Taxes and transfer payments that stabilize GDP without requiring explicit actions by policymakers are called automatic stabilizers. Both government spending and tax revenues are very sensitive to the state of the economy. Because tax collections are based largely on individual and corporate income, tax revenues will fall sharply during a recession as national income falls. At the same time, government transfer payments for programs such as unemployment insurance and food stamps will also tend to increase during a recession. The result is higher government spending and lower tax collections and the increased likelihood that the government will run a budget deficit. Similarly, when the economy grows rapidly, tax collections increase and government expenditures on transfer payments decrease, and the likelihood of the federal government running a surplus is greater. Now suppose an economy had a balanced federal budget neither deficit nor surplus. An external shock (such as a dramatic increase in oil prices or drought) then plunged the economy into a recession. Tax revenues fall and expenditures on transfer payments increase, resulting in a budget deficit. Believe it or not, the deficit actually serves a valuable role in stabilizing the economy. It works through three channels:
• Increased transfer payments such as unemployment insurance, food stamps, and other welfare payments increase the income of some households, partly offsetting the fall in household income.
• Other households whose incomes are falling pay less in taxes, which partly offsets the decline in their household income. Because incomes do not fall as much as they would have in the absence of the deficit, consumption spending does not decline as much.
• Because the corporation tax depends upon corporate profits and profits fall in a recession, taxes on businesses also fall. Lower corporate taxes prevent businesses from cutting spending as much as they would otherwise during a