Debt financing and fiscal illusion: evidence from Caribbean states

This original study constructs a fiscal illusion index to investigate the usefulness of democracy as a fiscal illusion indicator. Two key questions are addressed: is democracy a useful indicator of fiscal illusion and to what extent might it affect government spending and public sector debt? These questions are examined using fiscal and monetary data from eight (8) Caribbean countries: six (6) former British colonies (Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, Saint Lucia, and St. Vincent and the Grenadines) and two (2) British dependents (Anguilla and Montserrat) for the period 1988 to 2020. The fiscal illusion index has two (2) components: self-governance and transparency. It is constructed via Principal Component Analysis technique. The author utilizes Fixed Effect estimation techniques to evaluate fiscal illusion along three (3) dimensions: the income elasticity, debt illusion, and the democracy illusion hypothesis. The findings indicate that the democracy illusion hypothesis is a useful consideration for independent states, but not for dependent states. The results also suggest that the less self-governed and more transparent a country is, the less likely it is that fiscal illusion will occur. The paper provides policy-makers with powerful insights into the value of independent budgetary oversight institutions and fiscal rule as essential tools for minimizing the fiscal illusion and lowering fiscal deficits. To the best of the author’s knowledge, this study is the first formal assessment of fiscal illusion in these Caribbean states, which utilizes democracy as an indicator.