Automatic stabilizers—the intersection of labour market and fiscal policies

The automatic budget response or stabilizers is a summary concept for the automatic response of public sector revenues and expenditures to a change in the level of economic activity (the business cycle situation). These responses arise because revenues and expenditures (primarily unemployment benefits) are contingent on e.g. income and unemployment. A recession will therefore be associated with a deteriorating public budget position and vice versa.

The primary effect of these responses is to cushion disposable income to variations in market incomes, which in turn contributes to stabilization of private consumption and hence aggregate demand.⁶ This may be interpreted as social insurance or diversification of shocks via the public budget in the sense of running deficits when activity is low and surpluses when it is high. On average over the cycle, the budget is not affected, but the pro-cyclical movement of the budget diversifies shocks across time.

Since the source of the automatic stabilizers⁷ is the contingencies in expenditures and incomes, it follows that the extent of the welfare arrangements is of importance to the strength of the automatic stabilizers. It is hard to imagine an extended welfare state in which automatic budget effects would not be strong.

A necessary condition for automatic stabilizers to work is the presence of fiscal space allowing for the implied budget variations. The symmetry is important, budget surpluses (and thus consolidation) in upturns create the room for budget deficits and automatic stabilizers to work in downturns. In the presence of explicit fiscal norms/limits on the budget, it is particularly important that the budget balances in normal times are such that there is room to accommodate downturns within the budget norms.⁸

Automatic stabilizers work by stabilizing private consumption and thus one component of aggregate demand. This implies that the specific effects of the automatic stabilizers in general are shock dependent. Two dimensions of shocks are important, namely the nature of the shock (demand or supply) and its persistence (temporary or permanent). In general, the optimal policy response depends on the nature of the shock, while automatic stabilizers in some sense “average” across shock types.⁹ Automatic stabilizers do not distinguish between temporary and permanent shocks. Since it is possible to diversify temporary but not permanent shocks, this is important. The effects of aggregate shocks as reflected in the budget balance accumulate over time if shocks are persistent. It is an implication that automatic stabilizers can never be an “auto pilot”. If shocks are persistent, close monitoring and intervention are needed to avoid that public debt comes on an unsustainable trajectory; for further discussion, see e.g. Andersen (2005).

Here t denotes the tax rate, w _p the wage rate in the private sector, w _g the wage rate in the public sector, L _p the employment level in the private sector, L _g the employment level in the public sector, b the level of social transfers to non-employed,¹⁰ N the number of recipients of social transfers (not in employment), T other sources of tax revenue (exogenous) and G other public expenditures (exogenous). Note that the tax rate should be interpreted broadly as capturing both income and consumption taxes.¹¹ Observe also that in most OECD countries more than 90 % of tax revenue accrue from the direct and indirect taxation of labour incomes and about two thirds of public consumption is wage expenditures; hence, the above captures the main effects on the budget.

The direct budget effect of a transition of one single individual from non-work to work in the private sector is thus τw _p + (1 − τ)b, i.e. the sum of the tax paid, and the after tax value of the social transfer. Transition from work to non-work thus has a double effect on the budget, both the direct loss of tax revenue from reduced private income (τw _p) and the extra expenditures on social transfers ((1 − τ)b).¹³ Clearly, the more extended the welfare state, the higher the tax rate and social transfers and hence the more sensitive the budget is to changes in private employment.

It follows that the higher the participation tax, the more sensitive is the budget to changes in private employment.

The above clearly shows how the underlying design of welfare arrangements and their financing are at the root of the automatic stabilizers and that the participation tax is the main channel through which employment fluctuations affect the budget. In practice, the participation tax varies across groups in the labour market, and the budget effect is therefore in general the summation over changes in employment for different groups multiplied by their respective participation taxes. To illustrate the above interlinkage, Fig. 2 plots the metric for the size of automatic stabilizers and the participation tax for an average production worker living as single. There is a clear positive correlation between participation taxes and the assessed size of the automatic stabilizers.

Transition from private to public employment thus has a double effect on the budget, i.e. both the direct loss of tax revenue from private income and the extra expenditures on public wages. This suggests that an increase in public employment to improve the supply of welfare services can have large budgetary costs. Notice that τw _p + (1 − τ)b < τw _p + (1 − τ)w _g for b < w _g, and hence, the budgetary consequences of changes in public employment are larger than the consequences of changes in the number of recipients of social transfers (for a given population size).

Given the importance of participation taxes for the automatic stabilizers, it is a question whether recent reforms aiming at increasing the gains from work (making work pay) have had as an (un)intentional consequence that automatic stabilizers have been weakened;¹⁴ cf. also Knieser and Ziliak (2002). Figure 3 plots participation taxes for selected OECD countries over the period 2001–2013, where countries are grouped depending on whether participation taxes have been roughly unchanged, increased or decreased. Slightly more countries have decreased participation taxes than increased them, and for some countries, there are no discernible changes. Among the countries having decreased participation taxes (tending to weaken automatic budget reactions) are countries like New Zealand, Australia and the US, known to have more lenient welfare arrangements, but also Denmark and Sweden fall in this category. On the basis of the evidence in Fig. 3, it is not possible to conclude generally whether recent reforms motivated by structural concerns have tended to weaken automatic stabilizers.

The fact that automatic stabilizers have participation taxes as core determinants points to the trade-off between micro incentives and macro stability. A higher participation tax may be associated with large incentive problems, but at the same time, it implies more insurance and contributes to macroeconomic stability. Distribution, allocation and stabilization are mutually interlinked. This raises the question whether it is possible to improve on the insurance and stability side without jeopardizing incentives. The following section turns to this issue.

It is an important policy question whether automatic stabilizers can be maintained and possibly strengthened without jeopardizing the incentive structure. Is this at all possible, or is there an inevitable conflict? This section considers two possibilities by which to reduce this dilemma, namely the design of the social safety net and the possibility of introducing explicit business cycle conditions in unemployment insurance schemes.

4.1 Balancing incentives and insurance

Policy designs are important for both the moral hazard and adverse selection problems arising from insurance provided by the social safety net. Most discussions focus on participation taxes neglecting other aspects of the design of the social safety net. In particular, it is implicitly assumed that it is possible to passively claim social benefits when out of work. This may be a poor characterization of social insurance arrangements and overlooks important aspects of the design of the social safety net. The fact that the Nordic countries have high employment rates, also for low skilled, despite high participation taxes can be seen as an illustration of this. The social safety net is relatively generous measured in terms of replacement rates, but it also has a strong focus on workfare/active labour market policies. Eligibility to benefits includes numerous conditions to qualify for benefits; that is, although eligibility is universal in the sense that all have a formal right, there are conditions to be fulfilled to receive the transfers. These conditions apply both to the situation in which the person or family finds itself but also to behavioural variables like active job search, participation in education and activation programmes. The gateway into more permanent types of support like disability pension entails screening involving medical conditions, external monitoring, etc.

The eligibility conditions thus include various elements ranging from control/enforcement of job search and availability criteria to enhancement of qualifications to improve job-finding rates. These conditionalities have important implications, which can be seen by considering the limiting case of a participation requirement for an unemployment benefit recipient. That is, there is a requirement to participate in some programme to claim benefits. For the sake of argument, it is assumed that participation does not affect qualifications but only serves as an availability test. Participation in such a programme increases the opportunity costs of receiving benefits, which reduces both adverse selection and moral hazard problems related to individual search incentives.

As an illustration of how the trade-off between incentives and insurance is affected by such conditionalities, consider a standard search-matching model of the labour market frequently used to point to the adverse incentive effects of e.g. unemployment insurance (see Andersen and Svarer (2014)). In this setting, unemployment benefits distort search incentives and benefits financed by general taxation release standard common pool or moral hazard problems. Higher benefits (replacement rates) lower the gain from working, which in turn reduces job search and thus employment. Inclusion of workfare elements implies a higher opportunity cost from claiming benefits, which makes unemployed search more for the basic reason that employment becomes more attractive for given benefit levels. Moreover, this may affect wage setting. Therefore, such conditionalities serve to maintain incentives in the labour market and thus support high employment rates despite a high level of income insurance (replacement rate). Job search incentives can thus be strengthened either by a benefit cut or by strengthening of workfare elements. This is illustrated in Fig. 4 showing combinations of the replacement rate and the workfare requirement (measured in terms of the time requirement relative to normal working hours) delivering the same employment rate (see Andersen and Svarer (2014)).

The important point is that it is possible to maintain the incentive structure without necessarily deteriorating the level of economic support offered by the social safety net. It can also be interpreted in the sense that there is a complementarity between replacement rates and workfare requirements. From a policy perspective, the important lesson¹⁵ is that incentives in the labour market can be maintained without retrenchment of the social safety net and weakening automatic stabilizers.

Does the short-run stability achieved via automatic stabilizers come at the costs of a more sluggish adjustment process and thus stronger persistence in unemployment? Possible causes of such persistence include depreciation of human capital depending on the length of unemployment spells, changes in the wage-setting mechanism if it is primarily affected by insiders (the employed) with little weight given to the outsiders (unemployed), or a reduction of production capacity as a response to the crisis. The key question is whether these sources of persistence are strengthened by a generous social safety net and thus strong automatic stabilizers.

There are two lines of reasoning on this issue. The first is that automatic stabilizers (and aggregate demand management policies more generally) mute the consequences of shocks and therefore the increase in unemployment. When the increase in unemployment is smaller, the mechanisms outlined above will create less persistence.

Another approach stresses how the social safety net can be a source of persistence. Ljungqvist and Sargent (1995,1998) describe a generous welfare state as a “time bomb” in the sense that it may operate efficiently in tranquil times but be vulnerable to turbulence, in which case unemployment tends to become persistent.¹⁷ The cause of the latter is weakened job search activities and higher reservation wages due to a generous social safety net. It is argued that shocks tend to depreciate skills and thus require workers to accept a wage cut to find a new job, but unemployment benefits depending on past wages tend to create inertia in the adjustment of reservation wages, which prolongs unemployment spells. Moreover, mobility across jobs may be lowered, all of which reduces the restructuring process in the economy. The end result may be a higher structural unemployment rate.

For a different explanation of why a generous social safety net may induce persistence pointing to the role of work norms, see e.g. Lindbeck (1995) and Lindbeck et al. (2003). If there is a strong norm to be self-supporting, employment may be high, even if economic incentives to work are small due to generous welfare schemes. This situation is vulnerable if norms are endogenous. A large shock causing high unemployment implies that many live on public transfers. This, in turn, makes it more acceptable to be receiving benefits, which thus reduces work norms. If so, job-search incentives are reduced and unemployment remains persistently high.

If the social safety net is a source of persistence in unemployment, it is critical since the viability of generous welfare arrangements depends critically on maintaining a high (private) employment level; cf. above. Is there any empirical support that countries with more generous welfare arrangements and thus strong automatic stabilizers are suffering from more persistence in unemployment?

It is not straightforward how to measure persistence in the adjustment process; cf. Andersen (2015). Ideally, one would want to separate exogenous persistence (driven by persistence in shocks) from endogenous persistence (driven by adjustment mechanisms in the system). This is obviously very difficult and will invariably rely on identifying assumptions, which may be open for debate. It is beyond the scope of this paper to go into details with this, and rather, a more simplistic approach is pursued.

For illustration, Fig. 5 plots a measure of unemployment persistence¹⁸ and the participation tax. There is no strong statistical relation between the two (the same conclusion holds when considering the relation between automatic stabilizers and persistence) and thus no immediate support for the hypothesis that social insurance or strong automatic stabilizers are associated with more sluggishness or persistence in the adjustment process.¹⁹

It is too early to assess the extent to which the Great Recession is resulting in persistent unemployment. While unemployment has remained high for a number of years, it is premature to assess whether any endogenous mechanisms in the labour market have been released. Aggregate demand is still low in most countries, and therefore, the underlying shock has in itself been strongly persistent. An indicator of persistence is long-term unemployment. Most countries have experienced an increase in long-term unemployment; see Fig. 6. It is also clear from the figure that countries having experienced the largest increase in unemployment have seen the largest increase in long-term unemployment. It is a lesson from previous crises that deep employment crises are more likely to be persistent. Accordingly, from a labour market perspective, it is critical whether unemployment turns persistent. It is seen that e.g. Denmark, Finland and Sweden have experienced a relatively large increase in unemployment but not in long-term unemployment. Hence, from the evidence from the response to the Great Recession, it is not clear that countries with strong automatic stabilizers display more persistence in the labour market.

The issues of persistence in the labour market are closely related to possible marginalization affecting particular groups. This suggests that the traditional approach to these issues may be too aggregate, overlooking the specific mechanisms through which marginalization and long-term unemployment may arise. The next section turns to this issue.

There are a number of links in the transmission mechanism through which changes in fiscal policy affect the labour market. How strongly income affects consumption and thus aggregate demand is one, and another is how changes in aggregate demand and thus production affect employment. The latter is not much discussed, and this section takes up this interlinkage.

The first observation is that employment (hours or heads) is clearly cyclically dependent but the relation is not tight. Figure 7 gives some stylized business cycle facts on employment by considering the variability of employment (total numbers of hours worked) relative to output variability and the correlation between employment and output. In general, employment is less volatile than output, and the correlation between employment and output is well below unity.

Stabilization of output does not necessarily lead to a stabilization of employment. The direct effect of such policies, e.g. via the automatic stabilizers, is to cushion income, not employment. The immediate effect hereof is that the fall in employment is not reinforced by a decline in consumption, which further decreases production and employment. This is surely important, but it is equally clear that this is not directly targeted at stabilizing employment. The employment effect of a given change in aggregate demand depends critically on the composition of the change since sectors have different employment intensities and use different types of labour. This may be important both for overall volatility in the labour market but in particular if persistence problems are most relevant for particular groups in the labour market.

Traditional macro models take labour input to be homogenous,²⁰ and thus implicitly assume that it easily and at small costs is possible to relocate labour across uses/sectors. Only the level of aggregate activity matters, not its composition. A reduction in one component of aggregate demand (e.g. net exports) could according to this line of reasoning be substituted by an equal increase in any other component (e.g. public consumption) to leave aggregate activity and hence employment unchanged. The different demand components are perfect substitutes with respect to aggregate employment, or to put it differently, an increase in aggregate activity lifts all boats in the labour market.

Labour is not homogenous and differs across various dimensions, of which education/qualifications are particularly important. These differences are crucial in discussions of structural unemployment, wage dispersion, inequality, etc. Discussions on the importance of technological changes, globalization, etc. stress the increasing heterogeneity in the labour market. The homogeneity assumption w.r.t. labour is thus decreasingly a useful approximation of how the labour market is working. This applies along several dimensions including sectors and qualifications. These differences are also of importance in a cyclical context, both because various groups are generally exposed differently to cycles and because each cycle has its own structure. It is accordingly very difficult, if not impossible, to separate the cycle from structural changes.

Consider the sectoral composition of labour demand. Employment intensities differ across sectors, implying that the composition of demand matters for labour demand. The linkage from production to employment is complicated by several mechanisms: (a) different sectors have different labour intensities, and therefore, the nature/composition of shocks matters for the employment effects of a given change in GDP, and (b) firms may not adjust labour input immediately due to anticipation effects or explicit/implicit costs of adjustment work input. Even if labour in principle is perfectly substitutable across sectors in the long run, there are likely to be non-trivial costs of relocating labour across sectors.²¹ Whether a reallocation of labour is socially desirable depends on the extent to which changes are purely cyclical (transitory) or include structural (permanent) elements.

The importance of the sectoral dimension of labour demand is illustrated in Fig. 8, which shows the increases and decreases in employment across 14 sectors during upturns and downturns in the Danish economy prior to and after the Great Recession. Despite aggregate employment changes being approximately numerically equal in size across the two business cycle phases, the sectoral changes differ significantly. Changes in employment at the sector level are not symmetric across up- and downturns, although they at the macro level are equally sized.

The above discussion has important implications for how to perceive stabilization policies from a labour market perspective. Stabilization of aggregate demand and activity is not automatically ensuring a stabilization of employment. The cyclical swings may affect differently across sectors and skill groups. Active demand management policies may thus be poorly targeted in terms of the employment effects. The sectors affected negatively by the downturn are not necessarily those affected most by fiscal policy changes. The instruments available to increase aggregate demand in the short run (e.g. infrastructure investments) may primarily affect specific groups (the building sector), and it cannot generally be assumed that this is the area in largest need of a stimulus.²² More important in relation to the issue of unemployment persistence, aggregate demand management policies are in general poorly targeted those groups in high risk of marginalization (unskilled, migrants, old). Specific labour market instruments like active labour market policies and training and subsidies are more easily targeted and thus appropriate. The expectations on what aggregate demand management policy can accomplish in a labour market context may thus be overoptimistic. Even though a downturn is driven by a fall in aggregate demand, labour market policies remain important.