Briefly explain how the tax system can stabilize the economy.

Question

What will be an ideal response?

Answer 1

The most important automatic stabilizer is the tax system. Personal income taxes vary directly in amount with income and, in fact, rise or fall by greater percentages than income itself. Big increases and big decreases in GDP are both lessened by automatic changes in income tax receipts. Because incomes, earnings, and profits all fall during a recession, the government collects less in taxes. When you work less, you are paid less and therefore pay less in taxes. It’s like an automatic tax cut that acts to reduce the severity of a recession. This is also true for payroll taxes, which depend on a worker’s earnings, and corporate income taxes, which depend on a firm’s profits. When earnings and profits fall during a recession, so do government revenues. So, like the personal income tax, the corporate income tax and payroll taxes are automatic stabilizers, too. This reduced tax burden partially offsets the magnitude of the recession.