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Fiscal Illusion

By Chris Edwards, Cato Institute


Senator Rick Scott of Florida has proposed an 11‐​point economic and social plan called Rescue America. Kudos to Scott for detailing where he stands, which contrasts with the Senate GOP leader who won’t tell us his priorities until after the next election.

However, one of Scott’s proposals is raising eyebrows: “All Americans should pay some income tax to have skin in the game, even if a small amount. Currently over half of Americans pay no income tax.” It appears that the senator is proposing to raise taxes.

Scott explained further in an op‐​ed last week: “[T]he federal government has figured out how to disconnect many Americans from fiscal reality.” The politicians “give away money borrowed from your grandkids, get re‐​elected, and never pay a penalty for their irresponsibility … Part of the deception is achieved by disconnecting so many Americans from taxation.”

The senator is describing a political strategy called “fiscal illusion.” Ideally, lawmakers would carefully evaluate, and discuss with the public, the full costs of proposed spending programs. In practice, however, lawmakers use techniques to hide costs, which lead the public to demand too much government because the “price” appears artificially low.

Here are some of the techniques of fiscal illusion, beginning with the tax and debt methods mentioned by Scott:

Uneven Taxes. Congress collects the bulk of income taxes from a small group of people. In 2019, the top 10 percent of earners paid 71 percent of all individual income taxes. This structure biases people with lower and middle incomes to favor government expansion because the costs mainly fall on others. Scott is roughly correct that half of households don’t pay federal income taxes. The figure was 61 percent in 2020, 57 percent in 2021, and an estimated 42 percent in 2022.

Debt. Even after the pandemic subsides, the federal government is planning to spend about $1 trillion a year more than it raises in taxes. The recipients will see the benefits of the spending, but the costs will be pushed forward in the form of rising debt. Since 1930, the government has run deficits in 87 percent of the years, and the deficits have been trending ever larger. The political attraction of deficits is supported by Keynesian economic theory, which has wrapped irresponsible budgeting in a veneer of academic respectability.

Withholding. The federal government requires employers to withhold income and payroll taxes from paychecks, which makes earnings disappear before workers see the cash. Withholding was introduced during World War II to reduce resistance to government confiscation. Amity Shlaes noted, “No longer would the worker ever have to look his tax bill square in the eye … Government would put its hand into the taxpayer’s pocket and grab its share of tax—without asking.”

Inflation. Prices are rising the fastest we’ve seen in decades. One effect is to impose an “inflation tax” on the public as their cash and checking deposits decline in real value. Paul Kupiec calculates that with inflation at more than 5 percent, this tax is more than $1 trillion a year. Huge! An additional inflation tax stems from government creditors suffering losses to the extent that they are surprised by rising inflation. John Maynard Keynes was right about one thing: “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”

Business Taxes. The federal government collects hundreds of billions of dollars a year from taxes on businesses, including the corporate income tax and the employer half of the payroll tax that funds Social Security and Medicare. The burden of these taxes ultimately falls on individuals as savers, workers, and consumers, but the collection is invisible to them.

Real Bracket Creep. The federal income tax is partly indexed for inflation, but it is not indexed for real economic growth. Because the income tax is graduated—rates rise as one earns more—the government automatically gains a larger share of incomes over time as the economy grows. In its long‐​term projections, the Congressional Budget Office finds that “the largest source of growth in tax revenues is real bracket creep—the process in which, as income rises faster than inflation, a larger proportion of income becomes subject to higher tax rates.”

Tax Complexity. Congress has spread out the federal tax burden across multiple different tax bases, and it has made the largest tax—the income tax—hugely complex. These tax design features reduce the ability of voters to appreciate the overall cost of government.

Regulations. When Congress wants to redirect economic resources, regulations are an alternative to spending programs. Regulations require businesses to provide workers with certain employee benefits, for example, and regulations require gasoline retailers to mix ethanol into their products as a subsidy to corn farmers. Such regulations impose costs on the public just as taxes do, but the costs are hidden in the form of lower wages or higher prices.

Smoke and Mirrors. The government uses accounting tricks to make its budgeting seem less irresponsible. For example, budget projections often assume spending restraint years in the future, even though lawmakers know it won’t really happen. Another trick is the “salami strategy,” whereby officials in agencies such as the Pentagon only reveal the full costs of big projects one slice at a time to avoid possible project cancellation.

The problem of fiscal illusion has long been recognized. More than a century ago, Italian economist Amilcare Puviani described 11 techniques of fiscal illusion, as noted by David Boaz.

Fiscal illusion can be solved by restructuring government and imposing more rules on policymakers. Senator Scott mentions some possible solutions, such as balancing the federal budget. He also suggests raising taxes on current nonpayers, but he is getting pushback on that because the Republican Party is supposed to be for tax cuts, not hikes.

There is a better way to address the problem that Scott identifies. The large increase in nonpayers in recent years is mainly the result of expansions in the earned income tax credit and child tax credit. These credit programs are mainly spending subsidies. So rather than raising taxes, Congress should cut these subsidies.

Another reform would be to report the full 15.3 percent federal payroll tax on all worker paystubs—both the “employee” half and the “employer” half. Economists agree that the burden of both halves falls on workers. Social Security and Medicare are hugely expensive, and workers deserve to see the full cost they are paying to fund them.

Fiscal illusion is fiscal dishonesty. Whether people believe in smaller government or larger government, they should want policymakers to disclose the full costs of programs, to simplify the tax code for greater transparency, and to present budgets in a honest way.

For more on fiscal illusion and other structural problems with the government, see “Why the Federal Government Fails.”


Chris Edwards is the director of tax policy studies at Cato and editor of Down​siz​ing​Gov​ern​ment​.org.