Automatic Fiscal Stabilisers
or Non Discretionary Fiscal Policy
The size of the public sector surplus or deficit will automatically vary according to the level of income. The effect of this will reduce the level of fluctuations in national income without the government having to take any deliberate action.
Taxes whose revenues rise as nation income rises and benefits that fall as national income rises are called automatic stabilisers. They have the effect of reducing the size of the multiplier, reducing both upward and downward movements of national income. Thus, in theory, the business cycle should be dampened by such built in stabilisers. The more the taxes rise or benefits fall, the bigger will be the marginal tax propensity. Remember that we defined this as the proportion of any rise in income going in taxes and reduced benefits. The bigger the marginal tax propensity, the smaller will be the multiplier and the greater will be the stabilising effect.
Taxes whose revenues rise as nation income rises and benefits that fall as national income rises are called automatic stabilisers. They have the effect of reducing the size of the multiplier, reducing both upward and downward movements of national income. Thus, in theory, the business cycle should be dampened by such built in stabilisers. The more the taxes rise or benefits fall, the bigger will be the marginal tax propensity. Remember that we defined this as the proportion of any rise in income going in taxes and reduced benefits. The bigger the marginal tax propensity, the smaller will be the multiplier and the greater will be the stabilising effect.
The effectiveness
Automatic stabilisers have the obvious advantage that they act instantly as soon as aggregate demand fluctuates. By contrast, it may take some time before the government can institute discretionary changes in taxes or government expenditure, especially if forecasting is unreliable. Nevertheless automatic stabilisers can never be the complete answer to the problem of fluctuations. Their effect is merely to reduce the multiplier - to reduce the severity of fluctuation, not to eliminate them altogether.
In addition, they tend to suffer two specific drawbacks: adverse effects on aggregate supply and the problem of 'fiscal drag'. Let us examine each in turn.
In addition, they tend to suffer two specific drawbacks: adverse effects on aggregate supply and the problem of 'fiscal drag'. Let us examine each in turn.
Adverse supply-side effects
High tax rates may discourage effort and initiatives.
The higher the marginal tax rate, the greater the stability provided by the tax system. But the higher tax rates are, the more likely they are to create a disincentive work and to invest. For example, steeply progressive income taxes may discourage workers from doing overtime or seeking promotion. A high marginal rate of income tax is equivalent to a higher marginal cost of working. People may prefer to work less and substitute leisure for income. The substitution effect of more progressive taxes may thus outweigh the income effect.
High unemployment benefits may increase equilibrium unemployment
High unemployment benefits, by reducing the hardship of being unemployed, may encourage people to spend longer looking for their jobs rather than taking the first job offered. This has the effect of increasing unemployment and thus of shifting the Philips curve to the right. This because a longer average period of job search represents a higher level of friction in the economy and thus a higher natural (or equilibrium) level of unemployment.
High income-related benefits may create a poverty trap
The higher the level of income-related benefits and the more steeply they taper off, the greater will be the problem of the poverty trap. What is the point in unemployed people seeking jobs, or people in very low-paid jobs seeking better ones, if as a result they lose their benefits and end up being little or no better off than before? The more that people are discouraged in this way, the lower will be the level of aggregate supply.
The higher the marginal tax rate, the greater the stability provided by the tax system. But the higher tax rates are, the more likely they are to create a disincentive work and to invest. For example, steeply progressive income taxes may discourage workers from doing overtime or seeking promotion. A high marginal rate of income tax is equivalent to a higher marginal cost of working. People may prefer to work less and substitute leisure for income. The substitution effect of more progressive taxes may thus outweigh the income effect.
High unemployment benefits may increase equilibrium unemployment
High unemployment benefits, by reducing the hardship of being unemployed, may encourage people to spend longer looking for their jobs rather than taking the first job offered. This has the effect of increasing unemployment and thus of shifting the Philips curve to the right. This because a longer average period of job search represents a higher level of friction in the economy and thus a higher natural (or equilibrium) level of unemployment.
High income-related benefits may create a poverty trap
The higher the level of income-related benefits and the more steeply they taper off, the greater will be the problem of the poverty trap. What is the point in unemployed people seeking jobs, or people in very low-paid jobs seeking better ones, if as a result they lose their benefits and end up being little or no better off than before? The more that people are discouraged in this way, the lower will be the level of aggregate supply.
Fiscal Drag
Automatic stabilisers help to reduce upward and downward movements in national income. This is fine if the current level of income is the desirable level. But suppose that there is currently a deep recession in the economy, with mass unemployment. Who would want to stabilise the economy at this level?
In this circumstances, if the economy began to recover, the automatic stabilisers would act as a drag on the expansion. This is known as the fiscal drag. By reducing the size of the multiplier, the automatic stabilisers are, the bigger the change in G or T that would be necessary to achieve a given change in national income.
In this circumstances, if the economy began to recover, the automatic stabilisers would act as a drag on the expansion. This is known as the fiscal drag. By reducing the size of the multiplier, the automatic stabilisers are, the bigger the change in G or T that would be necessary to achieve a given change in national income.