Thursday, April 9, 2009

Automatic Stabilizers and Adjustment

Further attention must be posed in the so called Automatic Stabilizers. A definition must include features that tame the business cycle, every direct tax that observes progressiveness is an example of an automatic stabilizer, in this way whenever the business cycle expands tax revenues increase, as opposed to when the business cycle contracts. This, however, leads to a direct increase in debt issued by governments to fulfill expenditure levels.

The latter explains, part of the efforts for stimulate the economy, the other part comes from discrete actions taken. The IMF estimates the impact of automatic stabilizers on the fiscal balance of Mexico, for example, around -0.3 percent of GDP for 2008 and -0.8 percent of GDP for 2009. They find a strong correlation between the size of the government -measured by the size of public spending relative to the size of GDP- and the size of the effect from the automatic stabilizers.

Why are they so important? Because they provide a mechanism to reestablish balance and control that is not subject to a political process. Their effectiveness depends on the design of the tax system. The personal income tax (PIT) provides an excellent example of this mechanism. As the personal income increases, the PIT assures a greater tax revenue for the government, remember the rule: the more you earn, the more taxes you pay relative to your income. The contrary is also true, thus in a recession low taxes paid by the PIT provide a positive incentive to work more hours than before, thus helping the economy getting out of recession.

Discrete measures, opposed to automatic stabilizers, depend heavily on political arrangements and incentives, so they can violate optimality, they can be allocated poorly and, most importantly, they do not allow persons to make their own decisions.

Other forms of automatic stabilizers can be find in social benefits and unemployment insurance, these help in recession times to increase consumption demand and tame the lack of income, both mechanisms at work increase further public spending.

Finally, an important stabilizer, although not from the tax system, is the external trade. The U.S.' trade deficit is back from historical high levels to those of 1999, the latter as a result of a decrease in import demands from the U.S. and a some adjustments on exchange rates that make its exports cheaper. In the long run imbalances will disappear, the cost is the painful unemployment.

Reforms that address the weakness of automatic stabilizers should be pursued in those countries with low levels of automatic adjustments. Mexico is one of them.

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