Automatic stabilisers and the economic crisis in Europe and the US

Mathias Dolls, Clemens Fuest, Andreas Peichl 17 September 2010

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The big difference between the "great recession" and the "Great Depression" was government policy – especially stabilisation policy (Eichengreen and O'Rourke 2010). This time governments realised that they had to provide Keynesian stimulus while ensuring that the financial system did not collapse.

A crucial debate now is how long and how strong fiscal stimulus needs to be to ensure the recovery stays on track. Most of this debate focuses on the appropriate size of fiscal stimulus measures and whether the time to cut back spending has come (Corsetti 2010 and Reinhart and Rogoff 2010).

Much less attention has been devoted to the fact that a significant part of demand stabilisation is achieved without discretionary policy measures, through the automatic stabilisers in the tax and transfer system. Economic research has also neglected automatic stabilisers. As Blanchard (2006) puts it, “very little work has been done on automatic stabilisation [...] in the last 20 years”. Exceptions are papers by Gali (1994) and Fatas and Mihov (2001), both showing that output in countries with large governments is less volatile, and Auerbach and Feenberg (2000), who study automatic stabilisation effects of the US federal income tax.

Automatic stabilisers in the US and Europe

In recent research (Dolls et al. 2010), we compare the magnitude and composition of automatic stabilisation between the US and Europe. We take into account:

  • personal income taxes (at all government levels),
  • social insurance contributions,
  • payroll taxes, and
  • transfers to private households such as unemployment benefits.

Our analysis is based on microsimulation models for 19 European countries (EUROMOD) and the US (TAXSIM). These models use representative household data and allow us to compute how a change in gross income for some or all households affects disposable income.

In our simulations we use the tax and transfer systems that were in force in the summer of 2008, just before the collapse of Lehman led to the full outbreak of the crisis. We simulate two scenarios. The first is an income shock, where the gross income of all households falls by 5 %. The second is an employment shock, where the same aggregate income loss is distributed asymmetrically, i.e. some households lose their jobs, depending on their empirical probability of becoming unemployed, while others are unaffected.

How do automatic stabilisers cushion the impact of income shocks on household demand?

The extent to which automatic stabilisers mitigate the impact of income shocks on household demand depends on two factors. The first is how a given shock to gross income translates into a change in disposable income. A 40% income tax rate, for instance, will absorb 40% of the shock to gross income as this income would have been taxed anyway. We refer to this effect as “disposable income stabilisation”.

The second factor is the link between current disposable income and current demand for goods and services. If the income shock is perceived as transitory, yet current demand depends on some concept of permanent income, their demand will not change, and there is no role for automatic stabilisers. But if households are liquidity constrained, their current expenditures do depend on disposable income. In this case, automatic stabilisers play a role for household demand.

Using information on household characteristics to estimate the prevalence of liquidity constraints, we are able to calculate “demand stabilisation”. If there are two households in the economy and only one of them is liquidity constrained, an income tax of 40% would imply a disposable income stabilisation of 40% for the economy as a whole but a demand stabilisation coefficient of only 20%.

Results

We first consider disposable income stabilisation in Europe and the US (Figure 1). Of a proportional income shock, approximately 38% would be absorbed by automatic stabilisers in the EU. For the US, we find a slightly lower value of 32%. This difference of just six percentage points is surprising in so far as automatic stabilisers in Europe are usually considered to be drastically higher than in the US.

Figure 1. Decomposition of the income stabilisation coefficient for both scenarios – US vs. EU

Source: Own calculations based on Euromod and TAXSIM

In the case of the unemployment shock, the difference between the EU and the US is larger. EU automatic stabilisers now absorb 47% of the shock whereas the stabilisation effect in the US is only 34%. This difference can be explained by the importance of unemployment benefits, which account for a large part of stabilisation in Europe in this scenario. Benefits alone absorb 19% of the shock in Europe compared to just 7% in the US.

How do automatic stabilisers vary within Europe?

Figure 2 shows that there are huge differences. In the case of the income shock, we find the highest stabilisation coefficient for Denmark, where automatic stabilisers cushion 56% of the shock. The lowest values are measured for Estonia (25%), Spain (28%) and Greece (29%). With the exception of France, taxes seem to have a stronger stabilising role than social security contributions.

Figure 2. Decomposition of income stabilisation coefficient for both scenarios – country ranking

Source: Own calculations based on Euromod and TAXSIM
In the case of the unemployment shock, the stabilisation coefficients are larger for most countries. Again, the highest value emerges for Denmark (82%), followed by Sweden (68%) and Germany (62%). At the other end of the spectrum, there are some countries with values below the US level of 34%. These include Estonia (23%), Italy (31%), Greece (32%), and Poland (33%).

How does the cushioning of shocks translate into demand stabilisation?

Estimating how the cushioning of shocks outlined above might lead to demand stabilisation is more difficult. This is because the results are sensitive with respect to the method used to assess whether households are likely to be liquidity constrained. Figure 3 reports the results for both shock scenarios, for three different approaches to estimating liquidity constraints (details are explained in Dolls et al. 2010). Results range from 4%-22% for the EU and from 6%-17% for the US. Taking the Zeldes criterion, i.e. net wealth (based on asset income), as the determinant for liquidity constraints, demand stabilisation is 22% in the EU and 17% in the US. Demand stabilisation coefficients which are based on direct survey evidence with respect to liquidity constraints on average give the lowest estimates whereas those based on home ownership information usually lie in between. For the unemployment shock (US), the EU-US gap widens again. While in the US demand stabilisation coefficients mostly remain on their level of the income shock, they are now substantially higher for the EU-group reaching a peak of 30%. These results suggest that the transfers to the unemployed, in particular the rather generous systems of unemployment insurance in Europe, play a key role for demand stabilisation and drive the difference in automatic stabilisers between Europe and the US.

Figure 3. Income vs. demand stabilisation

Source: Own calculations based on Euromod and TAXSIM

Conclusions and policy implications

Our results suggest that social transfers, in particular the rather generous systems of unemployment insurance in Europe, play a key role in the stabilisation of disposable incomes and explain a large part of the difference in automatic stabilisers between Europe and the US.

An important result of our analysis is that automatic stabilisers are very heterogeneous within Europe. We find that eastern and southern European countries are characterised by rather low automatic stabilisers. This is surprising, at least from an insurance point of view, because lower average income (and wealth) implies that households are more vulnerable to income shocks. One explanation for this finding could be that countries with lower per capita incomes tend to have smaller public sectors. From this perspective, weaker automatic stabilisers in eastern and southern European countries are a side effect of the lower demand for government activity including redistribution.

We point out that our analysis is purely positive and does not allow us to conclude that automatic stabilisers should be higher or lower. Increasing taxes and transfers would lead to higher automatic stabilisers, but economic distortions would also increase. Moreover, while automatic stabilisers do help to cushion transitory income shocks, they may delay inevitable adjustment in the presence of permanent shocks.

References

Auerbach, A and D Feenberg (2000), “The significance of federal taxes as automatic stabilizers”, Journal of Economic Perspectives, 14:37-56.

Blanchard, O (2006), “Comments on ‘The Case Against the Case Against Discre-tionary Policy’, by Alan Blinder”, in R Kopcke, G. Tootell and R Triest (eds), The macroeconomics of fiscal policy, MIT Press,62-67.

Buettner, T and C Fuest (forthcoming), “The Role of the Corporate Income Tax as an Automatic Stabilizer”, International Tax and Public Finance .

Corsetti, G (2010), “Fiscal policy as a policy strategy to exit the global crisis”, Voxeu.org, 7 July.

Devereux, M. and Fuest, C (2009). Is the Corporation Tax an Effective Automatic Stabilizer?, National Tax Journal LXII: 429-437.

Eichengreen, Barry and Kevin H O’Rourke (2010), “A tale of two depressions: What do the new data tell us?”, VoxEU.org, 8 March.

Dolls, M, C Fuest, and A Peichl (2010), “Automatic Stabilizers and Economic Crisis: US vs. Europe”, NBER Working Paper 16275, August.

Fatás, A and I Mihov (2001), “Government size and automatic stabilisers: International and intranational evidence”, Journal of International Economics, 55 (1):3-28.

Galí, J. (1994), “Government size and macroeconomic stability”, European Economic Review, 38:117-132.

Reinhart, C and K Rogoff (2010), “Debt and growth revisited”, VoxEU.org, 11 August.

van den Noord, P (2000), “The size and role of automatic fiscal stabilisers in the 1990s and beyond”, OECD Economics Department Working Papers, No. 230, Paris: OECD.

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Topics:  Global crisis Macroeconomic policy

Tags:  fiscal stimulus, global crisis, macroeconomic policy, automatic stabilisers

Ph.D. candidate at the Cologne Graduate School in Management, Economics and Social Sciences

President of the ifo Institute, Professor for Economics and Public Finance at the University of Munich, Director of the CES and Executive Director of CESifo

Director of the ifo Center for Business Cycle Analysis and Surveys and Professor of Economics, esp. Macroeconomics and Public Finance at the University of Munich

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