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Comments on Automatic Stabilizers . William Gale Brookings Institution IMF Workshop on Fiscal Policy June 2, 2009 . Two Issues. Trade-offs between stabilization and efficiency Trade-offs between stabilization and sustainability . Stabilization and Efficiency . “Pure” Keynesian Model.

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comments on automatic stabilizers

Comments on Automatic Stabilizers

William Gale

Brookings Institution

IMF Workshop on Fiscal Policy

June 2, 2009

two issues
Two Issues
  • Trade-offs between stabilization and efficiency
  • Trade-offs between stabilization and sustainability
pure keynesian model
“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
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
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
  • 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.
automatic stabilizers also work through supply channels
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.
revised view of the trade off between stabilization and efficiency
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
  • 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.
us automatic stabilizers
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
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
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
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.