Question

Describe how certain aspects of fiscal policy function as automatic stabilizers for the economy.

Answer 1

Automatic stabilizers account for changes in economic activity without direct interference by policy makers. If income is high, tax obligations increase and the eligibility for government benefits falls, without any improvement in the tax code or other legislation. Conversely, as income falls, tax obligations decline and more households are eligible for government benefit services, such as food stamps and unemployment insurance, to cover their income.

Automatic stabilizers also operate in the tax and transfer processes of state and local governments. Nevertheless, state constitutions typically mandate balanced budgets, which can cause countervailing adjustments in spending and tax laws. These provisions do not force the full balance on an annual basis: they usually concentrate on budget forecasts rather than on execution, so that deficits can still exist when economic conditions are unexpectedly low.

When an economy is in recession, automatic stabilizers will result in higher budget deficits by design. This is an aspect of fiscal policy, a keynesian economics mechanism that uses government expenditure and taxes to boost aggregate demand in the economy during economic downturns. Through taking less money from private companies and households in taxation and giving them more in the form of subsidies and tax refunds, fiscal policy is intended to allow them to raise, or at least not decrease, their consumption and investment spending in order to help avoid the economic downturn from worsening.

Automatic stabilizers are meant to be the first line of protection, as they react almost instantly to shifts in income and unemployment in order to transform mild negative economic trends around. Governments, however, frequently turn to these other types of broader fiscal policy initiatives to tackle more serious or long-term recessions, or to target particular regions, sectors, or politically favored groups in society for extra economic relief.