Automatic stabilisers: their extent and role - public sector deficits of Organization for Economic Cooperation and Development countries

OECD Economic Outlook, June, 1993

Public sector deficits have increased in most OECD countries over the past three years. Cyclical factors now account for almost half of government deficits, reflecting the workings of the so-called "automatic stabilisers". The most important element in determining the extent of the automatic stabilisers is the size of the public sector relative to GDP, though the responses of specific tax bases to cyclical fluctuations in output and employment and the progressivity of the tax system also play important roles. Government expenditure reacts much less to the business cycle than does revenue.

Public sector deficits have increased markedly in nearly all OECD countries since 1990 -- the sole exceptions being Italy, Greece, the Netherlands and Portugal -- in line with the downturn in activity. Such widening has resulted mainly from cyclical movements in government revenues and expenditure rather than from specific policy actions. Cyclical changes in government borrowing tend to offset part of the fluctuation in output that would otherwise occur, hence they are often described as "automatic stabilisers". The extent of the automatic stabilisers varies across OECD countries reflecting, in particular, the overall size of the public sector, the progressivity of the tax system, the sensitivity of different tax bases to movements in economic activity, the generosity of unemployment benefit schemes and the extent to which employment fluctuates with output. This special note describes the main determinants of automatic stabilisers in OECD countries and assesses their impact on the economy.

The OECD Secretariat attempts to estimate the scale of automatic stabilisation by measuring the extent to which various forms of taxation and expenditure are sensitive to the cycle. Estimates are made of the size of government borrowing (or lending) that would occur if output were at its trend level rather than at its actual level, and thereby to estimate the cyclical component of government borrowing.

Estimates of the stabilisers cover taxation and expenditure separately. On the revenue side, all taxation receipts are adjusted, with taxes being grouped into four types. On the expenditure side, OECD Secretariat estimates of the automatic stabilisers are limited to the impact of the cycle on transfers to the unemployed, though debt-interest payments are also sensitive to some extent. While other public spending may also be cyclically sensitive (e.g. public employee wages, investment goods prices and industrial subsidies), short-term changes in these forms of expenditure require discretionary action as opposed to the automatic consequences for expenditure that stem from changes in the level of claims for unemployment benefits and related social transfers. Such a distinction is only valid in the short term as all government programmes are discretionary over a somewhat longer time horizon.

Automatic stabilisers and the tax system

The structure of the tax system has a significant impact on the size of the automatic stabilisers. The higher the average tax rate on income from a cyclically sensitive source, the larger will be the automatic stabiliser. For example, taxation is lost when an employee is made redundant. In this case, the amount of stabilisation depends on the average tax rate on labour income (defined as wage income plus social security contributions). This tax rate differs considerably between countries.(1)

The progressivity of the tax system is another significant factor in determining the size of the automatic stabilisers. On average, OECD Secretariat estimates suggest that government revenue fluctuates with a slightly greater amplitude than fluctuations in output. In part, this stems from the difference between the average to marginal rates of taxation on labour income. Such a difference means that when average income per person employed falls in a recession, either through a fall in overtime working or through a fall in wages, the drop in government revenue is more rapid than that of average incomes. In some countries (France, Italy, New Zealand and Sweden), the ratio of the average to marginal rate of taxation is close to unity.(2) More typically the ratio is around 1.4, with much higher ratios in Australia and Canada.

The sensitivity of the individual tax bases to the cycle is the final factor affecting the size of the automatic stabilisers on the revenue side. However, there are often offsetting factors at work. Employment generally fluctuates less than output over the business cycle, reflecting the hoarding of labour by employers. This limits the fluctuation of employment-related taxation at the expense TABULAR DATA OMITTED of large swings in corporate tax revenues. Such fluctuations can be particularly marked if corporations attempt to maintain dividends in periods of recession; one common method of so doing is by reducing retained profits that are often taxed at a higher rate than distributed profits. If the corporate tax rate is greater than the average tax rate on labour income, tax yields will be pushed down further in a recession.