Tax-Spend or Fiscal Illusion? Allowing for Asymmetric Revenue Effects in Expenditure Error-Correction Models

Abstract

The existing empirical literature on the US federal revenue-expenditure nexus has had mixed findings. Amongst those papers presenting evidence in favor of causation running from taxes to expenditures, support for the conventional, Friedman-type tax-spend hypothesis is nearly ubiquitous. Evidence in favor of the competing, fiscal illusion hypothesis (where taxes affect expenditures inversely) is scant. Using quarterly US data from 1959:3 to 2007:4, I argue that allowing for asymmetric revenue effects results in a compelling case for fiscal illusion: revenue increases inversely Granger-cause expenditure changes. This finding is robust to incorporating additional asymmetries in the error-correction process to long-run budgetary disequilibria.