Automatic Stabilizers

key terms

Automatic changes to taxes and government spending due to fluctuations in the economy.
Example – economic downturn:

• Assume that a negative aggregate demand shock causes income to fall and unemployment to rise.

• Tax revenue falls because
• Unemployed persons pay fewer taxes.
• Those who experience a cut in pay (or have to work fewer hours) pay fewer taxes and might drop into a lower tax bracket

• Government spending increases as it pays more in
• Unemployment insurance.
• Welfare (such as food stamps or healthcare to the uninsured).
• Job training of the recently unemployed.

• Thus the economic downturn causes taxes to fall and spending to increase.  This has the same effect on the deficit, output, and unemployment as discretionary fiscal policy without any legislated changes to the tax rate or spending.

Example – economic upswing:

• Assume Spain has a positive aggregate demand shock causing incomes to rise and unemployment to fall.

• Tax revenue increases because
• There are more people earning taxable income.
• Those who get a raise or work more hours have greater income and thus a greater tax liability. They may even creep into a higher tax bracket.

• Government spending decreases as it pays less in welfare including
• Unemployment insurance.
• Food stamps or healthcare to the uninsured.
• Job training of the recently unemployed.

Thus the economic upswing causes taxes to rise and spending to fall.  This has the same effect on budgetary balances, output, and unemployment as discretionary fiscal policy without any legislated changes to the tax rate or spending.