Tax Reforms, Fiscal Illusion and Moral Hazard: Some Econometric Evidence from Indian Economy

Abstract

Theory of Fiscal illusion as a theory of government expenditure was first conceived by an Italian economist Puviani suggesting that the benefits from tax revenue through government expenditure are not fully understood by the taxpayers if the government revenues are unobserved. This is due to information asymmetry. Since some or all taxpayers benefit from government expenditures from these unobserved or hidden revenues the public's demand for government expenditures increases, thus providing politicians incentive to expand the size of government. Fiscal Illusion is invoked as an explanation of the flypaper effect when a higher level of government provides a grant to a lower level of government because the local taxpayers are under the mistaken perception that the grant is to local government and not, in fact, to them. One of the sources of fiscal illusion is the complexity of the tax system. According to the fiscal illusion hypothesis, governments spending can be influenced by the size of the public sector and complexity in the tax system. An attempt is made in the present study to examine the fiscal illusion and explore its relationship with the fiscal dimension including revenue receipts and spending of the government. Considering the Indian federal system, the paper examines revenue diversification that has occurred during 1970 and 2016, and it estimates a model that examines the degree of moral hazard which arises mainly due to fiscal illusion within the framework of the principal agent.