Chapter 8.3: Automatic Stabilizers

8.3 Automatic Stabilizers

Learning Objectives

By the end of this section, you will be able to:

• Describe how the federal government can use discretionary fiscal policy to stabilize the economy
• Identify examples of automatic stabilizers
• Understand how a government can use standardized employment budget to identify automatic stabilizers

Automatic Stabilizers– Definition

It is not practical to expect the government to have to pass a law every time the economy fluctuates to stabilize the economy. Therefore, the government has created policies which respond automatically to shifts in economic conditions. These policies are known as automatic stabilizers because they are designed to automatically stabilize the economy with a need for legislation.

A prime example of an automatic stabilizer is unemployment insurance. When unemployment rises due to slowed production and corporate downsizing, individuals qualify for unemployment benefits. Congressional endorsement isn’t necessary for unemployment insurance; it’s inherent in the system. Therefore, the government automatically employs an expansionary fiscal strategy, in this case, unemployment insurance.

Another example of an automatic stabilizer is the way people often are required to pay less taxes during economic downturns. This happens automatically without government legislation because when people earn less, they often move into lower tax brackets and experience decreased tax liabilities. This lower tax burden can help stabilize the economy.

Federal Discretionary Policy

Federal discretionary policy refers to government actions taken through deliberate legislative or executive decisions to influence economic conditions, typically in response to specific circumstances or goals. Unlike automatic stabilizers, which operate automatically in response to economic conditions (such as unemployment benefits increasing during recessions), discretionary policies require active decision-making by policymakers.

During the COVID-19 pandemic in 2020, the government implemented both automatic stabilizers, such as unemployment insurance, and Federal Discretionary Fiscal Policy. An instance of Federal Discretionary Policy was the distribution of stimulus checks and the augmentation of state and local government assistance approved by Congress during that period.

Counterbalancing Recession and Boom

Consider a situation in which the economy is “overheating” and GDP is expanding too fast. This situation will increase inflationary pressure in the economy. The policy prescription in this setting would be contractionary fiscal policy, implemented through some combination of higher taxes and lower spending. To some extent, both changes happen automatically. On the tax side, a rise in aggregate demand means that workers and firms throughout the economy earn more. Because taxes are based on personal income and corporate profits, a rise in aggregate demand automatically increases tax payments. On the spending side, stronger aggregate demand typically means lower unemployment and fewer layoffs, and so there is less need for government spending on unemployment benefits, welfare, Medicaid, and other programs in the social safety net.

The process can work in reverse, too. If the economy is experiencing a recession, then the prescription would be for expansionary fiscal policy—some mix of tax cuts and spending increases. The lower level of aggregate demand and higher unemployment will tend to pull down personal incomes and corporate profits, an effect that will reduce the amount of taxes owed automatically. Higher unemployment and a weaker economy should lead to increased government spending on unemployment benefits, welfare, and other similar domestic programs. In 2009, the stimulus package included an extension in the time allowed to collect unemployment insurance.

A combination of automatic stabilizers and discretionary fiscal policy produced the very large budget deficit in 2020. The pandemic caused high levels of unemployment, which meant that there were less tax-generating economic activity. The high unemployment rate triggered the automatic stabilizers that reduce taxes and increase spending, due to the increased amount of unemployment insurance paid out by the federal and state governments. Most economists, even those who are concerned about a possible pattern of persistently large budget deficits, are much less concerned or even quite supportive of larger budget deficits in the short run of a few years during and immediately after a severe recession.

The Standardized Employment Deficit or Surplus

Each year, the nonpartisan Congressional Budget Office (CBO) calculates the standardized employment budget—that is, what the budget deficit or surplus would be if the economy were producing at potential GDP, where people who look for work were finding jobs in a reasonable period of time and businesses were making normal profits, with the result that both workers and businesses would be earning more and paying more taxes. In effect, the standardized employment deficit eliminates the impact of the automatic stabilizers. Figure 8.4 compares the actual budget deficits of recent decades with the CBO’s standardized deficit.

“Comparison of Actual Budget Deficits with the Standardized Employment Deficit” by OpenStax, is licensed under CC BY 4.0

Figure 8.4 Comparison of Actual Budget Deficits with the Standardized Employment Deficit When the economy is in recession, the standardized employment budget deficit is less than the actual budget deficit because the economy is below potential GDP, and the automatic stabilizers are reducing taxes and increasing spending. When the economy is performing extremely well, the standardized employment deficit (or surplus) is higher than the actual budget deficit (or surplus) because the economy is producing about potential GDP, so the automatic stabilizers are increasing taxes and reducing the need for government spending. (Sources: Actual and Cyclically Adjusted Budget Surpluses/Deficits, https://www.cbo.gov/data/budget-economic-data#8)

Notice that in recession years, like the early 1990s, 2001, or 2009, the standardized employment deficit is smaller than the actual deficit. (These data are only available up until February 2020, so they do not include the effects of the pandemic.) During recessions, the automatic stabilizers tend to increase the budget deficit, so if the economy was instead at full employment, the deficit would be reduced. However, in the late 1990s the standardized employment budget surplus was lower than the actual budget surplus. The gap between the standardized budget deficit or surplus and the actual budget deficit or surplus shows the impact of the automatic stabilizers. More generally, the standardized budget figures allow you to see what the budget deficit would look like with the economy held constant—at its potential GDP level of output.

Automatic stabilizers occur quickly. Lower wages means that a lower amount of taxes is withheld from paychecks right away. Higher unemployment or poverty means that government spending in those areas rises as quickly as people apply for benefits. However, while the automatic stabilizers offset part of the shifts in aggregate demand, they do not offset all or even most of it. Historically, automatic stabilizers on the tax and spending side offset about 10% of any initial movement in the level of output. This offset may not seem enormous, but it is still useful. Automatic stabilizers, like shock absorbers in a car, can be useful if they reduce the impact of the worst bumps, even if they do not eliminate the bumps altogether.

Child Tax Credit

One new form of government spending meant to support working families is an expanded Child Tax Credit (CTC). Under changes which took effect in 2021, qualifying families will receive the credit as a monthly payment directly into their bank accounts. The credit is also an expanded amount: from $2,000 per child to $3,600 per child under the age of 6 (less for children older than that). Introduced by President Joe Biden’s American Rescue Plan, it is hoped that the newly expanded CTC will help reduce child poverty and support families. Because the CTC works like a grant that is automatically extended to households, the CTC is considered a new kind of fiscal policy that is related to a universal basic income policy which some have argued for in the past. By sending money out monthly instead of a lump sum as part of a person’s tax refund, the intention is to help families better manage monthly bills for things like clothes and food.

This chapter is a revised version of the chapters 17.5 Automatic Stabilizers in Principles of Macroeconomics 3e by OpenStax, published under a Creative Commons Attribution 4.0 International License. Other additions and modifications have been made in accord with the style, structure, and audience of this guide.