ECON 20 Lecture Notes - Lecture 30: Automatic Stabilizer, Business Cycle, Aggregate Demand
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Trends and composition of taxes
● Taxes are not directly a component of the economy, but they do have an indirect effect on the
demand side through consumption. If taxes decrease, disposable income will increase,
consumption will increase, and AD will increase. Tax rates also matter through the supply
side because of their effect on incentives to work, save, and invest.
● Total tax revenues relative to GDP had a slow upward trend through 2000 during strong
economic times. It is clear that federal tax collections drop substantially when the economy
o This phenomenon is often called an “automatic stabilizer.” When incomes decline,
taxes collected go down, cushioning the fall of income.
o This drop in taxes during recessions likely prevents consumption from falling as
much as it would if tax collections stayed constant, which stabilizes demand.
o But the fall in tax revenue during recessions raises the government deficit (see
Federal government deficits
● The federal government ran huge budget deficits during World War II (well over 20% of
GDP). The government ran a surplus most of the time in the immediate period after World
War II. These surpluses began to pay down the huge debts incurred during that war.
● Look at the chart on the course website. Starting in the 1970s, the federal government began
to run persistent deficits, with the exception of the brief surplus period in the late 1990s
● The deficit is obviously affected by the business cycle. Whenever the economy slows or
goes into recession the deficit expands. As discussed above, recessions lower tax revenues
and raise spending. Therefore, it's not surprising that deficits accompany recessions.
● President Bush has been heavily criticized for the return of the deficit after the surpluses at
the end of the Clinton administration. It is true that the switch from a surplus equal to
roughly 2 percent of the economy to a deficit of more than 3 percent of the economy is a big
shift by historical standards. But these deficits, relative to GDP, were not particularly large
compared with experience over much of the past few decades (particularly around a
recession), and recent deficits have begun to shrink as a percent of GDP.
● The federal deficit has reached levels unprecedented since World War 2 during the deep
● High federal deficits have become a major political issue. The “fiscal cliff” at the beginning
of 2013 and the “sequester” which took place on March 1, 2013 represent politically