View FREE Lessons!
Definition of Automatic Stabilizers:
result from fiscal policies that help stabilize the economy by restraining the economy during expansionary periods and stimulating the economy when growth slows without deliberate action by the government.
Automatic stabilizers flatten a business cycle without direct government intervention by affecting people's disposable income and consumer spending. An increase in consumer spending is expansionary, while a decrease in consumer spending is contractionary.
During recessions incomes decrease, and automatic stabilizers play a valuable role in limiting the financial damage of a recession on consumers and businesses alike. Consumers and businesses spend less, so the economy’s aggregate demand decreases. Lower incomes result in taxpayers dropping to lower tax rates. The lower tax rates result in proportionally less tax being paid, which means that families have a higher disposable income than if they had not fallen to a lower tax bracket.
For example, assume a family earns $100,000 in Year 1. They are in the 30 percent tax bracket and pay $30,000 income tax. Their disposable income equals $70,000 ($100,000 - $30,000). Now assume in Year 2 their income falls to $60,000. They fall to a 15 percent tax bracket and owe $9,000. Their disposable income drops to $51,000, but that is higher than if they continued to be taxed at 30 percent, where they would pay $18,000 and only have $42,000 in disposable income. In this example, the family would have $9,000 more to spend because they are in a lower tax bracket. The added spending diminishes the severity of the recession by slowing down the decline of the economy's aggregate demand.
Transfer payments that automatically increase when the economy stalls are automatic stabilizers since these payments increase the economy’s aggregate demand. An economy’s aggregate demand, or the total amount purchased, decreases during a recession, but transfer payments can limit the fall. Food stamps is a transfer payment paid to low income people who struggle to pay for food. During recessions more families become eligible for assistance, so the total spent on food stamps increases. Food purchases typically decline during recessions, but food stamps offset some of this effect. The combination of lower progressive tax rates and an increase in transfer payments increases consumers’ disposable income. Automatic stabilizers can help avoid a recession or prolong economic growth by increasing consumers’ and businesses’ disposable income and the economy’s aggregate demand without government action.
Automatic stabilizers also slow the economy’s growth rate during overheated periods, when incomes are rising. The added income pushes taxpayers to a higher tax rate, which increases the taxpayer’s tax bill. Meanwhile fewer people would qualify for the transfer payments tied to income such as food stamps, or unemployment insurance, so transfer payments would decrease. This combination slows the growth of aggregate demand, reduces the likelihood of the economy overheating, which in turn reduces inflationary pressure.
This explanation assumes that disposable income and consumer spending are directly related. In the example used, it is apparent that low-income families are helped by lower tax rates and transfer payments. A drop in disposable income may not affect spending for the middle-class or wealthy as much in the short-run. However, on a macroeconomic level, a progressive tax system helps stabilize the economy. The Congressional Budget Office
estimated that during the Great Recession the stimulus exceeded $300 billion per year because of the stabilizers built in.
Dig Deeper With These Free Lessons:
The Federal Budget and Managing The National Debt
Fiscal Policy - Managing an Economy by Taxing and Spending
Aggregate Demand - Relating Inflation and Real Gross Domestic Product
Aggregate Supply and Demand - Macroeconomic Equilibrium