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AUTOMATIC STABILIZERS
Once the government sets a budget, it decides how
much it will tax and what programs it will operate.
How, over the course of a year, tax revenues and
expenditures may differ from the planned levels, if
GDP rises or falls more than anticipated.
Government revenues rise as GDP rises because
total tax payments increase as GDP rises.
Government expenditures fall as GDP rises, c.p.
Because transfer payments fall as GDP rises.
If government intended to balance its budget, it will
have planned for revenues to equal expenditures
when GDP equalled 600. But if income exceeds 600,
it will have a surplus. If income is less than 600 it
will have a deficit.
Rising tax revenues slow the economy down as GDP
rises. As taxes go up, consumers have less to spend
and AD shifts to the left, reducing equilibrium
income. The government doesn’t have to make any
decisions or pass any legislation. It doesn’t even
have to know that income is rising. The tax system,
particularly with progressive taxes that take a larger
portion of incomes the higher they are,
automatically results in revenues rising as GDP
rises.
Rising expenditures, especially transfer payments
speed the economy up down as GDP falls. As
transfers go up, consumers have more to spend and
AD shifts to the right left, increasing equilibrium
income. The government doesn’t have to make any
decisions or pass any legislation. It doesn’t even
have to know that income is falling. Established
gov’t programs, such as unemployment insurance,
welfare rebates, child tax benefits and welfare
automatically increase as GDP falls.
One result is that gov’t does not have full control
over its budget balance. If the economy performs
worse than anticipated, it will automatically run a
deficit or reduce its surplus. If the economy performs
better than anticipated, it will automatically run a
surplus or reduce its deficit.
A second result of these automatic stabilizers, is that
they reduce the size of the multiplier and stabilize
the economy. The aggregate expenditure curve is
flatter than it would otherwise be, because rising
taxes lower the increase in spending as GDP rises and
rising transfer payments reduce the fall in spending
as GDP falls.
Remember that the business cycle is caused by shifts
in AD. Ideally, AD will steadily shift to the right as
LAS sifts right due to long-term growth. We don’t
want it scooting to the right or falling to the left,
every time exports rise or fall or every time investors
become optimistic.
Note that if the government always tries to balance its
budget, it will DESTABILIZE the economy.
If we enter a recession, GDP falls and a government
that planned to balance its budget will have a deficit.
The government can only eliminate the deficit by
increasing taxes or cutting spending.
Substantial spending cuts would be required to
eliminate the deficit – and they wouldn’t work,
because, cutting spending would further reduce GDP,
so there would still be a deficit, though a smaller one.