Wagner’s Law and Fiscal Illusion: An analysis of state government finances in Brazil

Abstract

The aim of this article is to analyze state-level public finances in Brazil. We examine the dynamics of governmental spending in a panel of 26 Brazilian states in search of evidence of Wagner's Law and Fiscal Illusion Hypothesis. For the period ranging from 2002 to 2015, three methodologies are applied: dynamic ordinary least squares (DOLS), fully modified ordinary least squares (FMOLS), and pooled mean group (PMG). The main empirical results found indicate that (1) there is strong evidence of Fiscal Illusion caused by public deficit and by central government transfer grants; (2) there are possible Flypaper Effects; (3) there is no evidence in support of Wagner's Law; (4) there is low publicness degree of local expenditures; (5) due to FiscalIllusion, less-developed Brazilian states tend to be stuck in a public expenditure growth mechanism, especially in expenses related to non-public goods, which tend to benefit private interests and lobby groups. K E Y W O R D S dynamic panel, Fiscal Illusion, Flypaper Effects, public expenditures, Wagner's Law J E L C L A S S I F I C A T I O N C23; H40; H72; H77 | 629 PRADO AnD DA SILVA | INTRODUCTIONBetween 2002 and 2015, federal government spending in Brazil increased approximately 88%, while population grew only 17% and per capita gross domestic product (GDP) expanded 24% in the same period. This growing pattern has also been observed at the state level. Out of the 26 Brazilian state governments, 1 17 have increased their spending by more than 80% in recent years, of which 12 have more than doubled that figure. Part of this increase is due to the type of fiscal federalism chosen after the ratification of the constitution, in 1988. Under Brazil's taxation system, taxation powers are shared among the federal government, states, and municipalities. Nevertheless, this distribution of powers is not balanced enough, and intergovernmental financial transfers were created to solve this problem. Just to give an idea, as of 2015, federal government grants represented more than 40% of the net revenue of 16 Brazilian states. In fact, Figure 1 (left graph) shows a significant correlation between public spending and transfer revenues made by the federal administration and to the states.Such growth in public spending has different explanations in the literature. For instance, Wagner (1883) sees the increasing pattern in public expenditure as inevitable, due to growing demand for government-provided goods and services, especially after the beginning of industrialization. The socalled Wagner's Law claims that there is a long-run trend of more than a proportional growth in government spending, relative to production (an income elasticity of demand for government-provided goods and services higher than 1), due to increase in national income.The validity of Wagner's Law has been found by many researchers, for different countries and regions.

Framework Proposal for the Analysis of Tax Illusion, Its Antecedents, and Consequents

“…Such findings corroborate the State's attempt to discourage taxpayers from seeking information using combinations of constructs, as Prado andSilva (2020) explained. Corroborating this, Teixeira (2018) states that the lack of knowledge about how much taxpayers receive and pay to the State causes fiscal illusion.…”

“…On the other hand, the public budget is a favorable space for developing fiscal illusion, influencing the size and quality of expenditures (Siqueira & Nogueira, 2014). Furthermore, biases in budget decisions are made by taxpayers because of underestimating the costs of public spending (Gemmell, Morrissey, & Pinar, 1999;Dell'anno & Dollery, 2014;Prado & Silva, 2020).…”

“…From the perception of Guziejewska (2016) and Dollery and Worthington (1996), the illusion is a false belief about something that does not exist or an erroneous and distorted interpretation, causing a misinterpretation of the costs and benefits of public services. Puviani (1976), Guillamón, Bastida, and Benito (2011), and Prado and Silva (2020) expose that fiscal illusion is caused by numerous variables combined by institutions to discourage taxpayers from seeking information. Among these factors is the lack of disclosure of public information and the non-compliance with aspects of budgetary and fiscal governance.…”

“…In turn, Quayle (2021) states that accounting and accountability can respond to public interest challenges concerning social, political, and moral aspects, providing a conceptual framework to guide situations. However, among the justifications for this scenario of creating a fiscal illusion is the combination of factors conducted by institutions to discourage taxpayers from seeking information on the financing of public expenditures (Prado & Silva, 2020). In this environment, the study highlights aspects related to the lack of disclosure of public information and non-compliance with budgetary and fiscal governance in exercising government activity.…”

Fiscal illusion and income inequality: an empirical investigation

“…Abatemarco and Dell'Anno (2020) revealed that an increase in the median voter's income can positively or negatively affect tax progressivity depending on the type (pessimistic or optimistic) of fiscal illusion. Prado & da Silva (2020) indicated that due to fiscal illusion, the less-developed Brazilian states tend to be stuck in a mechanism of public spending growth, especially in spending on non-public goods that tend to benefit private interests and lobby groups. In another study, Serrano et al (2022) concluded that the expansion of public spending in Brazil is partly due to fiscal illusion.…”