The Phenomenon of Fiscal Illusion from Theoretical and Empirical Perspective: The Case of Euro Area Countries

Abstract

Purpose: The aim of the research is to build an index of fiscal illusion to assess the size of the problem in regards to the euro area countries in the period 2004-2016. Design/Methodology/Approach: The analysis of fiscal illusion phenomenon is based on critical analysis of public finance literature which helped in indicating the main sources of fiscal illusion and capturing its different dimensions. In addition, literature analysis enabled the selection of the most appropriate measures related to various aspects of illusion. Initially, the principal component analysis (PCA) was conducted to identify main factors which should be included in the formula of index. The selected factors were built on the basis of different measures and indicators that can be assigned to the selected dimensions of fiscal illusion. This allowed to construct the index of fiscal illusion. Findings: The authors noticed that economies characterized by a relatively high fiscal illusion and low quality of public finance may find it difficult to achieve fiscal sustainability in the long-term. In the analyzed period, the highest average value of the fiscal illusion index was recorded in Italy (the average FII 0,935), while the lowest in Estonia (the average FII 0,07). The results of the study revealed the significance of institutional determinants, which both influence the quality of public finance and the size of fiscal illusion. Practical Implications: The results are important not only for policymakers to understand the consequences of their decisions for public finance sustainability, but also for society, increasing its awareness of current tax burdens paid and benefits received. Originality/Value: The paper discusses the most important issues regarding fiscal illusion which seems to be obstacle in achieving public finance sustainability. The results of the research certainly enriched the existing knowledge on the phenomenon of fiscal illusion, its causes and ways of measurement. © 2020 International Strategic Management Association.All rights reserved.