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. And at other times, they dampen economic growth when it gets too hot, avoiding a sharp rise in inflation.
What are examples 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 a variety of 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 do automatic stabilizers work?
Automatic stabilizers work on a counter cycle. They affect government budgets or private sector spending, which in turn affects aggregate demand. They dampen the economy when it overheats and stimulates the economy when it slumps without direct government intervention. In other words, they play a key role in reducing extreme deviations to the 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.
During a recession, economic activity falls. 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 a deliberate action by the government, 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 are an item in government spending. Their rise and fall do not require government intervention and automatically follow the economic cycle but work in reverse. They offset fluctuations in aggregate demand. They increase government spending during a recession, and they 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. And high growth in consumption and investment increases aggregate demand and pushes the price level up. Inflation rates can spike uncontrollably – an unintended consequence – if aggregate demand continues to soar (via a wage-price spiral, for example).
And 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. And moderate growth in aggregate demand results in lower inflationary pressures.
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 increased, and demand for goods and services grew strongly. In addition, the unemployment rate is also low as businesses recruit workers to increase production. Thus, the business generates more profit during this period. Likewise, households are more prosperous as their incomes increase. As a result, high income and profits are subject to higher tax rates.
Higher tax rates moderate increases in consumption and investment. Households and businesses have to pay higher taxes for 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.