Explain Why Income Tax is Considered as an Automatic Stabiliser

 


Automatic stabilizers offset fluctuations in economic activity without direct intervention by policymakers. When incomes are high, tax liabilities rise and eligibility for government benefits falls, without any change in the tax code or other legislation. Conversely, when incomes slip, tax liabilities drop and more families become eligible for government transfer programs, such as food stamps and unemployment insurance, that help buttress their income.


Automatic stabilizers are quantitatively important at the federal level. A 2000 study estimated that reduced income and payroll tax collection offset about 8 percent of any decline in the gross domestic product (GDP). Additional stabilization from unemployment insurance, although smaller than that from the tax system, is estimated to be eight times as effective per dollar of lost revenue because more of the money is spent rather than saved. Altogether, a 2016 study estimated that if transfer payments were reduced in size by 0.6 percent of GDP, US output and hours worked would be about 6 and 9 percent more volatile, respectively.


The Congressional Budget Office estimates that through increased transfer payments and reduced taxes, automatic stabilizers provided significant economic stimulus during and in the aftermath of the Great Recession of 2007–09, and thereby helped strengthen economic activity. That stimulus amounted to more than $300 billion annually in 2009 through 2012, an amount equal to or exceeding 2.0 percent of potential GDP in each year. (Potential GDP measures the maximum sustainable output of the economy.)


Automatic stabilizers also arise in the tax and transfer systems of state and local governments. However, state constitutions generally require balanced budgets, which can force countervailing changes in outlays and tax rules. These requirements do not force complete balance annually: they generally focus on budget projections rather than realizations, so deficits can still occur when economic conditions are unexpectedly weak. In addition, many governments have "rainy day" funds they can draw down during periods of budget stringency. Even so, most state and local governments respond to an economic slowdown by legislating lower spending or higher taxes. These actions are contractionary, working at cross-purposes with automatic stabilizers.


Q.

What are automatic stabilizers and how do they work?

A.

Automatic stabilizers are features of the tax and transfer systems that temper the economy when it overheats and stimulates the economy when it slumps, without direct intervention by policymakers.


What is an Automatic Stabiliser?

Automatic stabilizers are a form of fiscal policy structured to counter fluctuations in the economic growth of a nation through its normal operation without additional, appropriate government or policymaker's authorization.

Progressively graduated corporate and personal income taxes and payment schemes, such as unemployment insurance and welfare, are the known automatic stabilizers. Automatic stabilizers are so-called because they serve to regulate economic cycles and are triggered automatically without further government action.


Understanding Automatic Stabilizers

Automatic stabilizers are designed primarily to combat negative economic shocks or recessions, although they may also be intended to "cool off" and expand the economy or battle inflation. Through their normal operation, these policies take more money out of the economy as taxes during periods of rapid growth and higher income. They may also put more money back into the economy in the form of government spending or tax refunds when economic activity slows down, or revenues fall. This has the intent to cushion the economy from changes in the business cycle.


Automatic stabilizers may include the use of a progressive tax structure under which the share of income received in taxes is higher when income is high and drops when income drops due to recession, job loss, or investment failures.


As an individual taxpayer earns higher salaries, for example, his additional income may be subject to higher tax rates based on the current segmented structure. The individual will remain in the lower tax range as dictated by his earned income if the salaries fall.


Likewise, unemployment insurance transfer payments decrease when the economy is in an expansionary period as there are less unemployed people filing claims, and increase when the economy is embroiled in recession and high unemployment.


When a person is unemployed in a way that makes him eligible for unemployment insurance, only a file is required to claim the benefit.


Automatic Stabilizers and Fiscal Policy

Through design, automatic stabilizers can result in higher budget deficits when an economy is in a recession. This is an aspect of fiscal policy, a Keynesian economics technique that makes use of government spending and taxes to boost aggregate economic demand during economic downturns.

Through taking less money out of private enterprises and households in taxation and giving them more at hand in the form of subsidies and tax refunds, the fiscal policy aims to encourage them to boost their consumption and investment spending, or at least not decrease, in order to help avoid a worsening economic setback.


COUNTERBALANCING RECESSION AND BOOM

Consider first the situation where aggregate demand has risen sharply, causing the equilibrium to occur at a level of output above potential GDP. This situation will increase inflationary pressure in the economy. The policy prescription in this setting would be a dose of contractionary fiscal policy, implemented through some combination of higher taxes and lower spending. To some extent, both changes happen automatically. On the tax side, a rise in aggregate demand means that workers and firms throughout the economy earn more. Because taxes are based on personal income and corporate profits, a rise in aggregate demand automatically increases tax payments. On the spending side, stronger aggregate demand typically means lower unemployment and fewer layoffs, and so there is less need for government spending on unemployment benefits, welfare, Medicaid, and other programs in the social safety net.

The process works in reverse, too. If aggregate demand were to fall sharply so that a recession occurs, then the prescription would be for expansionary fiscal policy—some mix of tax cuts and spending increases. The lower level of aggregate demand and higher unemployment will tend to pull down personal incomes and corporate profits, an effect that will reduce the amount of taxes owed automatically. Higher unemployment and a weaker economy should lead to increased government spending on unemployment benefits, welfare, and other similar domestic programs. In 2009, the stimulus package included an extension in the time allowed to collect unemployment insurance. In addition, the automatic stabilizers react to a weakening of aggregate demand with expansionary fiscal policy and react to a strengthening of aggregate demand with contractionary fiscal policy, just as the AD/AS analysis suggests.


The very large budget deficit of 2009 was produced by a combination of automatic stabilizers and discretionary fiscal policy. The Great Recession, starting in late 2007, meant less tax-generating economic activity, which triggered the automatic stabilizers that reduce taxes. Most economists, even those who are concerned about a possible pattern of persistently large budget deficits, are much less concerned or even quite supportive of larger budget deficits in the short run of a few years during and immediately after a severe recession.

A glance back at economic history provides a second illustration of the power of automatic stabilizers. Remember that the length of economic upswings between recessions has become longer in the U.S. economy in recent decades (as discussed in Unemployment). The three longest economic booms of the twentieth century happened in the 1960s, the 1980s, and the 1991–2001 time period. One reason why the economy has tipped into recession less frequently in recent decades is that the size of government spending and taxes has increased in the second half of the twentieth century. Thus, the automatic stabilizing effects from spending and taxes are now larger than they were in the first half of the twentieth century. Around 1900, for example, federal spending was only about 2% of GDP. In 1929, just before the Great Depression hit, government spending was still just 4% of GDP. In those earlier times, the smaller size of government made automatic stabilizers far less powerful than in the last few decades, when government spending often hovers at 20% of GDP or more.


THE STANDARDIZED EMPLOYMENT DEFICIT OR SURPLUS

Each year, the nonpartisan Congressional Budget Office (CBO) calculates the standardized employment budget—that is, what the budget deficit or surplus would be if the economy were producing at potential GDP, where people who look for work were finding jobs in a reasonable period of time and businesses were making normal profits, with the result that both workers and businesses would be earning more and paying more taxes. In effect, the standardized employment deficit eliminates the impact of automatic stabilizers. compares the actual budget deficits of recent decades with the CBO’s standardized deficit.


Notice that in recession years, like the early 1990s, 2001, or 2009, the standardized employment deficit is smaller than the actual deficit. During recessions, the automatic stabilizers tend to increase the budget deficit, so if the economy was instead at full employment, the deficit would be reduced. However, in the late 1990s the standardized employment budget surplus was lower than the actual budget surplus. The gap between the standardized budget deficit or surplus and the actual budget deficit or surplus shows the impact of the automatic stabilizers. More generally, the standardized budget figures allow you to see what the budget deficit would look like with the economy held constant—at its potential GDP level of output.


Automatic stabilizers occur quickly. Lower wages means that a lower amount of taxes is withheld from paychecks right away. Higher unemployment or poverty means that government spending in those areas rises as quickly as people apply for benefits. However, while the automatic stabilizers offset part of the shifts in aggregate demand, they do not offset all or even most of it. Historically, automatic stabilizers on the tax and spending side offset about 10% of any initial movement in the level of output. This offset may not seem enormous, but it is still useful. Automatic stabilizers, like shock absorbers in a car, can be useful if they reduce the impact of the worst bumps, even if they do not eliminate the bumps altogether.


KEY CONCEPTS AND SUMMARY

Fiscal policy is conducted both through discretionary fiscal policy, which occurs when the government enacts taxation or spending changes in response to economic events, or through automatic stabilizers, which are taxing and spending mechanisms that, by their design, shift in response to economic events without any further legislation. The standardized employment budget is the calculation of what the budget deficit or budget surplus would have been in a given year if the economy had been producing at its potential GDP in that year. Many economists and politicians criticize the use of fiscal policy for a variety of reasons, including concerns over time lags, the impact on interest rates, and the inherently political nature of the fiscal policy. We cover the critique of fiscal policy in the next module.


Self-Check Exercises

  1. In a recession, does the actual budget surplus or deficit fall above or below the standardized employment budget?
  2. What is the main advantage of automatic stabilizers over discretionary fiscal policy?
  3. Explain how automatic stabilizers work, both on the taxation side and on the spending side, first in a situation where the economy is producing less than potential GDP and then in a situation where the economy is producing more than potential GDP.

 

Review Questions

  1. What is the difference between discretionary fiscal policy and automatic stabilizers?
  2. Why do automatic stabilizers function “automatically?”
  3. What is the standardized employment budget?

 

Critical Thinking Questions

  • Is Medicaid (federal government aid to low-income families and individuals) an automatic stabilizer?

 

GLOSSARY

automatic stabilizers
  • Tax and spending rules that have the effect of slowing down the rate of decrease in aggregate demand when the economy slows down and restraining aggregate demand when the economy speeds up, without any additional change in legislation.

discretionary fiscal policy
  • The government passes a new law that explicitly changes overall tax or spending levels with the intent of influencing the level of overall economic activity.

standardized employment budget
  • The budget deficit or surplus in any given year adjusted for what it would have been if the economy were producing at potential GDP.


Solutions

Answers to Self-Check Questions

  1. It falls below because less tax revenue than expected is collected.
  2. Automatic stabilizers take effect very quickly, whereas discretionary policy can take a long time to implement.
  3. In a recession, because of the decline in economic output, less income is earned, and so less in taxes is automatically collected. Many welfares and unemployment programs are designed so that those who fall into certain categories, like “unemployed” or “low income,” are eligible for benefits. During a recession, more people fall into these categories and become eligible for benefits automatically. The combination of reduced taxes and higher spending is just what is needed for an economy in recession producing below potential GDP. With an economic boom, average income levels rise in the economy, so more in taxes is automatically collected. Fewer people meet the criteria for receiving government assistance to the unemployed or the needy, so government spending on unemployment assistance and welfare falls automatically. This combination of higher taxes and lower spending is just what is needed if an economy is producing above its potential GDP.



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