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What’s it: Automatic stabilizers are countercyclical fiscal tools. They moderate economic fluctuations without direct government intervention. At one time, when the economy was contracting, they helped the economy to avoid further deterioration, namely a recession. Other times, they prevent hyperinflation and the economy from overheating when expanding.
Welfare benefits and progressive taxes are examples. Both stimulate the economy when the economy weakens or contracts. At other times, they dampen economic growth when it gets too hot, avoiding a sharp rise in inflation.
Types of automatic stabilizers
Automatic stabilizers really work automatically. They do not require deliberate action from the government. For example, they do not involve changes in tax codes and other laws or voting by legislators for approval. The two examples are:
- Progressive tax
- Welfare benefits
Progressive taxes are a common example of an automatic stabilizer. They are set proportionately higher along with taxable income. In other words, the tax rate imposed will increase along with the increase in taxable income. In addition, because taxable income positively correlates with economic conditions, the tax rate will rise when the economy expands and falls during a recession.
Meanwhile, welfare and social benefits can take the form of various programs. Examples are unemployment benefits, food stamps, and stimulus checks. Spending on these programs decreases during a prosperous economy and increases during a downturn. Medicaid is another example and functions as an automatic stabilizer with a countercyclical effect.
How automatic stabilizers work in practice
Automatic stabilizers work on a countercyclical basis. They affect government budgets or private sector spending, which in turn affects aggregate demand. They dampen the economy when it overheats and stimulate it when it slumps without direct government intervention. In other words, they play a key role in reducing extreme deviations from potential output.
Progressive taxes and welfare benefits are important to prevent the negative consequences of unexpected growth rates, such as a recession in which economic activity falls. Or it cushions a spike in inflation and dampens an overheated economy.
Economic activity falls during a recession. The unemployment rate is high as businesses cut production and workers to keep profits. As such, households face deteriorating income and employment prospects. If not prevented by economic stimulus, the economy could lead to a recession or even depression.
However, unlike macroeconomic policies, which require the government’s deliberate action, automatic stabilizers work automatically. Moreover, they work in reverse with the current economic situation. Thus, government spending will increase, and tax revenues will decrease automatically during a recession.
Meanwhile, while expanding, the economy is testing its maximum limits. In the final stages of expansion, inflationary pressures increased significantly as the economy was operating above its productive capacity. Or in other words, real GDP exceeds potential GDP (positive gap or inflationary gap – revisit the concept of macroeconomic equilibrium). If not prevented, it could overheat the economy.
When the economy overheats, the inflation rate spikes. It causes the purchasing power of money to fall. If not prevented, it could lead to hyperinflation, where money becomes worthless in days. It happened because the price of goods and services rose uncontrollably. High inflation undermines confidence in the domestic currency and can trigger a crisis. The most recent example occurred in Venezuela, which started in 2016.
Then how do economic stabilizers work and affect the economy? Let’s discuss welfare benefits and income taxes as examples.
Welfare benefits
Welfare benefits are an item in government spending. Their rise and fall do not require government intervention and automatically follow the economic cycle; they work in reverse. They offset fluctuations in aggregate demand. They increase government spending during a recession and do the opposite during expansion.
Now take unemployment benefits as an example.
During a recession, businesses cut jobs and stop investing as they face profit pressures due to weak demand. Meanwhile, households face deteriorating income and employment prospects, forcing them to save more and spend less. As a result, a drop in consumption and investment could send activity down even further, possibly leading to a great recession.
So, during a recession, the unemployment rate increases. As a result, more people have lost their jobs and income. Those who are unemployed then apply for the government benefits program. As a result, spending on unemployment benefits increased.
As it replaces lost income, the benefits help cushion further declines in consumption. Those who are unemployed can still maintain their consumption, keeping aggregate demand strong and not falling further. Combined with other expansionary policies, for example, low-interest rates, controlled consumption can stimulate economic activity again.
On the other hand, unemployment benefits will decrease during an economic expansion. This is because the economy prospered, and business activity increased. As a result, households see strong prospects for income and employment, prompting them to increase consumption.
Strong demand pushes prices up, stimulating businesses to increase production to reap more profits. They then increase investment and recruit new workers to increase output. As a result, the economy’s output increases, and the unemployment rate decreases. High growth in consumption and investment increases aggregate demand and pushes the price level up. If aggregate demand continues to soar (via a wage-price spiral, for example), inflation rates can spike uncontrollably—an unintended consequence—if aggregate demand continues to soar (via a wage-price spiral, for example).
Spending on unemployment benefits works in reverse with the situation. Their payouts fell because the unemployment rate was low. Thus, government spending also fell, offsetting the increase in consumption and investment. As a result, it dampened a sharp increase in aggregate demand. Moderate growth in aggregate demand results in lower inflationary pressures.
Progressive tax
Taxes don’t just affect government revenue. But, it also affects consumption and investment. Rising tax rates weaken consumption and investment as households and businesses set aside more money for tax bills. As a result, less money is available for spending and investing.
For an example of an automatic stabilizer, let’s take progressive taxes an example.
During an economic expansion, taxable income increases. Economic activity increases, and demand for goods and services grows strongly. In addition, the unemployment rate is also low as businesses recruit workers to increase production. Thus, businesses generate more profit during this period. Likewise, households are more prosperous as their incomes increase. As a result, high incomes and profits are subject to higher tax rates.
Higher tax rates moderate increases in consumption and investment. Households and businesses pay higher taxes on any additional income, and an increase in income does not necessarily increase spending on goods and services. As a result, aggregate demand grew more moderately.
On the other hand, during a recession, economic activity falls. Household incomes fell, as did business profits. As a result, the tax bill is less because it is charged at a lower rate. In addition, households may qualify for unemployment insurance, food stamps, or other welfare benefits as their income declines. Lower tax rates and welfare benefits support demand for goods and services to remain strong during a recession, or at least prevent it from falling further.
The importance of automatic stabilizers
Automatic stabilizers act as the economy’s shock absorbers, automatically mitigating the effects of economic upswings and downturns. Here’s why they’re crucial for economic stability:
- Automatic and built-in: Unlike discretionary fiscal policy, which requires government action and can be slow to react, automatic stabilizers function continuously. They adjust based on economic conditions without needing legislative approval, offering a quicker response to economic fluctuations.
- Smoothing the boom-bust cycle: During economic expansions, automatic stabilizers act as a brake. Progressive taxes automatically collect more revenue from higher incomes, dampening economic growth and preventing overheating. Conversely, during recessions, automatic stabilizers provide a safety net. Welfare benefits automatically increase as unemployment rises, injecting additional spending into the economy and preventing a sharper decline.
- Promoting economic stability: By automatically adjusting government spending and tax burdens based on economic conditions, automatic stabilizers help maintain a more stable economic environment. This translates to benefits for businesses and individuals alike, fostering more predictable economic conditions for investment, hiring, and consumer spending.
Limitations and the need for additional support
It’s important to acknowledge that automatic stabilizers aren’t a cure-all.
- Limited impact: While they can certainly soften economic fluctuations, automatic stabilizers may not be powerful enough to address severe recessions or periods of hyperinflation.
- Time lag: Even though automatic, there can still be a slight time lag between economic changes and the full impact of automatic stabilizers.
Complementary fiscal policy
In situations of extreme economic hardship, additional fiscal policy measures might be necessary. These could involve temporary tax cuts, stimulus packages, or increased government spending on infrastructure projects. Automatic stabilizers work best in conjunction with other economic tools to ensure a more comprehensive approach to managing the business cycle.
In conclusion, automatic stabilizers are a vital component of economic policy, offering a crucial first line of defense against economic fluctuations. While they have limitations, their automatic nature and ability to dampen economic swings make them a valuable tool for promoting long-term economic stability.
