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LAFFER CURVE: The graphical inverted-U relation between tax rates and total tax collections by government. Developed by economist Arthur Laffer, the Laffer curve formed a key theoretical foundation for supply-side economics of President Reagan during the 1980s. It is based on the notion that government collects zero revenue if the tax rate is 0% and if the tax rate is 100%. At a 100% tax rate no one has the incentive to work, produce, and earn income, so there is no income to tax. As such, the optimum tax rate, in which government revenue is maximized, lies somewhere between 0% and 100%. This generates a curve shaped like and inverted U, rising from zero to a peak, then falling back to zero. If the economy is operating to the right of the peak, then government revenue can be increased by decreasing the tax rate. This was used to justify supply-side economic policies during the Reagan Administration, especially the Economic Recovery Tax Act of 1981 (Kemp-Roth Act).
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                           AUTOMATIC STABILIZERS: Taxes and transfer payments that depend on the level of aggregate production and income such that they automatically dampen business-cycle instability without the need for discretionary policy action. Automatic stabilizers are a form of nondiscretionary fiscal policy that do not require explicit action by the government sector to address the ups and downs of the business cycle and the problems of unemployment and inflation. Automatic stabilizers are a part of the structure of the economy that work to limit the expansions and contractions of the business cycle over what they would be otherwise. Induced taxes and transfer payments, payments from and to the household sector to the government sector, that are based on the level of aggregate production and income are the source of automatic business-cycle stabilization.- An increase in aggregate production and income associated with a business-cycle expansion causes an increase in taxes and a decrease in transfer payments, both of which limit the increase in disposable income and thus also limit the expansion.
- Alternatively, a decrease in aggregate production and income associated with a business-cycle contraction causes a decrease in taxes and an increase in transfer payments, both of which limit the decrease in disposable income and thus also limit the contraction.
The critical feature of automatic stabilizers is that they do in fact work AUTOMATICALLY. There is no need for Congress or the President to enact legislation, pass bills, or to undertake any other policy action. These stabilizers are built into the structure of the economy. The government sets up the rules and criteria under which taxes and transfer payments work. If people meet the criteria, then they pay the taxes or receive the transfer payments. The key is that the total of each depends on people meeting the criteria, and the number qualifying depends on business-cycle activity.Automatic stabilizers largely came into existence in response to the Great Depression of the 1930s. In the decades preceeding the Great Depression, business cycles tended to be particularly volatile. In the decades following the Great Depression, business cycles were substantially more subdued. Automatic stabilizers are given at least partial credit for the increased stability of recent times. Let's take a closer look at each of the two automatic stabilizers -- taxes and transfer payments. TaxesIncome taxes, especially federal income taxes, largely depend on the level of aggregate production and income in the economy. If production and income rise, then tax collections also rise. Income taxes also tend to be progressive -- the proportion of taxes paid increases with income.- An Expansion: The progressive nature of income taxes automatically act to stabilize a business-cycle expansion, limiting the upswing of a business cycle that might tend to cause inflation. As the economy expands, and aggregate income increases, people pay an increasing proportion of income in taxes. This leaves proportionally less disposable income available for consumption expenditures and further expansionary stimulation. In other words, the expansion is not as robust, not as great as it would be without progressive income taxes.
- A Contraction: The progressive nature of income taxes also automatically stabilize the downswing of a business-cycle contraction. As the economy declines, and aggregate income falls, people pay a decreasing portion of income in taxes. This then leaves proportionally more disposable income available for consumption expenditures that would be without a progressive income tax system.
Transfer PaymentsTransfer payments, including Social Security to the elderly, unemployment compensation to the unemployed, and welfare to the poor, also depend on the level of aggregate production and income. These, however, work opposite to taxes. If aggregate income rises, transfer payments tend to fall as people are less likely to retire, be unemployed, or fall into the ranks of the poor.- An Expansion: The connection between transfer payments and aggregate income also automatically acts to stabilize a business-cycle expansion, limiting the upswing of a business cycle that might cause inflation. As the economy expands, and aggregate income increases, people receive increasingly fewer transfer payments. The elderly is less likely to retire, fewer workers are likely to find themselves unemployed, and the poor are likely to be less poor and less in need of assistance. This means that the consuming public has less disposable income for consumption expenditures and further expansionary stimulation than they would have if transfer payments did not decline.
- A Contraction: Transfer payments also automatically act to stabilize the downswing of a business-cycle contraction -- which is actually a primary purpose for the existence of transfer payments. As the economy declines, and aggregate income decreases, people are supported by this safety net and receive increasingly more transfer payments. The elderly is more likely to retire, more workers are likely to find themselves unemployed, and people are more likely enter the ranks of the poor in need of assistance. This means that the consuming public has more disposable income for consumption expenditures and further expansionary stimulation than they would have if transfer payments did not increase.
Discretion Not NeededThe automatic stabilizing actions of taxes and transfer payments provide an alternative to discretionary changes in government spending and taxes that comprise fiscal policy. And more than a few folks -- economists and policy makers -- prefer automatic stabilizers over discretionary fiscal policy. They are preferred because:- Discretionary fiscal policy requires discretionary action and experience potentially lengthy policy lags that make fiscal policy pro-cyclical rather than counter-cyclical.
- Automatic stabilizers, by way of contrast, work automatically and respond almost immediately to changing economic conditions, with little or no policy lags.
 Recommended Citation:AUTOMATIC STABILIZERS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2025. [Accessed: May 11, 2025]. Check Out These Related Terms... | | | | | | | | | | | Or For A Little Background... | | | | | | | | | | | And For Further Study... | | | | | | | | | | | | | | | Related Websites (Will Open in New Window)... | |
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Today, you are likely to spend a great deal of time flipping through mail order catalogs seeking to buy either income tax software or a how-to book on the art of negotiation. Be on the lookout for empty parking spaces that appear to be near the entrance to a store. Your Complete Scope
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