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4.10 Definition and aims of monetary policy, and the role of the RBA
FIGURE 4.11 The two types of stabilisers used in budgetary policy as an aggregate demand policy measure.
The two types of budget ‘stabilisers’
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Automatic or cyclical budget stabilisers These are unconscious changes built into the budget to spontaneously help regulate AD, promote domestic macroeconomic goals and improve living standards In an upswing ... automatically tax receipts rise and welfare outlays fall, typically causing the budget outcome to gradually switch from an expansionary deficit to a contractionary surplus to help slow AD and economic activity In a slowdown ... automatically the value of tax receipts fall and welfare outlays rise, typically causing the budget outcome to gradually switch from a contractionary surplus to an expansionary deficit to help lift AD and economic activity
Discretionary or structural budget stabilisers These are deliberate policy decisions announced by the treasurer to help regulate AD, promote domestic macroeconomic goals and improve living standards In an upswing ... the Treasuer could announce discretionary rises in particular tax rates and/or cuts in levels of specific outlays, typically causing the budget outcome to switch from an expansionary deficit to a contractionary surplus to help slow AD and economic activity In a slowdown ... the Treasurer could announce discretionary cuts in particular tax rates and/or rises in the levels of specific outlays, typically causing the budget outcome to switch from an contractionary surplus to an expansionary deficit to help lift AD and economic activity By changing the value of budget receipts relative to outlays, these two stabilisers alter the budget outcome and affect the levels of household consumption spending (C), business investment spending (I), government consumption spending (G1), government capital spending (G2), national savings (S) and hence AD. At least in theory, fiscal or budgetary policy applied countercyclically, should be able to help steer the economy along the narrow but ideal pathway between boom on the one hand and recession on the other. So how exactly do these automatic and discretionary stabilisers work? 4.7.1 The role of automatic stabilisers in influencing aggregate demand and stabilising the business cycle Automatic stabilisers (also called cyclical stabilisers) involve upward and downward changes in the values of tax receipts and welfare outlays, without any deliberate, new policy decisions being made by the treasurer. They are driven solely by changes in economic activity and operate behind the scenes to countercyclically alter the budget outcome and stance, in a way to help stabilise AD. So, in a downturn, the budget stance would automatically switch towards more expansionary deficits, becauseUNCORRECTED PAGE PROOFS as we shall soon see, less tax revenue would be collected and there would also be higher welfare outlays for the rising number of unemployed. In a slowdown, this would stimulate AD and promote the government’s macroeconomic goals and living standards.
In reverse, during a recovery, the budget stance would again automatically switch towards contractionary surpluses, due to increased tax receipts relative to lower welfare outlays. This would slow AD and also help to improve macroeconomic conditions.
With these big ideas in mind, let’s now take a closer look at how automatic stabilisers work in this clever way.
During and immediately following a cyclical slowdown or in a recession (as in 2020), automatically, the budget switches to become more expansionary (typically a deficit). This helps to stimulate AD and economic activity, in two main ways. Firstly, the value of tax receipts collected decreases because output, employment, disposable incomes and spending are lower. For example: • Firms pay fewer dollars in company tax because their sales and profits are down. • Individuals (some of whom are now unemployed and on welfare payments) pay less personal income tax. • Excise and sales tax revenues are down because with lower incomes and confidence, people spend less and purchase fewer goods and services. Secondly, the budget automatically becomes more expansionary in a slowdown because there is an increase in government welfare outlays, simply because more people are unemployed and on lower incomes, and so a greater number of individuals qualify for benefits such as the JobSeeker allowance. With less tax receipts or leakages and more welfare outlays, expansionary automatic stabilisers work countercyclically boost household consumption, business investment, AD and economic activity. This helps to promote stronger but sustainable economic growth and lower cyclical unemployment that are needed for better living standards. Using automatic stabilisers during rising economic activity and an inflationary upswing During and immediately following a cyclical upswing or in a boom (as in 2007–08), the budget automatically becomes more contractionary (typically a surplus) designed to slow the growth in AD and economic activity, in two main ways. Firstly, the budget becomes more contractionary in a boom, simply because there is an automatic increase in the value of tax receipts collected by the government. This is due to a rise in output, employment, disposable incomes and spending. For example: • Firms pay more dollars in company tax because their sales and profits are higher. • Individuals pay more dollars in personal income tax as rising wages push people into higher tax brackets. • Excise and sales tax revenues are up because with higher incomes and confidence, people spend more and increase their purchases of goods and services. Secondly, the budget automatically becomes more contractionary as the economy strengthens, because there is a decrease in government welfare outlays due to lower unemployment numbers, higher incomes and fewer individuals qualifying for benefits. So in a boom with more tax receipts or leakages collected and fewer people on welfare, automatic stabilisers tend to countercyclically slow household consumption and business investment, AD and the level of economic activity to a sustainable pace. This helps to curb demand inflation, promote greater domestic economic stability and create improved living standards. Remarkable as it seems, automatic stabilisers work fairly quickly and efficiently, without the government having to change its policy decisions. In addition, given the right fiscal settings, cyclical budget deficits that are run up during a slowdown should be repaid by cyclical surpluses recorded in the recovery (at least in theory). As a UNCORRECTED PAGE PROOFS result, in the medium- to long-term the operation of automatic stabilisers should not lead to a rise in government debt.
Discretionary stabilisers (sometimes called structural stabilisers) involve deliberate policy decisions by the treasurer to either lower or raise tax rates (e.g. personal income and company tax), and/or make planned government outlays (e.g. on welfare, infrastructure, education) either more or less generous. When applied in a countercyclical way, discretionary stabilisers can influence the levels of C, I, G1 and G2, and thus help to promote the achievement of the government’s domestic macro goals and living standards. Discretionary measures are sometimes introduced when automatic stabilisers are not sufficiently powerful on their own to deal with a prolonged and severe recession. However, unless these are removed following the crisis, they could lead to permanent structural deficits. Again, let’s take a closer look at how discretionary stabilisers can be used during a contraction or period of expansion in economic activity. Using discretionary stabilisers during slowing economic activity and recession During a slowdown or recession (like that in 2020 and 2021), discretionary decisions could be made by the treasurer that grow the size of the budget deficit and cause the stance to become more expansionary. Here, two deliberate types of change could be announced: • There could be discretionary reductions in tax ‘rates’ or receipts from personal income and/or company tax to help stimulate C and I spending, and thus AD. • There could also be discretionary rises in planned outlays. For example, welfare payment rates could be made more generous to boost C, or the planned value of outlays on infrastructure, education or subsidies could be lifted, thereby increasing C, I and G spending. By causing the budget stance to be more expansionary (typically a bigger deficit) in a recession and supporting automatic stimulus measures, discretionary stabilisers can boost AD, cause firms to lift output, creating more jobs. Domestic economic stability and living standards should be improved. While often popular with voters, the danger with discretionary rises in budget outlays or cuts in receipts, is that they are politically difficult for the government to remove after the economy recovers. This is especially the case in an election year. As a result, there is a risk that a permanent structural budget deficit will develop, remaining even when the need for the stimulus has passed. Because of this bias towards expansionary budget deficits, over time government finances can weaken, and debt increase. To help avoid this problem of structural deficits, most of the COVID-19 discretionary stimulus measures of 2020 and 2021 were temporary, introduced for a limited period of time, after which they ceased. Using discretionary stabilisers during rising economic activity and an inflationary upswing When the economy starts to recover and/or there is a boom, theoretically, the treasurer could make discretionary decisions that cause the budget outcome to become more contractionary (typically a bigger surplus). Again, this can happen in two main ways: • There could be discretionary rises in tax rates to slow AD. A less obvious or politically damaging way to raise more revenue is to wait a few years until people move into higher tax brackets as a result of rising incomes. This is called bracket creep. • There could also be discretionary cuts or, more likely, slower rises in planned budget outlays to curb AD. By reinforcing the operation of automatic stabilisers and slowing the growth in spending, a more sustainable and non-inflationary rate of economic growth can be achieved, improving living standards. UNCORRECTED PAGE PROOFS
