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Passivity and Revenue: How a Passive Tax System Exacerbates Fiscal Illusion

It is often said that the only certainties in life are death and taxes, but how certain are we about the latter? Because of the interests of different parties involved in the tax system, the inquiry into the details of taxation can often be obscured. However, it is not completely impossible to determine the specifics of how taxes are allocated. My paper examines why the public often lacks information about how much they are paying in taxes, as well as provides a solution for better taxpayer awareness.

The idea of fiscal illusion was first introduced by John Stuart Mill and John Ramsay McCullough. It posits that citizens will systematically misunderstand and underestimate their tax burdens and the cost of public goods. This leads to inflated public sectors, because at the lower price, citizens will demand more. McCullough observed that this fiscal illusion can result from a prevalence of indirect forms of taxation that are more difficult to perceive than direct taxes. More modern scholars have identified five sources of fiscal illusion that veil a citizens understanding of the tax system. The revenue-complexity hypothesis submits that the more complex a tax system, the more difficult it is to understand the tax burden. And the revenue-elasticity hypothesis states that the more taxes that come from revenue elastic sources, the more difficult it is to perceive them because the contribution can change without a person noticing.

Some examples of why people do not recognize the tax burden, include the flypaper effect, which is the theory that people struggle to understand the cost of the public sector because of government transfer payments. Then there is also the renter illusion, which explains fiscal illusion in terms of the number of renters in a jurisdiction that tend to have higher demands for public goods without realizing the cost. Lastly, the other debt illusion claims citizens will not understand the cost of public goods when the payment of those goods are kicked down the road when debt finances them.

While these theories are compelling, I believe there might be another reason as to why citizens do not accurately perceive their tax burden. Baekgaard, Serritzlew, and Blom-Hansen showed that a citizen’s level of attention is more important than the amount of information they have in explaining their misperception of a tax. Because of this, I was curious to explore whether the collection of the tax in a more passive manner contributed to larger state tax revenues, a sign that fiscal illusion may be occurring.

I determined an active tax to be any tax that was paid out of pocket by the citizen, as opposed to, taxes like income taxes that are withheld from a paycheck. I used the percent of the revenue generated by these active taxes as a measure of the reliance a state has on active versus passive taxes. In my study, I found states that relied on more passive taxes generated more revenue than states that had more active tax systems. Indeed, there are other studies that corroborate these findings at a micro level. For example, Amy Finklestein found in her study of tolls that with the introduction of electronic toll collection, the toll rates increased 20-40 percent.

These findings suggest that citizens struggle to perceive their tax burden when taxes are collected without a requirement of overt action from the taxpayer; therefore, citizens should opt for more active taxes that require them to be more engaged in the payment of taxes. While the payment of taxes is inevitable, taxpayers may be able to curb the sting of taxation by paying closer attention.