What is the main advantage of automatic stabilizers over discretionary fiscal policy? Automatic stabilizers take effect very quickly, whereas discretionary policy can take a long time to implement.
Explain how automatic stabilizers work, both on the taxation side and on the spending side, first in a situation where the economy is producing less than potential GDP and then in a situation where the economy is producing more than potential GDP. In a recession, because of the decline in economic output, less income is earned, and so less in taxes is automatically collected.
During a recession, more people fall into these categories and become eligible for benefits automatically. The combination of reduced taxes and higher spending is just what is needed for an economy in recession producing below potential GDP. With an economic boom, average income levels rise in the economy, so more in taxes is automatically collected. Fewer people meet the criteria for receiving government assistance to the unemployed or the needy, so government spending on unemployment assistance and welfare falls automatically.
This combination of higher taxes and lower spending is just what is needed if an economy is producing above its potential GDP. What is the difference between discretionary fiscal policy and automatic stabilizers? Is Medicaid federal government aid to low-income families and individuals an automatic stabilizer? Skip to content Government Budgets and Fiscal Policy. 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.
Counterbalancing Recession and Boom Consider first the situation where aggregate demand has risen sharply, causing the equilibrium to occur at a level of output above potential GDP. 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.
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.
Key Concepts and Summary Fiscal policy is conducted both through discretionary fiscal policy, which occurs when the government enacts taxation or spending changes in response to economic events, or through automatic stabilizers, which are taxing and spending mechanisms that, by their design, shift in response to economic events without any further legislation.
Self-Check Questions In a recession, does the actual budget surplus or deficit fall above or below the standardized employment budget?
It falls below because less tax revenue than expected is collected. Review Questions What is the difference between discretionary fiscal policy and automatic stabilizers? What is the standardized employment budget?
How did the Tax Cuts and Jobs Act change personal taxes? How did the Tax Cuts and Jobs Act change business taxes? Key Elements of the U. What are itemized deductions and who claims them? How did the TCJA change the standard deduction and itemized deductions?
What are personal exemptions? How do federal income tax rates work? What are tax credits and how do they differ from tax deductions? How do phaseouts of tax provisions affect taxpayers?
Capital Gains and Dividends How are capital gains taxed? What is the effect of a lower tax rate for capital gains? What is carried interest, and how is it taxed? How might the taxation of capital gains be improved?
Who pays the AMT? How much revenue does the AMT raise? Taxes and the Family What is the child tax credit? What is the adoption tax credit? What is the earned income tax credit? Do all people eligible for the EITC participate? How does the tax system subsidize child care expenses? What are marriage penalties and bonuses? How did the TCJA change taxes of families with children? Taxes and the Poor How does the federal tax system affect low-income households?
What is the difference between refundable and nonrefundable credits? Can poor families benefit from the child tax credit? Why do low-income families use tax preparers? How does the earned income tax credit affect poor families?
What are error rates for refundable credits and what causes them? How do IRS audits affect low-income families? Taxes and Retirement Saving What kinds of tax-favored retirement arrangements are there? How large are the tax expenditures for retirement saving? What are defined benefit retirement plans? What are defined contribution retirement plans?
What types of nonemployer-sponsored retirement savings accounts are available? What are Roth individual retirement accounts? Who uses individual retirement accounts? How does the availability of tax-favored retirement saving affect national saving?
What is an automatic k? How might low- and middle-income households be encouraged to save? Taxes and Charitable Giving What is the tax treatment of charitable contributions? What entities are tax-exempt? Who benefits from the deduction for charitable contributions? How would various proposals affect incentives for charitable giving? How large are individual income tax incentives for charitable giving?
How did the TCJA affect incentives for charitable giving? Taxes and Health Care How much does the federal government spend on health care? Who has health insurance coverage? Which tax provisions subsidize the cost of health care? How does the tax exclusion for employer-sponsored health insurance work?
What are premium tax credits? What tax changes did the Affordable Care Act make? How do health savings accounts work? How do flexible spending accounts for health care expenses work?
What are health reimbursement arrangements and how do they work? How might the tax exclusion for employer-sponsored health insurance ESI be reformed? Taxes and Homeownership What are the tax benefits of homeownership? Do existing tax incentives increase homeownership? Taxes and Education What tax incentives exist for higher education? What tax incentives exist to help families pay for college? What tax incentives exist to help families save for education expenses?
What is the tax treatment of college and university endowments? Tax Complexity Why are taxes so complicated? What are the benefits of simpler taxes? What policy reforms could simplify the tax code?
Wealth Transfer Taxes How do the estate, gift, and generation-skipping transfer taxes work? Who pays the estate tax? How many people pay the estate tax?
What is the difference between carryover basis and a step-up in basis? How could we reform the estate tax? What are the options for taxing wealth transfers? What is an inheritance tax? Payroll Taxes What are the major federal payroll taxes, and how much money do they raise?
What is the unemployment insurance trust fund, and how is it financed? It is important to note that changes in expenditures and taxes that occur through automatic stabilizers do not shift the aggregate demand curve.
Because they are automatic, their operation is already incorporated in the curve itself. For example, the increase in defense spending in the early s under President Ronald Reagan and in the administration of George W. Bush were undertaken primarily to promote national security. That the increased spending affected real GDP and employment was a by-product. The effect of such changes on real GDP and the price level is secondary, but it cannot be ignored.
Our focus here, however, is on discretionary fiscal policy that is undertaken with the intention of stabilizing the economy. As we have seen, the tax cuts introduced by the Bush administration were justified as expansionary measures. Discretionary government spending and tax policies can be used to shift aggregate demand. Expansionary fiscal policy might consist of an increase in government purchases or transfer payments, a reduction in taxes, or a combination of these tools to shift the aggregate demand curve to the right.
A contractionary fiscal policy might involve a reduction in government purchases or transfer payments, an increase in taxes, or a mix of all three to shift the aggregate demand curve to the left.
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