cause of government expenditure growth. They argued that replacing current tax financing with government borrowing reduces the perceived cost of services to taxpayers (who do not anticipate the future tax liability implied by the borrowing). However, Buchanan and Wagner offered no empirical support for their hypothesis.
The purpose of this research is to test the Buchanan and Wagner hypothesis by examining unfunded state pension obligations as a source of fiscal illusion. This research examines the proposition that unfunded government obligations are a source of fiscal illusion and allow states to provide more services than would be possible if the plan were fully funded. Misiolek and Elder (1988) integrated the fiscal illusion and fiscal stress theories into one model to examine the factors that increase the level of state and local government expenditures. Their results supported the fiscal stress theory but not the fiscal illusion theory.
This study extends Misiolek and Elder's research by investigating unfunded state pension obligations as a source of fiscal illusion. Although prior research in the public choice literature suggests that unfunded obligations of governments should be included in the definition of public debt, little attention has been paid to unfunded government obligations as a potential source of fiscal illusion (Buitler and Tobin, 1979; Hills, 1984; Peacock and Rizzo 1987; Rizzo, 1990). However, Peacock (1986) and Peacock and Rizzo (1987) argue that adding unfunded government obligations to the definition of public debt could be an important extension of the fiscal illusion theory.
The research results provide evidence that unfunded government obligations are a source of fiscal illusion for state governments. Debt financing allows a government to provide more services than would otherwise be possible if the pension plan were fully funded. The unfunded pension obligations allow governments to "hide" the true cost of services, thereby increasing the demand for a higher level of government spending. The research results are among the first to lend empirical support to Buchanan and Wagner's claim that unfunded government obligations create government growth.
Prior attempts to test the fiscal illusion hypothesis using unfunded government obligations were hampered because of data availability (Rizzo, 1990). …