Question

During the recession of \(2007-2009,\) the U.S. federal government's tax collections fell from about \(2.6\) trillion dollars down to about \(2.1\) trillion dollars while GDP declined by about 4 percent. Does the U.S. tax system appear to have built-in stabilizers? a. Yes. b. No.

Short answer

a. Yes, the U.S. tax system has built-in stabilizers.

Step-by-step solution

Identify the Concept of Built-in Stabilizers

Built-in stabilizers are economic mechanisms that automatically adjust tax collections and government spending without direct intervention during economic fluctuations. They do this to counteract the natural economic cycle downturns or upturns.

Evaluate Tax Collection Changes

During the recession, tax collections fell from $2.6 trillion to $2.1 trillion. This indicates a decrease in tax revenue collection.

Analyze GDP Changes

A 4% decline in GDP suggests an economic contraction. Typically, built-in stabilizers would naturally lead to reduced tax revenues in such scenarios as they are partially related to income levels, which fall in recessions.

Determine the Functioning of Stabilizers

The drop in tax collections by $0.5 trillion as GDP declined suggests that the tax system automatically adjusted to the reduced economic activity, which is characteristic of the activation of built-in stabilizers.

Conclude on System Function

Since tax collections decreased during the economic downturn, reducing the fiscal pressure on the economy, it implies that the U.S. tax system has built-in stabilizers that acted as intended during the recession.

Key concepts

Tax Collections

Tax collections refer to the process by which governments gather revenues from individuals, businesses, and other entities. These revenues typically come from various forms of taxes such as income tax, sales tax, and corporate tax. In times of economic stability, tax collections can be quite predictable, as they are based on a percentage of income or sales. However, during economic fluctuations, tax collections can vary significantly.

When the economy is doing well, businesses and individuals earn more income, leading to higher tax revenues. Conversely, during a recession, both earnings and spending tend to decrease, leading to lower tax revenues. This is a natural adjustment that helps the economy, as people and businesses have more flexibility in their finances during tough times. Thus, tax collections play a crucial role in the government's ability to function effectively and provide essential public services.

Economic Recession

An economic recession is defined as a significant decline in economic activity across the economy, lasting more than a few months. It is visible in GDP, real income, employment levels, industrial production, and wholesale-retail sales. Recessions are part of the business cycle and are often characterized by rising unemployment, falling consumer spending, and decreased industrial activity.

During a recession, the adverse effects are widespread, impacting employment, household income, and the broader business environment. People tend to cut back on spending, which further slows down economic growth. The government often steps in to try to stimulate the economy through various fiscal policies and measures. In this context, built-in stabilizers automatically adjust to ease the impact and help maintain a level of economic balance.

Automatic Fiscal Policy

Automatic fiscal policy involves mechanisms like built-in stabilizers that adjust economic conditions without deliberate intervention by the government. These stabilizers include tax systems that automatically lower tax collections when income falls and increase tax collections during periods of economic expansion. They are essential tools to maintain economic equilibrium and help soften the impact of economic cycles.

The beauty of automatic fiscal policies lies in their capacity to react promptly to economic changes without the need for legislative action. This fast response helps prevent the kind of sudden, severe economic adjustments that can deepen recessions or fuel inflation. Through automatic adjustments in tax collections and sometimes government benefits, these policies inherently support aggregate demand during downturns and help build surpluses in better times.

GDP Decline

GDP, or Gross Domestic Product, measures a country's overall economic production and health. A decline in GDP indicates that the economy is shrinking, which can signal the onset or presence of a recession. When GDP falls, it can lead to widespread effects such as increased unemployment, reduced income levels, and lower spending by businesses and consumers alike.

This decline can be influenced by various factors, including decreases in consumer demand, export slowdowns, or cuts in industrial production. Monitoring GDP trends is crucial for policymakers, businesses, and economists, as it provides valuable insights into the current economic climate. In the event of a GDP decline, automatic fiscal policies, such as reduced tax collections from built-in stabilizers, help mitigate the impact and guide the economy toward recovery by allowing more disposable income to circulate within the economy.