To identify a key source of the automatic stabilizers, consider the following stylized representation of the public sector primary budget balance (B):
$$ B=t\left({w}_{\mathrm{p}}{L}_{\mathrm{p}}+{w}_{\mathrm{g}}{L}_{\mathrm{g}}+bN\right)+T-{w}_{\mathrm{g}}{L}_{\mathrm{g}}-bN-G $$
(1)
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,Footnote 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.Footnote 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 population accounting identity is that the total population (P) is given asFootnote 12
$$ P={L}_{\mathrm{p}}+{L}_{\mathrm{g}}+N $$
(2)
Consider next the budget effect of a change in private employment (for given public employment L
g and population P) which from (1) is given as
$$ dB=\left(t\left({w}_{\mathrm{p}}-b\right)+b\right)d{L}_{\mathrm{p}} $$
or
$$ dB=\left(t{w}_{\mathrm{p}}+\left(1-t\right)b\right)d{L}_{\mathrm{p}} $$
(3)
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).Footnote 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.
The budget term in (3) can be reformulated as
$$ t{w}_{\mathrm{p}}+\left(1-t\right)b={w}_{\mathrm{p}}\left(t+\left(1-t\right)\left(\frac{b}{w_{\mathrm{p}}}\right)\right)={w}_{\mathrm{p}}\tau, $$
where
$$ \tau \equiv t+\left(1-t\right)\left(\frac{b}{w_{\mathrm{p}}}\right) $$
is the so-called participation tax for the individual when transiting between work and non-work and b/w
p is the replacement rate of the transfers. To see this, note that the difference between income when working and non-working is
$$ {w}_{\mathrm{p}}\left(1-t\right)-b\left(1-t\right)={w}_{\mathrm{p}}\left(1-\left(t+\left(1-t\right)\frac{b}{w_{\mathrm{p}}}\right)\right)={w}_{\mathrm{p}}\left(1-\tau \right) $$
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.
The preceding also stresses the importance of maintaining a high structural employment rate in the private sector to ensure the financial viability of welfare arrangements. To elaborate on this, consider how an increase in population size (e.g. due to ageing or migration) affects public finances depending on whether it leads to an increase in private employment or recipients of transfers. An increase in population leading to an increase in private employment dL
p = dP improves the budget by dB = τw
p > 0, while an increase in population leading to more receiving benefits dN = dP deteriorates the budget by dB = −(1 − t)b < 0. This shows in a nutshell why tax-financed welfare arrangements are sensitive to the balance between the number of people working in the private sector and receiving transfers (see below). In the same vein, note that the effect of a change in public employment matched by lower private employment is
$$ dB=\left(-\left(1-t\right){w}_{\mathrm{g}}-t{w}_{\mathrm{p}}\right)d{L}_{\mathrm{g}} $$
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;Footnote 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.