Comments on Automatic Stabilizers

Comments on
Automatic Stabilizers
William Gale
Brookings Institution
IMF Workshop on Fiscal Policy
June 2, 2009
Two Issues
• Trade-offs between stabilization and
• Trade-offs between stabilization and
Stabilization and Efficiency
“Pure” Keynesian Model
• Automatic stabilizers work through aggregate demand.
• All shocks are demand shocks.
• In this framework, a more progressive tax system
provides more “income insurance” against shocks and
therefore is a better stabilizer.
• This creates a trade-off between efficiency (which
requires lower rates) and stabilization
Keynesian Model
• “It takes a lot of Harberger triangles to fill
an Okun gap.”
– Captures the notion of a trade-off
– Implies that in the Keynesian framework, the
terms are tilted heavily toward stabilization
policy, away from efficiency.
How strong is the AD channel?
• Depends on the sensitivity of after-tax income to
changes in pre-tax income…
• …And on the sensitivity of consumption to
temporary changes in after-tax income.
– Standard models suggest temporary income tax cuts
should generate a smaller response than a
permanent one.
• Empirical evidence is mixed, but the MPC out of
temporary resources is clearly not zero.
Supply shocks
• Supply shocks do exist.
• We don’t want to stabilize output in
response to a supply shock, we want to let
output adjust.
• But automatic stabilizers often still
Automatic stabilizers also work
through supply channels
• …Regardless of whether the shock is to demand or
• The policy commitment not to leave resources idle
should spur investment in human and physical capital.
(Positive effect on long-term efficiency)
• More complete insurance against downturns can mute
the private sector response and needed adjustments.
(Negative effect on long-term efficiency)
• Progressive taxes will affect labor supply, as well as
– Note that a temporary income tax rate change should generate a
stronger labor supply response than a permanent change.
Revised View of the Trade-off between
Stabilization and Efficiency
• If (a) the negative effects of automatic stabilizers
on aggregate supply are sufficiently strong, and
(b) initial tax rates are sufficiently high, there
may not be a trade-off between efficiency and
stabilization policy.
• In practice, the evidence suggests that some
OECD countries are in the relevant range.
– But the evidence is not overwhelming
Stabilization and Sustainability
• Long expansion fueled by housing and asset
• Substantial boost in revenues. How much is
temporary, due to the changing composition of
the economy, how much is permanent/
• The majority is temporary/compositional.
• Has important implications for understanding
what is cyclical and what is structural.
– The recent downturn shows the dangers of not
making careful distinctions.
US Automatic Stabilizers
• US has smaller automatic stabilizers than
European countries
• They operate almost exclusively through
the tax side.
• Auerbach/Feenberg and Cohen/Follette
find that 8-10% of income fluctuations are
offset by automatic stabilizers.
Trade-off between automatic stabilizers
(rules) and discretionary fiscal policy
• US has a larger discretionary fiscal
package in the current downturn and
significantly more fluid labor markets.
• What’s the best combination of automatic
and discretionary policy?
American Evidence on the Trade-off
Between Stabilization and Efficiency
• Kneiser and Ziliak, AER, 2002
• The tax reforms in the 1980s reduced
MTRs significantly.
• They measure the effects on labor supply,
consumption volatility and utility.
• PSID data
Kneiser and Ziliak, cont.
• The tax cuts generate efficiency gains but
stabilization losses.
– The lower MTRs raised consumption volatility such
that the average household would pay 2.5% of
income to obtain the same consumption volatility
under the post-1986 system as they had under the
pre-1981 tax system.
• Similar micro work in European context would be