In macroeconomics, the concept of automatic stabilizers describes how modern government budget policies, particularly income taxes and welfare spending, act to dampen fluctuations in real GDP. The size of the government budget deficit tends to increase when a country enters a recession, which tends to keep national income higher by maintaining aggregate demand. This effect happens automatically depending on GDP and household income, without any explicit policy action by the government, and acts to reduce the severity of recessions.
Here is an example of how automatic stabilizers would work in a recession. When the country takes an economic downturn, more people become unemployed. As a result more people file for unemployment and other welfare measures, which increases government spending and aggregate demand. The unemployed also pay less in taxes because they are not earning a wage, which in turn decreases government revenue. The result is an increase in the federal deficit without Congress having to pass any specific law or act.
Similarly, the budget deficit tends to decrease during booms, which pulls back on aggregate demand. Because more people are earning wages during booms, the government can collect more taxes. Also, because fewer individuals need social services support during a boom, government spending also decreases. As spending decreases, aggregate demand decreases. Therefore, automatic stabilizers tend to reduce the size of the fluctuations in a country's GDP.
Fiscal Multiplier Effect
What makes automatic stabilizers so effective in dampening economic fluctuations is the fiscal multiplier effect. The fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. When this multiplier exceeds one, the enhanced effect on national income is called the multiplier effect.
The multiplier effect occurs as a chain reaction. The increased funds received from the government by citizens allows them to increase their consumption. As a result, producers must increase their production, which requires firms to hire more workers. Because of the increased purchases and lower unemployment, people have more money to spend and increase their consumption. This consumption-production-consumption cycle leads to the multiplier effect, resulting in an overall increase in national income greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output (and hence the aggregate income that it generates) that is a multiple of the initial change.
Tax Form 1040
Taxes are a part of the automatic stabilizers a country uses to minimize fluctuations in their real GDP. During boom times when the economy is doing well, people earn more income and this translates to higher tax revenues for the government, lowering the budget deficit.