In-Built Stabilizers

Although there is some call for a deliberate fiscal policy which manipulates expenditure and taxation in an attempt to influence aggregate demand, the income tax system provides a degree of automatic stabilization. An increase in employment and incomes will tend to increase taxation relative to government expenditure, acting as a brake on the economy. Conversely, a decrease in employment and incomes will tend to reduce taxation relative to expenditure, thus tending to stimulate economic activity. These effects will come into play without any explicit action by government authorities, and may be important in reducing fluctuations in economic activity.

An in-built stabilizer can be defined as any policy which automatically reduces government expenditure and/or increases taxation when income and output are increasing, and increases government expenditure and/or reduces taxation when income and output are falling. The most important in-built stabilizers are taxes, transfers and price supports. Almost all taxes vary with income; not only direct income taxes, but also sales taxes, excise taxes, taxes on profits, value-added taxes, etc. The effect is most marked with income taxes, especially if the tax is highly progressive (higher-income households are taxed at a higher average rate than lower-income households). Transfers are also in-built stabilizers when the payments tend to vary inversely with income and output. For example, unemployment insurance pays more when income is lower and vice-versa.

Price supports are systems for maintaining prices in the face of adverse market pressures, for example so that farmers can maintain a livable income even if downward price pressure exists. Price supports are similar to welfare programs in that they pay out more when income would have been lower.

The properties of stabilization built into government programs are not always desirable. If the economy is running near full employment with reasonably low inflation, fluctuations are generally bad and stabilizers are helpful. However, if the economy is running with substantial unemployment or inflation, in-built stabilizers will tend to resist the desired change. Some economists believe that there are strong forces at work which tend to return an economy to full employment. Because of this, they believe that any discretionary fiscal policy is damaging, and advocate a non-discretionary fiscal policy which relies solely on in-built stabilizers to return the economy to full employment. They propose that the aim of fiscal policy should be to achieve a balanced budget at Q (defined as the highest level of income consistent with price stability). Given a full employment budget balance and the appropriate use of in-built stabilizers, any economic upturn or downturn will automatically trigger a surplus or defecit that will tend to return the economy to its full employment level.

Economists who support a non-discretionary fiscal policy are called monetarists, and also support a non-discretionary monetary policy. The monetarists’ view is that discretionary policies will tend to increase the amplitude of market fluctuations. The opposing view is held by Keynesians, who believe that discretionary fiscal and monetary policy will have a stabilizing influence. Both monetarists and Keynesians would agree that there are times when in-built stabilizers are undesirable. If an economy has high employment or high inflation then the effect of ‘fiscal drag’ may produce unplanned and undesirable results. In a situation of heavy unemployment, if aggregate demand increases, in-built stabilizers will tend to reduce the magnitude of the increase. Another undesired effect can occur when unindexed taxes are combined with high inflation. If tax thresholds are set in money terms, then under high inflation they quickly drop in real terms. This can result in a rapid, unplanned transfer of income from households to the government