Discretionary policy and automatic stabilisers

Overview

Automatic stabiliser, discretionary fiscal policy and fiscal drag.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is an automatic stabiliser?

   Model answer

   An automatic stabiliser is a feature of the existing tax and benefit system that causes government revenue and spending to change with the level of economic activity without any new decision being taken. Because taxes are levied on income, profits and spending, revenue falls automatically when the economy weakens and rises when it strengthens; because benefits are paid to people out of work or on low incomes, spending automatically rises in a downturn and falls in a recovery. The effect is to damp fluctuations in disposable income and therefore in demand, so the cycle is smoother than it would otherwise be, and it happens as a by-product of the system's ordinary operation.

2. 2

   What is discretionary fiscal policy?

   Model answer

   Discretionary fiscal policy is a deliberate change in tax rates, tax structures or spending programmes made in order to influence the economy. Cutting income tax to raise disposable income, launching a programme of public investment, raising benefit rates in a recession or increasing tax rates to restrain demand in a boom are all discretionary acts. It differs from an automatic stabiliser in that it requires a decision, and normally legislation and administration, so it can be aimed precisely at a chosen group or region but arrives only after the decision has been taken and implemented.

3. 3

   Which parts of the tax and benefit system act as automatic stabilisers, and why?

   Model answer

   On the revenue side, income tax and social contributions fall when employment and earnings fall; corporation tax falls when profits fall, and profits are far more volatile than output, so this element is a powerful stabiliser; consumption taxes fall when spending falls; and transaction taxes on property and shares fall when markets are quiet. On the spending side, unemployment benefit rises directly with the number out of work, and means-tested support for housing and low incomes rises as incomes fall. Each of these responds to the state of the economy through its existing rules, so the government's net withdrawal from the circular flow shrinks in a downturn and grows in a boom without anyone deciding that it should.

4. 4

   Set out step by step how automatic stabilisers cushion a recession.

   Model answer

   Demand falls, so firms reduce output and lay off workers. Those who lose their jobs stop paying income tax and contributions, so the state takes less out of household income than before. They immediately become entitled to unemployment and means-tested benefits, so the state puts money back in. Firms whose profits have fallen pay less corporation tax, which protects their cash flow and reduces the pressure on them to cut further. Households whose spending has fallen pay less in consumption taxes. The combined effect is that disposable income falls by considerably less than pre-tax income has fallen, so consumption falls by less than it otherwise would, and the second round of job losses that a larger fall in spending would have produced is reduced. The government's deficit widens by exactly the amount of this support, so the fall in private demand is partly replaced by public borrowing.

5. 5

   How do automatic stabilisers restrain a boom?

   Model answer

   As output and employment rise, more people are in work and earnings grow, so income tax and contributions rise, and with a progressive system some of the extra income is taxed at higher rates, so revenue rises proportionately more than income. Company profits rise strongly, so corporation tax rises sharply. Consumer spending grows, so consumption and transaction taxes grow. At the same time fewer people claim unemployment and means-tested benefits, so that spending falls. The state therefore withdraws a growing share of the extra income generated, so disposable income and demand rise by less than output does, which restrains the expansion and the inflationary pressure it would otherwise generate, and the budget balance improves automatically.

6. 6

   Why is a progressive income tax a stronger automatic stabiliser than a flat-rate tax?

   Model answer

   Under a flat tax, revenue changes in the same proportion as income, so the share of any change in income taken by the state is constant. Under a progressive system the marginal rate exceeds the average rate, so when income rises the extra income is taxed at a higher rate than the income already earned, and when income falls the income lost was being taxed at that higher rate. A larger fraction of any change in pre-tax income is therefore absorbed by the tax system, so disposable income moves less for a given movement in output. The more steeply the marginal rate rises with income, the stronger the stabilising effect, which is one reason economies with progressive taxes and generous means-tested benefits show smaller cyclical swings in consumption.

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