Automatic Stabilizers in Economics: Definition & Examples

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  • 0:05 Automatic Stabilizers…
  • 3:39 Progressive Tax Code
  • 4:54 Government Programs
  • 5:58 Benefits of Automatic…
  • 6:31 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

Watch this lesson to learn about the features that are built into the tax code and the government's budget that help offset declines in aggregate demand during recessions. Referred to as automatic stabilizers, they also address the needs of individuals facing hard times.

Automatic Stabilizers in the Real World

For the last six months, the economy has begun to contract. At first, nothing seemed to change. The parking lots at the mall were still full. The lines at the premium coffee shops were still long. People still waited for hours in the lobby of restaurants to get in for dinner on Friday night. Little by little, though, over several months, the telltale signs have begun to emerge: an abundance of coupons showing up at the checkout registers of the grocery store; foot traffic at the dollar store has tripled while the other retail stores are now half empty. In addition, news stories on the radio are including segments touting the economic benefit of carpooling to work.

It's a Saturday morning here in the town of Ceelo, and Dave is the manager of the First National Bank of Ceelo. His office is conveniently located to the side of the front door, with windows facing the lobby. Right now, Dave's in his office talking with Joe about a way to refinance his business. Joe the Plumber remodels kitchens and bathrooms for a living, and last year he had the best year he's ever had, completing enough remodeling projects to earn a six-figure income. However, he hasn't received a call in several months, and he's at the bank trying to restructure his business loan payments in response to an economy that's now clearly in recession. Because his income is lower this year, he'll pay much less in taxes next April. Across the lobby from Dave's office are several other Ceelo residents. Sometimes people refer to them as 'Ceelonians,' but that sounds too much like one of those elements in the periodic table.

Eve is a single mom with two kids who used to work as a receptionist for a retail store, but she's been laid off. Because of how low her income is, she qualifies for welfare. Eve is at the bank this morning waiting to cash her welfare check from the federal government. Right behind Eve is Lydia. Lydia has worked at least twenty years for an assembly line in a factory that produces cars. Challenged by cheap labor overseas, car companies have had no choice but to lay off some workers, and Lydia was one of those that got laid off. Lydia's at the bank standing in line waiting to cash the unemployment check that she just received from the government.

What do all of these bank customers have in common? They're benefiting from what economists call 'automatic stabilizers.' What most people don't realize is that things are happening automatically behind the scenes of the government's budget that help smooth out business cycles, raising taxes when the economy is expanding and lowering them during contractions of real GDP.

Automatic stabilizers are a type of fiscal policy that happen automatically and tend to offset fluctuations in economic activity without direct intervention from policymakers. They are tax structures and government spending programs that lead to larger budget deficits during recessions and larger surpluses during expansions. Sometimes called 'non-discretionary,' they are 'automatic,' meaning that no spending law has to be passed in order for them to take place. In addition, they help stabilize a contracting economy; therefore, they're referred to as economic 'stabilizers.'

Progressive Tax Code

Tax rates increase with an increase in income.
Progressive Tax Code

In the United States, the tax code is progressive, which means that the tax rates consumers pay get progressively higher the more income they earn. Last year, Joe paid a higher income tax than Dave did because he earned more than Dave earned. This year, however, Joe will pay less than Dave because of the progressive nature of the tax rates. This is like an automatic tax cut! People pay less in taxes when their income falls. This acts as an automatic stabilizer during recessions, which helps cushion the blow of falling economic output. According to a study completed in 2000, lower income tax and payroll tax paid during recessions offsets about 8% of the decline in real GDP that a recession brings.

The progressivity of the tax code has changed through the course of many different presidential administrations. Some administrations, like Reagan, have made the tax code flatter, while others, like Bill Clinton, have made it more progressive. The more progressive it is, the greater the effect it has as an automatic stabilizer.

Government Programs

Alright, let's talk about government programs. During recessions, government spending automatically increases. Thanks to the unemployment insurance assistance that Lydia is receiving, she has at least enough money to pay for the essentials of life. Transfer payments from programs like welfare and food stamps give people money to buy goods and services, thereby stimulating consumption and increasing economic output. They also address the needs of consumers, like Lydia, who are going through difficult times. Unemployment insurance is an automatic stabilizer that's ready to kick in when people need it the most.

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