Question

Explain how built-in (automatic) stabilizers work. What are the differences between proportional, progressive, and regressive tax systems as they relate to an economy’s built-in stability?

Short answer

Automatic stabilizers increase or decrease in quantity with increasing or decreasing spending components to reduce fluctuations and maintain economic stability.

The progressive tax rates are the most stable because they change in the same direction as GDP changes.

Step-by-step solution

Concept of built-in stabilizers

Built-in stabilizers are instruments of fiscal policy which act on their own to maintain the smooth running of the economy.Built-in stabilizers do not require any external push. These include components like taxes and transfer payments. These stabilizers reduce the multiplier effect, and hence, the impact on the final GDP is less than a situation with no stabilizers.

During an economic boom, an increase in any of the aggregate expenditure components results in multiple increases in the real GDP than the initial push. The multiplier does the work.However, the automatic stabilizers suck some amount of money from the economic system and reduce the multiplier effect.

During an economic crisis, the built-in stabilizers reduce the multiplier effect of a small decline in any aggregate expenditure components by injecting the money into the economy, reducing the effect of the fall in aggregate expenditure.

As an economy’s GDP increases, the quantity of built-in stabilizers increases.The amount of automatic stabilizers refers to the net taxes. Net taxes are the total taxes minus the transfer payments.

Tax system in the context of the economic stability

The progressive tax holds a constantly increasing average tax rate with increasing GDP. The proportional tax rate maintains a constant average tax rate with an increase in the GDP. While the regressive tax rate may increase, decrease, or keep constant the average tax rate with change in the GDP.

The progressive tax rate corresponds the best to the changes in the GDP. If GDP increases, the progressive tax rate also increases, thus increasing the average tax rate and vice-versa. Therefore, a progressive tax system provides the best stabilizing effect in the economy compared to the other two tax systems.