Automatic stabilizers are changes in fiscal policy Opens in new window that stimulate aggregate demand Opens in new window when the economy Opens in new window goes into a recession Opens in new window but that occur without policymakers having to lift a finger or take any deliberate action.
The most important automatic stabilizer is the tax system Opens in new window.
When the economy goes into a recession, the amount of taxes collected by the government falls automatically because almost all taxes are closely tied to economic activity.
- The personal income tax depends on household’s incomes,
- the payroll tax depends on workers’ earnings, and
- the corporate income tax depends on firm’s profits.
Because incomes, earnings, and profits all fall in a recession, the government’s tax revenue falls as well. This automatic tax cut stimulates aggregate demand and, thereby, reduces the magnitude of economic fluctuations.Some government spending also acts as an automatic stabilizer.
In particular, when the economy goes into a recession and workers are laid off, more people become eligible for unemployment insurance benefits Opens in new window, welfare benefits Opens in new window, and other forms of income support.
This automatic increase in government spending stimulates aggregate demand at exactly the time when aggregate demand is insufficient to maintain full employment.
Indeed, when the unemployment insurance system was first enacted in the 1930s, economists who advocated this policy did so in part because they recognized its power as an automatic stabilizer.
The automatic stabilizers in the U.S. economy are not sufficiently strong to prevent recessions completely. Nonetheless, without these automatic stabilizers, output and employment would probably be more volatile than they are.
For this reason, many economists oppose a constitutional amendment that would require the federal government to always run a balanced budget, as some politicians have proposed.
When the economy goes into a recession, taxes fall, government spending rises, and the government’s budget moves toward deficit.
If the government faced a strict balanced-budget rule, it would be forced to look for ways to raise taxes or cut spending in a recession. In other words, a strict balanced-budget rule would eliminate the automatic stabilizers inherent in our current system of taxes and government spending.