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Lesson summary: automatic stabilizers

AP.MACRO:
POL‑1 (EU)
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POL‑1.C (LO)
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POL‑1.C.1 (EK)
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In this lesson summary review and remind yourself of the key terms and graphs related to automatic stabilizers, including the different kinds of automatic stabilizers and why fiscal policy is subject to lags.

Lesson Summary

Are the lags, or delays, in discretionary fiscal policy frustrating you? Don't worry, if lags are causing policymakers to be slow to act, automatic stabilizers will help in the meantime.
In a previous lesson, we learned that policymakers can use discretionary fiscal policy as a tool to end recessions or inflationary booms. But delays in putting those plans in place are common, and may even destabilize an economy even more. Luckily, there are mechanisms in place called automatic stabilizers. These mechanisms will kick in immediately to soften the swings of the business cycle, even if policymakers can't act quickly.
Automatic stabilizers are tools built into federal budgets that reduce the impact of the business cycle. They are “automatic” because they happen without requiring anyone to take any action. When aggregate demand decreases, two actions kick in automatically. First, income taxes will go down because the amount of income has decreased. At the same time, transfer payments like unemployment compensation and welfare benefits will increase. As a result, consumption will not decrease by as much as it would have.

Key Terms

Key termdefinition
discretionary fiscal policya fiscal policy action that requires a deliberate act, such as passing a spending bill or a tax plan
automatic stabilizersfiscal policy actions that require no action and will occur automatically based on the current phase of the business cycle; the most common automatic stabilizers are progressive tax systems and transfer payments.
progressive tax systema way of taxing that has higher tax rates at higher levels of income; for example, Holly makes dollar sign, 60, comma, 000 per year and pays 10, percent in income taxes, but Nasrin makes dollar sign, 80, comma, 000 per year and pays 15, percent in income taxes.
disposable incomethe amount of income left over after taxes are deducted; if you make dollar sign, 100 per week, but dollar sign, 10 in taxes are deducted, you have dollar sign, 90 in disposable income that you can actually spend.
transfer payments(sometimes called income supports) payments that received without the exchange of a good or service, such as welfare payments or unemployment compensation; when people lose jobs during recessions, unemployment compensation will mean that consumption will not decrease by as much.

Key takeaways

Automatic stabilizers support the economy during downturns and prevent overheating during booms

Automatic stabilizers might not smooth out the business cycle completely, but they do make the swings of the business cycle less extreme. Automatic stabilizers are any part of the government budget that offsets fluctuations in aggregate demand. They offset fluctuations in demand by reducing taxes and increasing government spending during a recession, and they do the opposite in expansion.

Taxes are automatic stabilizers

Taxes work as an automatic stabilizer by increasing disposable income in downturns and decreasing disposable income during booms.
Let's think about this at the individual level. Suppose you make dollar sign, 1000 per week and pay 20, percent in income taxes, so you have to pay dollar sign, 200 in taxes and have dollar sign, 800 to spend. All of a sudden there is a serious recession.
The bad news is your pay got cut in half, so now you only make dollar sign, 500 per week. The good news is that your take-home pay did not get cut in half! It turns out that you live with a progressive tax system, so when your pay got cut, your tax rate fell to 10, percent. So instead of your disposable income falling to dollar sign, 400, it only falls to dollar sign, 450.
The same concept works in reverse. Suppose there is a positive shock to aggregate demand, and you get a dollar sign, 1000 bonus. However, that pushes you to a higher tax rate of 30, percent, so even though your paycheck doubles, your take-home pay does not.

Government policies and institutions can act as automatic stabilizers

Many countries have government agencies that help out when people are out of work, such as welfare payments or unemployment compensation. Spending on these programs increase during recessions and decrease during expansions. That spending isn't directly part of GDP (remember that transfer payments do not count in the government spending component). However, spending on programs like these does have an indirect effect on GDP through consumption.
Suppose you lose your dollar sign, 1000 per week salary because you lose your job. Without unemployment compensation, your spending might fall dramatically, which would lower the consumption part of GDP. However, if it turns out that you can get dollar sign, 400 per week in unemployment benefits, your consumption would not fall as dramatically.

Automatic stabilizers can cause budget deficits during downturns and surpluses during expansions

Imagine two countries that have the same tax revenues and government spending.
Salvania starts out in long-run equilibrium and a balanced budget, with dollar sign, 500 million in government outlays paid for with dollar sign, 500 million in tax revenues collected every year. Suddenly, the stock market crashes in Salvania causing widespread panic and decreased consumption. Luckily, the automatic stabilizers kick-in. Tax revenues decrease to dollar sign, 300 million, while the government is now paying for dollar sign, 700 million in government spending and transfer payments. Salvania is now facing a budget deficit of dollar sign, 400 million.
On the other hand, Nadyaland’s long-run equilibrium is interrupted by a boom. When the automatic stabilizers kick in, tax revenues increase to dollar sign, 600 million and spending falls to dollar sign, 400 million. As a result of the stabilizers, Nadyaland has a budget surplus of dollar sign, 200 million.
In the real world, there are a lot of other reasons that a country might run a budget deficit or a budget surplus. But, automatic stabilizers contribute to those deficits and surpluses too. For example, the United States was in a recession during 1982. That year it ran a deficit of around dollar sign, 182 billion. But if you remove the effect of automatic stabilizers that had kicked in, the deficit was actually only dollar sign, 72 billion. Similarly, during the expansion in 1999, the United States had a budget surplus of around dollar sign, 126 billion, but if you remove the effect of automatic stabilizers, the surplus was actually around dollar sign, 39 billion.

Common misperceptions

  • Discretionary fiscal policy and automatic stabilizers are frequently confused with each other. If a government has to take any action to make it happen, it is discretionary fiscal policy. If it is something that happens on its own, it is an automatic stabilizer.
  • Some students think transfer payments are in the “G” category (“government spending") of aggregate demand, but this is not correct. Transfer payments and tax rebates do not count directly in real GDP. They impact real GDP indirectly through their effect on consumption. When Holly gets a dollar sign, 200 tax rebate from the government, it is not counted as government spending because the government is not buying anything from her. But when she spends that money on veggie burgers and baseball gear, it gets counted in consumption.

Discussion questions

  • Which of the fiscal policy lags do automatic stabilizers avoid? Explain.
  • Describe the process by which automatic stabilizers would reduce output in an positive output gap.
  • How do transfer payments show up in aggregate demand if they are not a part of government spending?

Want to join the conversation?

  • piceratops ultimate style avatar for user Z
    Can someone provide their input on the first bullet point of the "Discussion questions" section? I don't understand that question.
    (2 votes)
    Default Khan Academy avatar avatar for user
    • blobby green style avatar for user Moshe Halberstam
      The lags cause time to be wasted while the data has to come in, and decisions have to be made. This is only the case with discretionary fiscal policy. With the automatic stabilizers, they kick in with out a whole decision making process by the government. Taxes will automatically go down as soon as people are making less income, and government spending will automatically go up when people are making less income and need welfare programs.
      (8 votes)
  • blobby green style avatar for user gm
    So, is it true that progressive taxes are an automatic stabilizer (uses %), whereas changing the amount of the lump sum tax is a discretionary fiscal policy?
    (1 vote)
    Default Khan Academy avatar avatar for user