The Economy’s Influence on the Government Budget |Economics|CBCS

The economy affects the federal government budget even if there are no explicit fiscal policy changes. There are effects that the government has no direct control over. They can be lumped under the general heading of “automatic stabilizers and destabilizers.”

Automatic Stabilizers and Destabilizers

Most of the tax revenues of the government result from applying a tax rate decided by the government to a base that reflects the underlying activity of the economy. The corporate profits tax, for example, comes from applying a rate (say 35 percent) to the profits earned by firms. Income taxes come from applying rates shown in tax tables to income earned by individuals. Tax revenues thus depend on the state of the economy even when the government does not change tax rates. When the economy goes into a recession, tax revenues will fall, even if rates remain constant, and when the economy picks up, so will tax revenues. As a result, deficits fall in expansions and rise in recessions, other things being equal. Some items on the expenditure side of the government budget also automatically change as the economy changes. If the economy declines, unemployment increases, which leads to an increase in unemployment benefits. Welfare payments, food stamp allotments, and similar transfer payments also increase in recessions and decrease in expansions.

Automatic stabilizers- Revenue and expenditure items in the federal budget that automatically change with the state of the economy in such a way as to stabilize GDP. They help stabilize the economy. In recessions taxes fall and expenditures rise, which create positive effects on the economy, and in expansions the opposite happens. The government does not have to change any laws for this to happen.

Another reason that government spending is not completely controllable is that inflation often picks up in an expansion.  Some government transfer payments are tied to the rate of inflation; so these transfer payments increase as inflation increases. Some medical care transfer payments also increase as the prices of medical care rise, and these prices may be affected by the overall rate of inflation.

Automatic destabilizer- Revenue and expenditure items in the federal budget that automatically change with the state of the economy in such a way as to destabilize GDP. Government spending increases as inflation increases, which further fuels the expansion, which is destabilizing. If inflation decreases in a recession, there is an automatic decrease in government spending, which makes the recession worse.

Full-Employment Budget

Because the condition of the economy affects the budget deficit so strongly, we cannot accurately judge either the intent or the success of fiscal policies just by looking at the surplus or deficit. Instead of looking simply at the size of the surplus or deficit, economists have developed an alternative way to measure how effective fiscal policy actually is.

It is "What the federal budget would be if the economy were producing at the full-employment level of output".

The distinction between the actual and full-employment budget is important. Suppose the economy is in a slump and the deficit is $250 billion. Also suppose that if there were full employment, the deficit would fall to $75 billion. The $75 billion deficit that would remain even with full employment would be due to the structure of tax and spending programs instead of the state of the economy. This deficit—the deficit that remains at full employment— is sometimes called the structural deficit.

The deficit that occurs because of a downturn in the business cycle is cyclical deficit. 

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