The Great Recession, starting in late , 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. The three longest economic booms of the twentieth century happened in the s, the s, and the — 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. 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 the automatic stabilizers. Visit this website to learn more from the Congressional Budget Office. Notice that in recession years, like the early s, , or , 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 s 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.
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 fiscal policy. We cover the critique of fiscal policy in the next module. Is Medicaid federal government aid to low-income families and individuals an automatic stabilizer?
Skip to content Chapter Government Budgets and Fiscal Policy. Learning Objectives By the end of this section, you will be able to: Describe how discretionary fiscal policy can be used by the federal government to stabilize the economy. Identify examples of automatic stabilizers. Understand how a standardized employment budget can be used to identify automatic stabilizers. Self-Check Exercises In a recession, does the actual budget surplus or deficit fall above or below the standardized employment budget?
What is the main advantage of automatic stabilizers over discretionary fiscal policy? 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 What is the difference between discretionary fiscal policy and automatic stabilizers?
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 or 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.
The process works in reverse, too. Consider the situation where aggregate demand has risen sharply, causing the macro equilibrium to occur at a level of output above potential GDP. Because taxes are based on personal income and corporate profits, a rise in aggregate demand automatically increases tax payments, reducing disposable income and thus spending.
On the spending side, stronger aggregate demand typically means lower unemployment, so there is less need for government spending on unemployment benefits, welfare, Medicaid, and other programs in the social safety net. The combination of these automatic stabilizing effects is to prevent aggregate demand from rising as high as it otherwise would, so that inflationary pressure is dampened.
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. The three longest economic booms of the twentieth century happened in the s, the s, and the — 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. This video briefly explains the difference between automatic stabilizers and discretionary government spending. From the previous section, it should be clear that the budget deficit or surplus responds to the state of the economy. That is, the automatic stabilizers cause the budget to go into deficit higher spending and lower tax revenues during recessions and to go into surplus lower spending and higher tax revenues during booms.
Tax Complexity Why are taxes so complicated? What are the benefits of simpler taxes? What policy reforms could simplify the tax code?
Wealth Transfer Taxes How do the estate, gift, and generation-skipping transfer taxes work? Who pays the estate tax? How many people pay the estate tax? What is the difference between carryover basis and a step-up in basis?
How could we reform the estate tax? What are the options for taxing wealth transfers? What is an inheritance tax? Payroll Taxes What are the major federal payroll taxes, and how much money do they raise? What is the unemployment insurance trust fund, and how is it financed? What are the Social Security trust funds, and how are they financed?
Are the Social Security trust funds real? What is the Medicare trust fund, and how is it financed? Excise Taxes What are the major federal excise taxes, and how much money do they raise? What is the Highway Trust Fund, and how is it financed? Energy and Environmental Taxes What tax incentives encourage energy production from fossil fuels?
What tax incentives encourage alternatives to fossil fuels? What is a carbon tax? Business Taxes How does the corporate income tax work?
What are pass-through businesses? How are pass-through businesses taxed? Is corporate income double-taxed? Tax Incentives for Economic Development What is the new markets tax credit, and how does it work?
What are Opportunity Zones and how do they work? Taxes and Multinational Corporations How does the current system of international taxation work? What are the consequences of the new US international tax system? How does the tax system affect US competitiveness? How would formulary apportionment work? What are inversions, and how will TCJA affect them? What is a territorial tax and does the United States have one now? What is the TCJA repatriation tax and how does it work?
What is the TCJA base erosion and anti-abuse tax and how does it work? What is global intangible low-taxed income and how is it taxed under the TCJA? What is foreign-derived intangible income and how is it taxed under the TCJA? Comprehensive Tax Reform What is comprehensive tax reform? What are the major options for comprehensive tax reform? Broad-Based Income Tax What is a broad-based income tax?
What would and would not be taxed under a broad-based income tax? What would the tax rate be under a broad-based income tax? National Retail Sales Tax What is a national retail sales tax? What would and would not be taxed under a national retail sales tax? What would the tax rate be under a national retail sales tax?
What is the difference between a tax-exclusive and tax-inclusive sales tax rate? Who bears the burden of a national retail sales tax? Would tax evasion and avoidance be a significant problem for a national retail sales tax? What would be the effect of a national retail sales tax on economic growth?
What transition rules would be needed for a national retail sales tax? Would a national retail sales tax simplify the tax code? What can state and local sales taxes tell us about a national retail sales tax?
What is the experience of other countries with national retail sales taxes? How would a VAT be collected? What would and would not be taxed under a VAT? What would the tax rate be under a VAT?
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