Question

In: Economics

Why do we call proportional income taxes and the welfare system “automatic stabilizers”?

2. Explain the following:

a) Why do we call proportional income taxes and the welfare system “automatic stabilizers”? Choose one of these mechanisms and explain carefully how and why it affects fluctuations in output.

b) What happens to the size of multiplier if we consider progressive tax system? Explain using formulas. What kind of an impact will it have on the slope of AE schedule and S&T schedule? Use diagrams.

c) What is full employment balanced budget? Is it a more useful measure than unadjusted balanced budget? Carefully explain.

Solutions

Expert Solution

(A) ANSWER-

Automatic Stabilizers

Automatic stabilizers are modern government budget policies that act to dampen fluctuations in real GDP.

In macroeconomics, the concept of automatic stabilizers describes how modern government budget policies, particularly income taxes and welfare spending, act to dampen fluctuations in real GDP. The size of the government budget deficit tends to increase when a country enters a recession, which tends to keep national income higher by maintaining aggregate demand. This effect happens automatically depending on GDP and household income, without any explicit policy action by the government, and acts to reduce the severity of recessions.

Here is an example of how automatic stabilizers would work in a recession. When the country takes an economic downturn, more people become unemployed. As a result more people file for unemployment and other welfare measures, which increases government spending and aggregate demand. The unemployed also pay less in taxes because they are not earning a wage, which in turn decreases government revenue. The result is an increase in the federal deficit without Congress having to pass any specific law or act.

Similarly, the budget deficit tends to decrease during booms, which pulls back on aggregate demand. Because more people are earning wages during booms, the government can collect more taxes. Also, because fewer individuals need social services support during a boom, government spending also decreases. As spending decreases, aggregate demand decreases. Therefore, automatic stabilizers tend to reduce the size of the fluctuations in a country’s GDP.

Proportional tax

A proportional tax is a tax imposed so that the tax rate is fixed, with no change as the taxable base amount increases or decreases. The amount of the tax is in proportion to the amount subject to taxation. “Proportional” describes a distribution effect on income or expenditure, referring to the way the rate remains consistent (does not progress from “low to high” or “high to low” as income or consumption changes), where the marginal tax rate is equal to the average tax rate.

(B) ANSWER-

What determines the size of Multiplier?

  • The size of the multiplier depends on withdrawals and the marginal propensity to consume
  • If nurses spend 90% of their extra income, the multiplier effect will be high. If they spend only 10% of extra income the multiplier effect will be low.
  • A cut in income tax means that people keep a high % of their gross income. Therefore the multiplier effect will be higher. A cut in income tax is a withdrawal – leading to less spending and therefore it reduces the size of the multiplier.
  • Multiplier Formula = 1 / 1-mpc
  • It depends on which rate of income tax is cut. For example, high-income earners have a lower marginal propensity to consume – they find it harder to find things they need to buy. If you cut the top rate of income tax, a higher % of the tax cut will be saved. Therefore, the multiplier effect will be lower.
  • If the income tax rate for low-income earners is cut (e.g. raising income tax threshold). This will have a bigger impact on increasing spending because low-income earners have a higher marginal propensity to spend.
  • Ricardian equivalance. It may also depend on whether households expect the tax cut to be temporary or permanent. For example, if the government cut taxes by increasing borrowing, then householders may feel in the future tax rates will have to rise to reduce the deficit. In this case, more of the tax cut will be saved rather than spent.
  • Marginal propensity to import (MPM). If the economy has a high propensity to spend extra income on imports, then the multiplier effect will be lower.
  • State of the economy. If the economy is close to full capacity, a cut in income tax may cause only a minor increase in real output. – the tax cut will be inflationary. However, if there is spare capacity (the economy is in recession) then the multiplier effect will be bigger as the tax cut may encourage unused resources to become used.

(C) ANSWER-

Although the idea of budget balance in the administrative budget has been the dominant consideration in the budgetary policy of most countries, it has gradually been realized that such a concept may be inappropriate when external shocks such as exchange rate movements or a world recession occur. Because varying levels of unemployment are a major reason why expenditures may change without comparable change in the public sector output, the concept of a full-employment budget has emerged. This type of budgeting is based on receipts and expenditures that would prevail under conditions of full employment. The approach views the actual expenditures and receipts for the coming year as of secondary importance; it assigns primary importance to the influence of the budget on the national economy. In time of recession a budget deficit may thus be presented as a necessary step toward achieving a balanced budget at full employment. Ideally, the budget should include estimates of expenditures and revenues at full employment, and also estimates of the same items at the anticipated level of employment. These ideas have been extensively used in the United States


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