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Automatic Stabilizers

The use of taxes and spending by the government to eliminate recessionary and inflationary gaps is known as discretionary fiscal stabilization. In other worlds, discretionary fiscal stabilization policy refers to the deliberate changes in tax rates and government spending that are targeted at stabilizing the economy.

Sometimes it is possible to achieve stabilization in the economy without the discretionary fiscal stabilization policy. We knew that as GDP increases, private individual’s capacity to pay taxes also increases.

When people are better off, government spending on transfer (payments e.g., unemployment allowance) also decreases. Thus, net taxes (i.e., total tax receipts net of transfer payments) move in the same direction as GDP. Tax is a leakage from the GDP. Therefore, the leakages increase as the economy expands and the leakages decrease as the economy contracts.

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