1 Comments on Automatic Stabilizers William Gale Brookings Institution IMF Workshop on Fiscal Policy June 2, 2009

2 Two Issues Trade-offs between stabilization and efficiency Trade-offs between stabilization and sustainability

3 Stabilization and Efficiency

4 “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

5 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.

6 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.

7 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 stabilize.

8 Automatic stabilizers also work through supply channels …Regardless of whether the shock is to demand or supply 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 consumption. –Note that a temporary income tax rate change should generate a stronger labor supply response than a permanent change.

9 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

10 Stabilization and Sustainability

11 Spain Long expansion fueled by housing and asset growth. Substantial boost in revenues. How much is temporary, due to the changing composition of the economy, how much is permanent/ structural? 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.

12 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.

13 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?

14 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

15 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 interesting.