Automatic Stabilizers: Study Guide (Macroeconomics 3.9)

The idea: a fiscal policy that runs itself

In Topic 3.8 you met discretionary fiscal policy: the government deliberately changes its spending, taxes or transfers to close an output gap. That kind of policy has lags. Someone has to notice the problem, agree on a plan and pass it into law, and then the spending or tax change has to be put into practice. By the time it arrives, the economy may already have moved on.

Some parts of fiscal policy do not need anyone to decide anything. They are already written into the tax and benefit rules. When real GDP changes, they change too.

Automatic stabilizers are features of the tax and transfer system that, without any new government action, cushion disposable income when the economy weakens and hold it back when the economy strengthens. They support the economy in recessions and help stop it overheating in expansions.

The key words are:

• Automatic: no new law, vote or announcement is needed. The rules already exist.
• Stabilizer: the change always works against the direction of the business cycle. It makes swings in output smaller.

Taxes as automatic stabilizers

Most tax revenue depends on how much the economy produces and earns:

• Income taxes depend on how much people earn.
• Sales and spending taxes depend on how much people buy.
• Taxes on company profits depend on how much firms earn.

The tax rates stay the same, but the amount collected moves with real GDP.

When real GDP falls (a recession). Incomes, spending and profits fall, so tax revenue falls automatically. Households lose some income, but they also pay less tax, so their disposable income (income after taxes, plus transfers) falls by less than their income. Because consumption depends on disposable income, consumption falls by less too. The fall in spending is smaller, so the economy does not fall as far.

When real GDP rises (an expansion). Incomes, spending and profits rise, so tax revenue rises automatically. Part of each extra valda of income goes to the government instead of into households’ pockets. Disposable income and consumption rise by less than income. This slows the growth of spending and helps prevent the economy from overheating (moving well beyond full-employment output, with rising inflation).

Background. A progressive income tax, where higher incomes pay a higher share in tax, makes this effect stronger, because revenue changes by a larger share of each change in income. You only need to know that tax revenue moves in the same direction as real GDP.

Transfer payments as automatic stabilizers

Transfer payments are payments from the government to households that are not in return for goods or services. Many are paid according to rules that depend on a household’s situation. Examples include:

• unemployment benefits, paid to workers who lose their jobs;
• income support for households whose income falls below a set level;
• food or housing assistance that a household qualifies for when its income is low.

In a recession, more workers lose their jobs and more households’ incomes fall below the qualifying level. Transfer payments rise automatically. This puts income back into the hands of households that are likely to spend it, so consumption falls by less.

In an expansion, unemployment falls and incomes rise. Fewer households qualify, so transfer payments fall automatically. This takes some spending power out of the economy just when demand is strong.

Notice that transfers move in the opposite direction to real GDP, while tax revenue moves in the same direction. Both work against the business cycle.

	Recession (real GDP falls)	Expansion (real GDP rises)
Tax revenue	falls automatically	rises automatically
Transfer payments	rise automatically	fall automatically
Disposable income	falls by less than income	rises by less than income
Consumption and AD	fall by less	rise by less
Effect on the cycle	recession is milder	economy less likely to overheat

Our fictional economy: Valdoria

Valdoria is the fictional country used across the Marlbridge macroeconomics pages; its currency is the valda (VD). For this topic, assume:

• Valdoria’s income tax takes 25% of every valda of income, and the rate does not change.
• Each unemployed worker receives an unemployment benefit of VD 20,000 a year.
• The MPC is 0.8.

All data are fictional and simplified: we treat national income as equal to real GDP, and we look only at the first round of spending.

Worked example 1: a recession, with and without stabilizers

Question. A fall in foreign demand for Valdoria’s exports cuts national income by VD 60 billion in the first round. As a result, 250,000 more workers become unemployed.

(a) Calculate the automatic change in tax revenue. (b) Calculate the automatic change in transfer payments. (c) Calculate the change in disposable income and the change in consumption. (d) Compare (c) with an economy where tax revenue and transfers do not respond to income.

(a) Tax revenue changes by 25% of the change in income: 0.25 × (−60) = −VD 15 billion. Revenue falls even though the tax rate has not changed.

(b) Transfers rise by 250,000 × VD 20,000 = VD 5,000,000,000 = +VD 5 billion.

(c) Disposable income = income − taxes + transfers, so:

Change in disposable income = −60 − (−15) + 5 = −60 + 15 + 5 = −VD 40 billion.

Change in consumption = MPC × change in disposable income = 0.8 × (−40) = −VD 32 billion.

(d) Without stabilizers, disposable income would fall by the full VD 60 billion and consumption by 0.8 × 60 = VD 48 billion.

Interpretation. Households lost VD 60 billion of income but only VD 40 billion of disposable income: about two-thirds of the loss. The next round of lost spending is VD 32 billion instead of VD 48 billion, so the downturn spreads less. No minister had to act: the tax rules and benefit rules did the work.

Check. The VD 20 billion difference between the fall in income (60) and the fall in disposable income (40) is exactly the fall in tax revenue (15) plus the rise in transfers (5).

Preview of Topic 5.4. In this example the government collects VD 15 billion less tax and pays VD 5 billion more in transfers, so its budget balance worsens by VD 20 billion. Budget deficits tend to grow automatically in recessions and shrink in expansions, even with no change in policy.

Showing the effect in the AD–AS model

Start at long-run equilibrium, where AD₁ crosses SRAS and LRAS at full-employment output (Yf). A fall in export demand shifts AD to the left.

• Without stabilizers, the fall in exports is followed by large falls in consumption. AD shifts a long way left, to AD₃. Real GDP falls to Y₃ and the price level to PL₃.
• With stabilizers, falling tax revenue and rising transfers cushion disposable income, so consumption falls by less. AD shifts left by less, to AD₂. Real GDP falls only to Y₂ and the price level only to PL₂.

The recessionary gap is smaller with stabilizers, but it does not disappear. Stabilizers do not move AD back to AD₁.

The same reasoning works in reverse. If a rise in business confidence shifts AD to the right, rising tax revenue and falling transfers hold back consumption, so AD shifts right by less. The inflationary gap and the rise in the price level are smaller than they would be without stabilizers.

Background: why the chain of spending is shorter. In Topic 3.2, each round of new income was passed on at the MPC. With a 25% income tax, each extra valda of income becomes only VD 0.75 of disposable income, so only 0.8 × 0.75 = 0.6 of it is spent in the next round. In this simple model a VD 50 billion fall in investment would cut AD by 50 ÷ (1 − 0.8) = VD 250 billion with no tax response, but by only 50 ÷ (1 − 0.6) = VD 125 billion with it. You will not be asked to calculate this, but it shows why stabilizers make the multiplier effect smaller.

Worked example 2: an expansion

Question. A rise in business confidence raises Valdoria’s national income by VD 80 billion in the first round, and unemployment falls by 100,000 workers. Use the same assumptions as before (25% income tax, VD 20,000 benefit, MPC 0.8).

(a) Calculate the changes in tax revenue and in transfer payments. (b) Calculate the change in disposable income and the change in consumption. (c) Compare with no stabilizers, and explain how this helps prevent overheating. (d) Did the government change any policy?

(a) Tax revenue: 0.25 × 80 = +VD 20 billion. Transfers: 100,000 × VD 20,000 = VD 2 billion fewer, so −VD 2 billion.

(b) Change in disposable income = 80 − 20 + (−2) = +VD 58 billion. Change in consumption = 0.8 × 58 = +VD 46.4 billion.

(c) Without stabilizers, consumption would rise by 0.8 × 80 = VD 64 billion. With them it rises by VD 46.4 billion, VD 17.6 billion less. Spending grows more slowly, so AD shifts right by less. Output is less likely to rise far beyond full employment, and upward pressure on the price level is weaker.

(d) No. The tax rate and the benefit level stayed the same. Revenue rose and transfers fell only because incomes rose and fewer people were unemployed. (The budget balance improves by 20 + 2 = VD 22 billion, again with no new policy.)

Check. Income rose by 80; disposable income rose by 58. The gap of 22 equals the extra tax (20) plus the transfers no longer paid (2).

Worked example 3: automatic or discretionary?

Question. For each Valdorian event, decide whether it is an automatic stabilizer or discretionary fiscal policy.

1. During a recession, income tax revenue falls by VD 12 billion while the tax rate stays at 25%.
2. Parliament votes to raise the unemployment benefit from VD 20,000 to VD 24,000 a year.
3. In a boom, fewer families qualify for housing assistance, so spending on it falls.
4. The government announces a new VD 30 billion programme of road building to fight a recession.

Answers.

1. Automatic. Revenue fell because incomes fell, not because of a decision.
2. Discretionary. A new decision changes the benefit rules. (Once the new rules are in place, the benefit system goes on acting as an automatic stabilizer.)
3. Automatic. The qualifying rules did not change; fewer households meet them.
4. Discretionary. It is a deliberate change in government purchases, with the lags that come with it.

Test to use: ask “Did anyone have to make a new decision?” If not, and the change works against the business cycle, it is an automatic stabilizer.

Strengths and limits

• No decision or implementation lag. Stabilizers start working as soon as incomes change. This is their main advantage over discretionary policy.
• They work in both directions, cushioning recessions and restraining booms.
• They moderate, not cure. They make the shift in AD smaller but do not reverse it. A large shock can still leave a recessionary or inflationary gap, so discretionary policy, or the economy’s long-run self-adjustment (Topic 3.7), may still be needed to return to full employment.
• Their size depends on the system. Taxes that move more with income, and more generous benefits, give stronger stabilizers.

Common misconceptions

• “Automatic stabilizers are laws passed during a recession.” They are already in place. A newly passed tax cut or spending plan is discretionary policy.
• “Tax revenue fell, so the government must have cut taxes.” With unchanged rates, revenue falls because incomes, spending and profits fall.
• “Stabilizers only help in recessions.” They also slow consumption in expansions and help prevent overheating.
• “Stabilizers end recessions and restore full employment.” They make the fall in AD smaller; the output gap remains, only smaller.
• “Stabilizers shift AD right in a recession.” AD still shifts left, but by less than it would without them.
• “Transfer payments are part of government purchases (G).” Transfers are not purchases of goods and services. They work through disposable income and consumption, like a tax change in reverse.
• Getting the direction of transfers wrong. Tax revenue moves with real GDP; transfers move against it.
• “A growing budget deficit in a recession proves the government chose expansionary policy.” Much of it can be automatic: lower revenue and higher transfers.

Where this leads

This topic closes Unit 3. Unit 4 turns to money and the financial sector, starting with Topic 4.1, Financial Assets, on the way to monetary policy, the other tool for stabilizing the economy. In Topic 5.4 you will see how automatic changes in revenue and transfers affect the government budget. If discretionary policy and its lags are not yet secure, go back to Topic 3.8, Fiscal Policy.

Now try the practice questions, then use the revision notes and the checklist to consolidate.