Question

Difference between automatic stabilizers and discretionary fiscal policy measures

Answer 1

Discretionary Fiscal Policy:

The central government exercises discre­tionary fiscal policy when it identifies an unemployment or inflation problem, esta­blishes a policy objective concerning that problem, and then deliberately adjusts taxes and/or spending accordingly.

Depending on the situation, the central government could, for example, institute a tax cut or raise the tax rate, change personal income tax exemptions or deductions, grant tax rebates or credits, levy surcharges, initiate or postpone transfer programmes, and either initiate or eliminate direct spending projects.

Automatic Fiscal Policy:

Another type of fiscal action — automatic stabilisation — takes place when changing economic conditions cause government expen­ditures and taxes to change automatically, which, in its turn, helps to combat unem­ployment or demand-pull inflation.

These adjustments in government expenditures and taxes occur without any deliberate legislative action, and stimulate aggregate spending in a recession and reduce aggregate spending during economic expansion. Two automatic fiscal policy stabilisers are of primary impor­tance transfer payments, especially unem­ployment compensation, and the personal income tax.

To understand how automatic stabilisers work, consider a recession. During a down­swing, when people lose their jobs and earned incomes are reduced, some important changes in government expenditures and taxes occur automatically.

Firstly, some unemployed individuals become eligible for a number of transfer payments, particularly unemploy­ment benefit. Second, because the personal income tax is normally progressive tax with several rates, some of the unemployed experience a decline in the percentage of their income that is taxed, thus resulting in lower tax payments or a tax refund.