The Static Theory of Automatic Fiscal Stabilization

IN RECENT discussions of automatic fiscal stabilizers, a consensus has been reached that they are helpful in damping fluctuations but that they will not, of themselves, reverse the direction of economic activity.' But there are differences of opinion as to precisely what constitutes a stabilizer. On the one hand, the critical magnitude is held to be the relationship of marginal money tax revenues to, say, money income or output: if this ratio is positive, the fiscalmonetary system is presumed to be stabilizing; if it is zero, neutral; if it is negative, destabilizing.2 On the other I"Some economists would place exclusive reliance on built-in stabilizers. They believe that these automatic stabilizers are very likely to reduce economic fluctuations to tolerable magnitudes.... Most economists approve the greatest possible use of automatic stabilizers, but do not consider it prudent to rely solely on them" (Emile Despres et al., "The Problem of Economic Instability," American Economic Review, XL [September, 1950], 522). "We feel strongly that the existing automatic flexibility makes an important contribution to economic stability, which should not be frittered away. ... But we do not believe it prudent for policy to regard automatic flexibility as more than a first line of defense; more must be done to cope with serious economic fluctuations" (National Planning Association Conference of University Economists, "Federal Expenditure and Revenue Policy for Economic Stability" [81st Cong., 1st sess.], Hearing before the Joint Committee on the Economic Report on Federal Expenditure and Revenue Policies [Washington: Government Printing Office, 1949]), p. 9. "It must be remembered, however, that such [built-in] stabilizers, by the nature of the case, can only have the effect of dampening the range of economic fluctuations. They can mitigate the fall in consumers' demand that occurs in response to a fall in investment demand; they cannot conjure up an actual rise in consumers' demand that would be needed to offset the fall in investment demand" (report by a group of experts, National and International Measures for Full Employment [Lake Success, N.Y.: United Nations, Department of Economic Affairs, December, 1949], pp. 37-38). "We believe that this automatic flexibility is a valuable contribution to stability.... But its limitations should also be recognized. In the first place, though it can retard or perhaps even stop a decline of business activity or a rise of prices and can provide time for recovery forces to come into play, it cannot by itself reestablish full-employment conditions or push prices back to a preinflation level. In the second place, though automatic flexibility probably represents the maximum extent to which fiscal policy should be employed to combat moderate economic fluctuations, it is almost certain to be inadequate in the face of a serious depression or inflation" (Monetary, Credit, and Fiscal Policies: Report of the [Douglas] Subcommittee on Monetary, Credit, and Fiscal Policies of the Joint Committee on the Economic Report [Senate Doc. No. 129; 81st Cong., 2d sess.] [Washington: Government Printing Office, 1950], p. 16). "The built-in stabilizing effect of the budget, although obviously not a complete answer to the problem of recessions, is extremely valuable" (Research and Policy Committee of the Committee for Economic Development, Defense against Recession [New York: Committee for Economic Development, March, 1954], p. 13). For an exposition of a position embodying extreme reliance on automatic stabilization see Milton Friedman, "A Monetary and Fiscal Framework for Economic Stability," American Economic Review, XXXVIII (June, 1948), pp. 245-64. 2 The original proponents of the concept of builtin flexibility seem to have two concepts in mind, though greater reliance is clearly placed on this first. For example, they state: ". . . [The] yield of most excises is relatively insensitive to changes in income and employment; they therefore can contribute very little to the automatic stabilizing power of the tax system." And: "Other taxes have little built-in flexibility. Their yield is relatively stable, and it is larger in relation to incomes when incomes are low than when they are high" (Melvin G. deChazeau et al., Jobs and Markets [New York: McGraw-Hill Book Co., Inc., 1956], pp. 68 and 119). "The term 'built-in flexibility' is often used erroneously as a synonym for 'elasticity.' Built-in flexibility equals AT/IY, while elasticity equals