What is the difference between automatic and discretionary fiscal policy

These acts do not follow a strict set of rules, rather, they use subjective judgment to treat each situation in unique manner. A budget policy that automatically changes to stabilize fluctuations in GDP. In fiscal policy , there are two different approaches to stabilizing the economy: automatic stabilizers and discretionary policy. Both approaches focus on minimizing fluctuations in real GDP but have different means of doing so.

Discretionary policy is a macroeconomic policy based on the judgment of policymakers in the moment, as opposed to a policy set by predetermined rules. Discretionary policies refer to actions taken in response to changes in the economy, but they do not follow a strict set of rules; rather, they use subjective judgment to treat each situation in unique manner. In practice, most policy changes are discretionary in nature.

Examples may include passing a new spending bill that promotes a certain cause, such as green technology, or the creation of a federal jobs program.

The WPA is an example of a Depression-era discretionary policy meant to reduce unemployment by providing jobs for the unemployed.

Discretionary policies are generally laws enacted by Congress , which requires that any policy go through the same vetting and marking up process as any other law.

The key difference between these two types of financial policy approaches is timing of implementation. When the economy begins to go through an economic fluctuation, automatic stabilizers immediately respond without any official or government body having to take action. With discretionary policy there is a significant time lag. Before action can be taken, Congress must first determine that there is an issue and that action needs to be taken.

We calculate the change in the structural balance between the pre-crisis year and the average for the years in order to focus on the endogenous response of fiscal policy to the economic crisis Higher values of this measure of active fiscal policy indicate larger fiscal packages. We also distinguish discretionary fiscal policies in the years and given that fiscal policy changed substantially in some countries in the course of the crisis.

In OECD the size of the fiscal packages is determined as the deviation of fiscal balances compared with a "no-crisis-related-action scenario". Moreover, detailed information on the composition of fiscal packages is provided. It is evident from both data sources that the cross-country variation in the size of fiscal stimulus measures is substantial.

Figures 7 and 8 data from IMF present results for the relationship between the change in the general government structural balance from to and automatic stabilizers. These graphs indicate that countries with larger automatic stabilizers have passed smaller fiscal stimulus packages in the economic crisis. Change in structural balance 08 11 and automatic stabilizers. Change in structural balance and automatic stabilizers unempl. As discretionary fiscal policy has varied enormously over the period, moving from highly expansionary to highly contractionary in some countries, we conduct the analysis separately for discretionary measures passed in Figures 9 a and 10 a and Figures 9 b and 10 b.

Change in structural balance and automatic stabilizer. While the negative correlation is visible for both sub-periods, it is much stronger and hence also stronger than for the average for the first part of the crisis.

Largest shifts from expansionary to contractionary fiscal policies can be observed for countries such as Greece or Ireland which received financial support from the European Financial Stability Facility EFSF under the condition of severe fiscal adjustment programs. In other countries fiscal policy was not expansionary Austria, Germany, Italy or contractionary Hungary even in the period.

Austerity measures recently implemented in many EU countries, in particular in Spain, Portugal or the UK, are only partly reflected in Figure 9 b as they will persist to and beyond. The negative correlation between automatic stabilizers and discretionary fiscal policy in is confirmed when estimating multivariate regression equations controlling for various pre-determined variables.

The first four regressors control for the budgetary situation in those countries under consideration before the start of the economic crisis 14 , trade openness and GDP per capita for other potentially important determinants of discretionary fiscal policy.

All these controls are standard in this context see, e. All regressors are pre-determined since they are measured in the pre-crisis year except the two measures of fiscal space which are based on averages for the years The results are shown in Table 1.

When interpreting them, it should be taken into account that they are based on 19 observations only. The coefficient for the size of automatic stabilizers income stabilization coefficient is significant in all specifications.

The R 2 indicates that the best fit is achieved with additional regressors controlling for the fiscal position before the start of the crisis.

Our results thus confirm that countries whose fiscal position was weak before the economic crisis unfolded were constrained in their ability to react with discretionary fiscal stimulus Romer Regression results with the income stabilization coefficient for the unemployment shock as dependent variable are presented in Table 2.

The qualitative results are similar to those shown in Table 1 for the income shock. A further concern in the policy debate put forward by supporters of large and coordinated discretionary measures was that countries could limit the size of their programs at the expense of countries with more generous fiscal policy responses. The central factor behind this hypothesis is the degree of openness of an economy. The more open an economy is, i.

Hence, the idea behind this argument is that some countries might show a free-rider behavior and profit from spill-over effects of discretionary measures We find only weak evidence for this hypothesis. While the correlation between discretionary measures passed in and trade openness is negative which is confirmed when we estimate a univariate regression between these two 16 , the coefficient on openness becomes insignificant once our measure for automatic stabilization is included as can be seen in column 6 of Table 1.

This is due to the fact that the correlation between openness and automatic stabilization is positive. All in all, our results suggest that policymakers did take into account the forces of automatic stabilizers when designing active fiscal policy measures to tackle the recent economic crisis.

Fiscal policy has been a central tool for governments to counteract economic stagnation in the recent crisis, both in terms of automatic stabilization as well as discretionary fiscal policy. Many papers have investigated the effectiveness of stabilization policies in the recent recession, but little is known on the relationship between the two components of fiscal policy. The aim of this paper is to fill this gap. Using up-to-date data on discretionary fiscal policy and two measures of automatic stabilization - income stabilization coefficients resulting from an income and an unemployment shock scenario - we find that countries with larger automatic stabilizers tended to enact smaller fiscal stimulus packages in the recent economic crisis.

The US, for example, a country with rather small automatic stabilizers - both in an international perspective as well as in its own historical context - was the country with the largest fiscal stimulus package amounting to 5.

Given the low automatic stabilizers, however, the total effect of fiscal policy in the US has been more moderate than the size of the discretionary program might suggest. Of course, there are other determinants of discretionary fiscal policy. We find that the fiscal position of each country before the start of the crisis was a further important determinant for the size of discretionary fiscal stimulus packages. Our results suggest that social protection systems, and in particular out-of-work benefits, play a key role for the stabilization of disposable incomes and explain a large part of the difference in automatic stabilizers between Europe and the US.

This is confirmed by the decomposition of stabilization effects in our analysis. Note, however, that considerable heterogeneity exists within Europe. Automatic stabilizers have the major advantage of providing income replacement immediately, i. While means-tested income support is generally available as a basic social security net in most EU Member States, unemployment insurance systems are more exclusive as they do not protect all types of workers equally.

Here, a discretionary expansion of benefit generosity or easing access to benefits can play a substantial role in reaction to crises. However, discretionary changes to benefit systems or the creation of new benefits may take some time and may be more difficult to administer and deliver, in particular if new groups are to be integrated or new benefits created — or if fiscal restrictions are considered.

Therefore, it might be worth to redesign active and passive labor market policies in such a way that they automatically respond to cyclical variations as for instance the extended unemployment insurance in Canada and the US.

How to optimally design such instruments in an automatic way provides an interesting avenue for future research. A limitation of our analysis is that we only consider a rather small sample of European countries as well as the US. It would be interesting to extend this analysis also to developing countries. As it is common in this literature, we have to assume the full take-up of social benefits for our simulations which might overestimate the automatic stabilizer measures in countries where non-take-up is important.

In addition, we abstract from any potential behavioral responses as we are interested in separating the automatic response from discretionary and general equilibrium effects. For an analysis of automatic stabilizers in the corporate tax system, see Devereux and Fuest and Buettner and Fuest The tax-benefit systems included in the model have been validated against aggregated administrative statistics in order to make sure they reflect the initial baseline conditions in each country as well as national tax-benefit models where available , and the robustness checked through numerous applications see e.

Bargain The qualitative results are robust with respect to different sizes of the shocks. The results for the unemployment shock do not change much when we model it as an increase of the unemployment rate by 5 percentage points for each country.

It would be further possible to derive more complicated scenarios with different shocks on different income sources or a combination of income and unemployment shock.

However, this would only have an impact on the distribution of changes which are not relevant in the analysis of this paper. Therefore, we focus on these two simple scenarios in order to make our analysis as simple as possible. One should note, though, that our analysis is not a forecasting exercise. We do not aim at quantifying the exact effects of the recent economic crisis but of stylized scenarios in order to explore the build-in automatic stabilizers of existing pre-crisis tax-benefit systems.

Conducting an ex-post analysis would include discretionary government reactions and behavioral responses see, e. Their analysis focuses on changes in absolute and relative poverty rates after changes in the income distribution and the employment rate. The reweighting approach is the only feasible option for this scenario as EUROMOD does not simulate unemployment benefits for all countries but takes it from the data.

This approach is equivalent to estimating probabilities of becoming unemployed Bell and Blanchflower and then selecting the individuals with the highest probabilities when controlling for the same characteristics in the reweighting estimation see Herault One should note, however, that this leads to a downward bias of the short-run stabilization as unemployment benefits depend strongly on unemployment duration and would be higher for newly unemployed compared to long-term unemployed.

The EB program provides an additional 13 to 20 weeks of unemployment benefits to workers receiving unemployment insurance in states that meet certain thresholds in terms of their unemployment rates. This increased duration of unemployment benefits slightly increases the stabilization coefficient for the US and, thus, reduces the difference to the EU. A discussion of this concept can be found in Blanchard and Mohr and Morris In short, there are several conceptual difficulties in separating the cyclical component of fiscal policy from structural movements which requires strong assumptions on potential output and cyclical elasticities of different fiscal variables.

These methodological problems can lead to sizeable ex-post revisions of structural balances. Note that the results presented in this section do not change if we base our analysis on IMF Hence, the purpose of this policy was to avoid weakening automatic stabilizers at this lower level of government.

Book Google Scholar. Scandinavian Journal of Economics , 1 — Article Google Scholar. Oxford University Press, New York; American Economic Review , 99 2 Google Scholar. Auerbach A, Feenberg D: The significance of federal taxes as automatic stabilizers. Journal of Economic Perspectives , 37— Elsevier; IZA, Bonn; Blanchard O: Suggestions for a new set of fiscal indicators.

Bourguignon F, Spadaro A: Microsimulation as a tool for evaluating redistribution policies. Journal of Economic Inequality , 4 1 — International Tax and Public Finance , 17 6 — Economic Papers European Economy, Brussels; Journal of the American Statistical Association , — Econometrica , — Journal of Public Economics , — Do not sell my personal information. Cookie Settings Accept.

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