Fiscal policy is the umbrella term used to refer to the government's plans for taxing and spending. It has an impact on the macroeconomy, because government spending becomes income in the hands of households and businesses. So, some people argue that the government can use changes in taxes and spending to counteract the business cycle. This is referred to as countercyclical fiscal policy. Under this approach, when the economy is in recession, the government should tax less and spend more, but when the economy is in an expansion, the government should tax more and spend less. If this worked, then the economic fluctuations of the business cycle would be dampened.
However, it may not be necessary for the government to be quite so interventionist. The economy has some automatic stabilisers, that automatically (hence the name) adjust to increase household incomes when the economy is in recession, and decrease when the economy is in expansion. One example of an automatic stabiliser is the unemployment benefit. In a recession, more people are unemployed and this increases the number of unemployment benefit claims, reducing somewhat the negative impact of the high unemployment on spending. When the economy is in expansion, fewer people are unemployed and there are fewer unemployment benefit claims, reducing the amount of stimulus provided by the unemployment benefits.
To be fair, the unemployment benefit doesn't provide enough stabilisation on its own to substantially reduce the size of business cycle fluctuations. But the unemployment benefit is not the only automatic stabiliser. Progressive income taxation may be another.
A progressive income tax is one where the marginal tax rate (the amount of the next dollar that is paid in tax) is greater than the average tax rate (the proportion of total income that is paid in tax). A typical tax schedule that leads to progressive income tax is a graduated income tax, like that employed in New Zealand, where there are specific income bands that have different marginal tax rates, with higher marginal tax rates within higher income bands.
That looks something like the following graph, which uses the current income tax rates for New Zealand. The blue solid line shows the marginal tax rate, and the red dotted line shows the average tax rate. Notice that the marginal tax rates jumps up at regular intervals (this is a graduated income tax). Above the first income tax threshold, the average tax rate is always below the marginal tax rate. This is a progressive income tax. Also, notice that no one pays 39 percent income tax (which is a point that I have made before). Even at the highest income shown in the diagram ($250,000), the average tax rate is just over 31 percent. That's because, even for those at the highest incomes, their first $14,000 is taxed at 10.5 percent, the next $34,000 at 17.5 percent, and so on. Only each dollar above $180,000 in income attracts a marginal tax rate of 39 percent.
Anyway, coming back to progressive taxation as an automatic stabiliser, when the economy is in an expansion, incomes rise, and more taxpayers will find themselves paying more tax (because they move to the right along the diagram above). In fact, because of the progressive nature of the tax system, the percentage change in taxes is bigger than the percentage change in income. A taxpayer moving from $50,000 to $55,000 in income (a 10% increase) will go from paying $8,020 in tax to paying $9,520 (an 18.7 percent increase). This also works in reverse. When the economy is in a recession, incomes fall, and more taxpayers will find themselves paying less tax. So, a taxpayer moving from $50,000 to $45,000 in income (a 10% decrease) will go from paying $8,020 in tax to paying $6,895 (a 14.0 percent decrease). The same applies to other levels of incomes and income changes that we might consider.
So, when the economy is in recession, progressive taxation removes less from household incomes, and when the economy is in expansion, progressive taxation removes more from household incomes. This will act to reduce the size of economic fluctuations of the business cycle, making progressive taxation an automatic stabiliser.
[HT: John Quiggin, in his book Economics in Two Lessons, which I reviewed here]
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