In macroeconomics

Macroeconomics

Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...

, automatic stabilizers describes how modern government budget

Government budget

A government budget is a legal document that is often passed by the legislature, and approved by the chief executive-or president. For example, only certain types of revenue may be imposed and collected...

 policies, particularly income tax

Income tax

An income tax is a tax levied on the income of individuals or businesses . Various income tax systems exist, with varying degrees of tax incidence. Income taxation can be progressive, proportional, or regressive. When the tax is levied on the income of companies, it is often called a corporate...

es and welfare spending, act to dampen fluctuations in real GDP

Real GDP

Real Gross Domestic Product is a macroeconomic measure of the value of output economy adjusted for price changes . The adjustment transforms the money-value measure, called nominal GDP, into an index for quantity of total output...

.

The size of the government budget deficit tends to increase when a country enters a recession

Recession

In economics, a recession is a business cycle contraction, a general slowdown in economic activity. During recessions, many macroeconomic indicators vary in a similar way...

, which tends to keep national income higher by maintaining aggregate demand

Aggregate demand

In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...

. There may also be a multiplier effect

Multiplier (economics)

In economics, the fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. More generally, the exogenous spending multiplier is the ratio of a change in national income to any autonomous change in spending In economics, the fiscal...

. This effect happens automatically depending on GDP and household income, without any explicit policy action by the government, and acts to reduce the severity of recessions. Similarly, the budget deficit tends to decrease during booms, which pulls back on aggregate demand. Therefore, automatic stabilizers tend to reduce the size of the fluctuations in a country's GDP.

Induced taxes

Tax revenues generally depend on household income and the pace of economic activity. Household incomes fall and the economy slows down during a recession, and government tax revenue

Tax revenue

Tax revenue is the income that is gained by governments through taxation.Just as there are different types of tax, the form in which tax revenue is collected also differs; furthermore, the agency that collects the tax may not be part of central government, but may be an alternative third-party...

s fall as well. This change in tax revenue occurs because of the way modern tax systems are generally constructed.

• Income tax
  Income tax
  An income tax is a tax levied on the income of individuals or businesses . Various income tax systems exist, with varying degrees of tax incidence. Income taxation can be progressive, proportional, or regressive. When the tax is levied on the income of companies, it is often called a corporate...
  
  es are generally at least somewhat progressive. This means that as household incomes fall during a recession, households will pay less a smaller proportion of their income as income tax. Therefore, income tax revenue tends to fall faster than the fall in household income.
• Corporate tax
  Corporate tax
  Many countries impose corporate tax or company tax on the income or capital of some types of legal entities. A similar tax may be imposed at state or lower levels. The taxes may also be referred to as income tax or capital tax. Entities treated as partnerships are generally not taxed at the...
  
   is generally based on profits
  Profit (economics)
  In economics, the term profit has two related but distinct meanings. Normal profit represents the total opportunity costs of a venture to an entrepreneur or investor, whilst economic profit In economics, the term profit has two related but distinct meanings. Normal profit represents the total...
  
  , rather than turnover
  Revenue
  In business, revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. In many countries, such as the United Kingdom, revenue is referred to as turnover....
  
  . In a recession profits tend to fall much faster than turnover. Therefore, a company pays much less tax while having only slightly less economic activity.
• Sales tax
  Sales tax
  A sales tax is a tax, usually paid by the consumer at the point of purchase, itemized separately from the base price, for certain goods and services. The tax amount is usually calculated by applying a percentage rate to the taxable price of a sale....
  
   depends on the dollar volume of sales, which tends to fall during recessions.

If national income rises, by contrast, then tax revenues will rise. During an economic boom, tax revenue is higher and in a recession tax revenue is lower, not only in absolute terms but as a proportion of national income.

Some other forms of taxation do not exhibit these effects, if they bear no relation to income (e.g. poll tax

Poll tax

A poll tax is a tax of a portioned, fixed amount per individual in accordance with the census . When a corvée is commuted for cash payment, in effect it becomes a poll tax...

es, export tariff

Tariff

A tariff may be either tax on imports or exports , or a list or schedule of prices for such things as rail service, bus routes, and electrical usage ....

s or property tax

Property tax

A property tax is an ad valorem levy on the value of property that the owner is required to pay. The tax is levied by the governing authority of the jurisdiction in which the property is located; it may be paid to a national government, a federated state or a municipality...

es).

Transfer payments

Most governments also pay unemployment

Unemployment

Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

 and welfare benefits. Generally speaking, the number of unemployed people and those on low incomes who are entitled to other benefits increases in a recession and decreases in a boom.

This means that government expenditure increases automatically in recessions and decreases automatically in a boom in absolute terms. Since the trend of output is to increase in booms and decrease in recessions, expenditure is expected to increase as a share of income in recessions and decrease as a share of income in booms.

Automatic stabilizers incorporated into the expenditure multiplier

This section incorporates automatic stabilization into a broadly Keynesian multiplier

Multiplier (economics)

In economics, the fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. More generally, the exogenous spending multiplier is the ratio of a change in national income to any autonomous change in spending In economics, the fiscal...

 model.

• MPC = Marginal propensity to consume
  Marginal propensity to consume
  In economics, the marginal propensity to consume is an empirical metric that quantifies induced consumption, the concept that the increase in personal consumer spending occurs with an increase in disposable income...
  
  
• T = Induced taxes
• MPI = Marginal Propensity to Import

Holding all other things constant, ceteris paribus

Ceteris paribus

or is a Latin phrase, literally translated as "with other things the same," or "all other things being equal or held constant." It is an example of an ablative absolute and is commonly rendered in English as "all other things being equal." A prediction, or a statement about causal or logical...

, the greater the level of taxes, or the greater the MPI then the value of this multiplier will drop. For example, lets assume that:

→ MPC = 0.8

→ T = 0

→ MPI = 0.2

Here we have an economy with zero marginal taxes and zero transfer payments. If these figures were substituted into the multiplier formula, the resulting figure would be 2.5. This figure would give us the instance where a (for instance) $1 billion change in expenditure would lead to a $2.5 billion change in equilibrium real GDP.

Lets now take an economy where there are positive taxes (an increase from 0 to 0.2), while the MPC and MPI remain the same:

→ MPC = 0.8

→ T = 0.2

→ MPI = 0.2

If these figures were now substituted into the multiplier formula, the resulting figure would be 1.79. This figure would give us the instance where, again, a $1 billion change in expenditure would now lead to only a $1.79 billion change in equilibrium real GDP.

This example shows us how the multiplier is lessened by the existence of an automatic stabiliser, and thus helping to lessen the fluctuations in real GDP as a result from changes in expenditure. Not only does this example work with changes in T, it would also work by changing the MPI while holding MPC and T constant as well.

There is broad consensus among economists that the automatic stabilizers often exist and function in the short term.

Additionally, imports often tend to decrease in a recession, meaning more of the national income is spent at home rather than abroad. This also helps stabilize the economy.