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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

William Gale

Brookings Institution

IMF Workshop on Fiscal Policy

June 2, 2009

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Two Issues

  • Trade-offs between stabilization and efficiency

  • Trade-offs between stabilization and sustainability

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“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

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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.

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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.

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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.

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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.

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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

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Spain Efficiency

  • 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.

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US Automatic Stabilizers Efficiency

  • 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.

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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?

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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

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Kneiser and Ziliak, cont. Efficiency

  • 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.