Keynesians view budget deficits as the right medicine to cure a recession and surpluses as remedies for inflation. Most politicians enjoy granting the tax cuts and new spending projects as they are generally popular with voters. But raising taxes and slashing budgets to fight inflation are poison for incumbents when re-election time rolls around. Fortunately, certain features of our tax system and some government spending programs automatically push budgets toward surpluses during booms of the business cycle and into deficit during cyclical downturns.
Keynesians count on certain built-in mechanisms in the economy, including but not limited to discretionary variations in spending and taxes which require congressional action, to dampen swings in Aggregate Spending and economic activity. Until now, we have unrealistically assumed that neither taxes nor government spending depends on income. The fact that both are sensitive to changes in National Income gives our economy some automatic resilience.
Automatic stabilizers are tax structures and government spending programs that cause budget deficits to grow automatically during recessions, or surpluses to grow when expansion is rapid.
Automatic stabilizers are sometimes called "nondiscretionary" fiscal policy because no overt government action is required.
Automatic Tax Adjustments
Personal and corporate income tax revenues are both closely tied to income. When prosperity boosts National Income, federal revenues from progressive corporate and personal income taxes rise more than proportionally. Corporate profit is the most sensitive of all incomes to swings in economic activity. A 10 percent decline in National Income might totally wipe out corporate profit, while 10 percent growth may cause aggregate profit to double or even triple, as illustrated in Figure 4. Thus, tax revenue from corporate income is highly cyclical.
FIGURE 4 Corporate Tax Revenue and Employment
This figure illustrates the effects of automatic tax adjustments when unemployment increases as the economy enters a recession. A downturn in economic activity reduces employment, which causes corporate profits to decline (or their rates of growth to decline). As a result, corporate tax revenues decline substantially. The opposite chain of events occurs when the economy recovers and employment expands.
Source: Economic Report of the President, 1994.
Progressive personal income tax rates are the main reason why tax collections rise or fall proportionally faster than income. This process acts as an automatic stabilizer during inflationary episodes because as income rises, tax collections rise even faster, accelerating withdrawals from the economy and dampening inflationary growth of nominal income. This effect is now partially offset because Congress indexed personal income tax brackets (the ranges across which particular tax rates apply) to inflation beginning in 1985.
When a recession begins, tax revenues tumble even faster than gross income falls, swelling budget deficits.
Automatic Changes in Government Outlays
Transfer payments rise during recessions, thus helping stabilize consumption, and ultimately, Aggregate Spending. More people are eligible for welfare payments during hard times. People retire earlier during recessions and later during booms. Consequently, Social Security payments help buffer the economy against both downturns and inflationary expansions.
Unemployment compensation, which is available to certain workers for limited periods of time, is another automatic stabilizer because those workers' incomes do not drop to zero when they are laid off. Consumption by their families would plummet during widespread layoffs without unemployment compensation, and cyclic downturns would be worse than they are. The Great Depression would probably have been much less severe had modern automatic stabilizers been in effect.
Falling tax collections and rising transfer payments during downturns help consumers maintain their customary spending levels. Facilitating consumption helps buffer any declines in National Income. Just how powerful are automatic stabilizers? Although inadequate to completely offset strong pressures for a recession, they do slow abrupt changes in the economy, giving policymakers more time to formulate discretionary policy. Some studies suggest that recent recessions would have been from one-third to one-half more severe in the absence of automatic stabilizers. But automatic stabilizers may be a mixed blessing.
When potential income is growing rapidly, our built-in stabilizers may retard actual economic growth, a problem Keynesians refer to as fiscal drag.
Fiscal drag may hinder the natural growth of GDP because rising income boosts tax revenue and may shrink outlays for transfer programs.
Suppose all resources are fully employed and the budget is balanced. Technological advance, capital accumulation, and labor force growth all contribute to growth of potential GDP. If tax rates are not lowered, economic growth boosts tax revenues; a budget surplus may even emerge if government outlays are stable. This potential surplus hinders growth in disposable income and Aggregate Spending; withdrawals grow but injections do not. This may retard economic growth, so increasing government spending or lowering tax rates may unshackle the economy. Both approaches are politically popular. Most of us can think of areas where we would like more government spending, or where we would like our taxes cut.