Thursday, March 21, 2013

Automatic Fiscal Stabilizers

Standard macroeconomic theory suggests that a central government can ameliorate swings in the business cycle through fiscal policy. Thus, when an economy is in recession, it's a good time for the government to prop up demand with some combination of tax cuts or spending increases. Conversely, when an economy is running red-hot, it's a good time for the government to slow down demand with some combination of tax increases or spending cuts. Indeed, a number of tax and spending programs adjust this way automatically, without the passage of legislation, and thus are know as "automatic stabilizers." The Congressional Budget Office has published a short  primer: "The Effects of Automatic Stabilizers on the Federal Budget as of 2013." 

For example, during the sluggish aftermath of the Great Recession, more people are drawing unemployment benefits, and relying on programs like Food Stamps and Medicaid. Conversely, the unemployed and underemployed are making lower income tax payments than they would have made if employed. These effects are built into the design of the tax code and into the design of safety net programs. This is how automatic stabilizers work. The CBO reports: "In fiscal year 2012, CBO estimates, automatic stabilizers added $386 billion to the federal budget deficit, an amount equal to 2.3 percent of potential GDP ... That outcome marked the fourth consecutive year that automatic stabilizers added to the deficit by an amount equal to or exceeding 2.0 percent of potential GDP, an impact that had previously been equaled or exceeded only twice in the past 50 years, in fiscal years 1982 and 1983 ..."

Here's a figure showing the actual budget deficits with the automatic stabilizers, and then what the budget deficit would have looked like in the absence of automatic stabilizers. Notice that during the dot-com boom years of the late 1990s, the actual budget surplus was larger than it would have been without the automatic stabilizers--that is, the stabilizers were working to slow down the economy. Around 2005, the automatic stabilizers were neither making the actual budget deficit higher or lower. But then during the recent recession, as in past recessions, the automatic stabilizers contribute to making the deficit larger.

For the record, you may sometimes hear someone make a comment about the “cyclically adjusted deficit” or the “structural deficit.” These terms refer to what the budget deficit (or surplus) would be without the automatic stabilizers--it's the blue line in the figure above.

As a policy tool, automatic fiscal stabilizers have the great advantage that they take effect in real time as the economy changes, without a need for legislation. Even those who may oppose discretionary fiscal policy, where additional tax cuts or spending increases are passed after a recession is underway, don't oppose the idea that when people's income falls, their taxes should fall and their use of safety net programs should rise.