Automatic fiscal stabilisers in the euro area and the COVID-19 crisis

Prepared by Othman Bouabdallah, Cristina Checherita-Westphal, Maximilian Freier, Carolin Nerlich and Kamila Sławińska

Published as part of the ECB Economic Bulletin, Issue 6/2020.

1 Introduction

Authorities in the euro area have taken exceptional policy action to stem the economic fallout from the coronavirus (COVID-19) pandemic. The ECB committed to using the full potential of the monetary policy tools at its disposal within its mandate. At the same time, euro area governments implemented sizeable packages of fiscal measures, consisting, in particular, of discretionary fiscal stimulus measures. As of end-May 2020, the discretionary fiscal measures by themselves amounted to about 3.25% of GDP at the aggregate euro area level.^[1] Furthermore, leaders at the European level have agreed on a major recovery plan embedded in the EU budget. When implemented, the EU budget will temporarily almost double in size to around 2% of GDP.^[2]

In addition to these discretionary measures, automatic fiscal stabilisers in the euro area countries play an important role in cushioning the economic shock caused by the pandemic. Automatic fiscal stabilisers refer to elements, built into government revenues and expenditures, that reduce fluctuations in economic activity without the need for discretionary government actions. Together with discretionary fiscal policy measures, these are especially important in a currency union such as Economic and Monetary Union (EMU), where – alongside the common monetary policy – instruments are needed that address idiosyncratic, country-specific shocks. In principle, automatic stabilisers have the advantage of being timely, targeted and temporary in smoothing the economic cycle. Furthermore, these do not suffer some of the same drawbacks as discretionary fiscal measures, such as the need for measurement of the economic cycle or implementation lags.

This article examines automatic fiscal stabilisers in the euro area and their ability to provide economic stabilisation during the COVID-19 crisis.^[3] While the concept is well-established in macroeconomics, the term “automatic fiscal stabilisers” is not used entirely consistently in the literature and may refer to somewhat different concepts, which are presented in Section 2. Estimates made by the European System of Central Banks (ESCB), as presented in Section 3, suggest that automatic fiscal stabilisers are generally sizeable but vary significantly across euro area countries. Box 1 shows that this assessment is also broadly confirmed by other comparable estimates. Even though they are related, the size of automatic fiscal stabilisers should be distinguished from their effectiveness in terms of their impact on reducing fluctuations in economic activity. During the COVID-19 crisis a number of factors may have limited the effectiveness of automatic stabilisers in contributing to macroeconomic stabilisation (Section 4). In this respect, Box 2 provides a model-based quantification of the effectiveness of automatic stabilisers at the euro area level under normal conditions and under conditions akin to the lockdown phase of the COVID-19 crisis. Overall, both the depth and the nature of the COVID-19 crisis provide a strong rationale for additional fiscal measures, as decided and implemented at the national and European level. In this context, the article discusses policy proposals to establish quasi-automatic fiscal instruments that could provide additional timely, targeted and temporary macroeconomic stabilisation for the euro area. The article also reflects on important efficiency considerations over the cycle, and the need to build fiscal buffers in good economic times (Section 5). An overall conclusion can be found in Section 6.

2 Elements of automatic stabilisation in the government budget balance

Faced with a recessionary shock, governments can provide support to the economy in different ways. Most noticeably, governments can decide to take discretionary fiscal policy measures. Typical discretionary measures include policies to boost household and firm confidence, and consumption and investment opportunities. They may also include, among many others things, tax rate cuts, higher tax allowances, car scrapping schemes and support for private investment programmes. Governments can also decide to provide guarantees (or other forms of implicit and explicit contingent liabilities), e.g. to provide liquidity support to the economy, preventing severe supply side disruptions or contagion through financial channels. Less noticeably, most government revenues, and part of government expenditures, also adjust automatically with the economy cycle and without any specific action from the government. Even less obviously, the government contributes implicitly to mitigating the repercussions of a negative macroeconomic shock by keeping a large part of its expenditure at the budgeted level, and not cutting it in a recession.

Automatic fiscal stabilisers refer to those elements built into the government budget that reduce fluctuations in economic activity without the need for discretionary actions. The first source of automatic stabilisation is found in those elements of the government budget that react to the economic cycle. We will refer to these components of the budget balance as cyclical elements of the automatic fiscal stabilisers. The second source is found in non-cyclical components of the budget balance (mainly in the form of public spending) which are characterised by relatively high inertia and can also be considered to provide automatic stabilisation. We will refer to these components of the budget balance as the non-cyclical, implicit elements of the automatic fiscal stabilisers.^[4] While this article will focus on recessionary shocks – such as the one presented by the COVID-19 crisis – in principle automatic fiscal stabilisers operate in both directions. They cushion the macroeconomic impact of a downward (e.g. recessionary) as well as an upward (e.g., overheating) shock. These two sources of automatic stabilisation are examined in more detail below.

• First, elements of automatic fiscal stabilisation in the government budget balance are cyclically-sensitive budgetary items. These are the items that closely follow their macroeconomic bases – the macroeconomic variable that determines government revenue and spending; for example, the number of unemployed persons in the case of unemployment benefits – and react immediately to a shock. On the revenue side, the drop in tax and social security contributions, alongside increasing transfers to households, are the source of automatic stabilisation that most economists will have in mind. However, this drop in revenues can be further broken down into two elements: (i) the proportional drop in revenues with respect to GDP as taxes and contributions of households and firms drop in line with their income – this can reduce economic fluctuations compared to, for example, a counterfactual scenario with a poll or lump-sum tax;^[5] and (ii) the progressivity of the tax system typically implies that revenues decline in excess of the drop in GDP, e.g. as households fall into a lower tax bracket in the personal income tax system. Tax progressivity is considered to have an important stabilisation effect on demand in case of a negative income shock, as personal income taxes play an important role in reducing volatility of disposable income.^[6] On the expenditure side, unemployment benefits represent the most relevant automatic stabiliser of this type.^[7]
• Second, the budget balance also provides implicit stabilisation via non-cyclical items, particularly on the spending side. Governments typically do not significantly reduce their spending level (i.e. in millions of euro) in times of a temporary economic downturn. This inertia in government expenditure helps stabilise total output in a downturn because the bulk of government expenditure already approved – such as wages, transfers or intermediate consumption – does not react to the drop in output. In the counterfactual, the government would reduce its expenditure to keep its budget balance unchanged in reaction to the economic slowdown. This would imply no stabilisation. The size of the government is thus often considered a proxy for the size of automatic fiscal stabilisers in a country. It should be noted that the size of the government also contributes to dampening an overheating economy, given that budgeted public expenditures are not immediately increased in times of an economic upswing. Research shows that there is a negative relationship between government size and business-cycle volatility for the Organisation for Economic Co-operation and Development (OECD) economies.^[8]

An illustration of these stabilising elements in the government budget balance is presented in Chart 1. Governments provide fiscal support to the economy, which is broadly captured ex post by the change in the general government budget balance as a share of GDP. This total fiscal support through the budget can be decomposed into two main categories: the discretionary and the cyclical components of the budget balance (green and blue bars respectively).^[9] The non-cyclical elements of the automatic fiscal stabilisers – which act as a stabilisers vis-à-vis a counterfactual drop in government investment and consumption – are not part of the change in the budget balance (red bar).

Automatic fiscal stabilisers are considered to be particularly efficient in cushioning country-specific shocks. As demonstrated during the COVID-19 crisis, discretionary fiscal measures can provide quick support in times of crisis, helping to stabilise expectations. However, discretionary measures – especially those with the largest positive long-term impact (such as productive government investment) – may only be implemented with lags. Furthermore, governments may find it difficult to reverse spending hikes after the crisis subsides. Automatic fiscal stabilisers have the advantage of providing fiscal support: (i) as the downturn occurs and without delay (this is the “timely” aspect); (ii) to those entities that require it most (the “targeted” aspect); and (iii) only for as long as is needed (the “temporary” aspect).

While automatic fiscal stabilisers provide benefits in terms of macroeconomic stabilisation, they may also have costs in terms of economic efficiency. As described above, large automatic fiscal stabilisers are associated with large government revenues and expenditures as a share of GDP and a progressive tax system. As pointed out by the literature, since taxes generally distort economic decisions, very large governments can be a drag on (potential) growth, especially when accompanied by high public debt ratios. When assessing tax structure effects on output volatility, there is evidence that for high ratios of total taxes to GDP further tax increases can be economically destabilising.^[10] Moreover, automatic stabilisers can cushion temporary shocks, while their effectiveness is limited when it comes to persistent or permanent shocks.^[11] In such cases, automatic stabilisers may lead to increasing government debt and induce risks to fiscal sustainability. Other types of measures and policies, especially structural reforms (including on the fiscal side) are needed to deal with these long-term or permanent shocks.

3 Estimating the size of automatic fiscal stabilisers in euro area countries

To estimate the size of automatic stabilisers, a microeconomic, a macroeconomic or a statistical approach can be used.^[12] The microeconomic approach estimates the extent to which a shock to household market income translates into a change in disposable income, using micro data on the tax and benefits system. The macroeconomic method additionally takes into account feedback effects and the behavioural responses of economic agents – it quantifies the stabilising impact of fiscal policy on total income. Finally, the statistical approach evaluates the automatic stabilisation effect of a budget balance in terms of changes in economic activity. It considers not only stabilisation properties related to the size of the government – as measured by public expenditure ratio – but also direct taxes paid by households, indirect taxes and transfers. The latter approach captures the cyclical component of the budget balance (in percentage of GDP) and is the most widely used approach in institutional fiscal surveillance.

This section focuses on the statistical approach and therefore estimates the size of automatic fiscal stabilisers as the part of the budget balance that automatically adjusts to the economic cycle.^[13] The statistical approach can capture both elements of the automatic stabilisers discussed in Section 2. When the elasticities of revenues and cyclical expenditures to the output gap are used, automatic fiscal stabilisers are estimated as changes in cyclical budgetary items.^[14] If the focus is shifted to the elasticities of revenues and expenditures as a ratio to GDP (the concept of semi-elasticities^[15]), the statistical approach delivers an estimate of the size of automatic fiscal stabilisers, focusing mainly on the stabilising effect of the inert public expenditures and, to a lesser extent, on the other components of a budget balance. These react non-proportionally to the economic cycle, e.g. income tax progressivity induces tax revenues to grow faster than GDP.

The ESCB method of estimating the cyclical component uses the concept of semi-elasticity to gauge the reaction of the budget balance-to-GDP ratio to cyclical conditions.^[16] In this approach the budgetary semi-elasticity is measured as the difference between semi-elasticities of revenue and expenditure components. Semi-elasticities of the relevant budgetary categories are estimated considering both a response of the budgetary category to its macroeconomic base and a reaction of the base to the output gap.^[17] One of the main novelties of the ESCB method is the incorporation of the lagged response of a budget to macroeconomic shocks. Potential lagged collection of the revenues and lagged responses of macroeconomic bases to the cycle, e.g. a lagged reaction of wages to the business cycle, not only result in a contemporaneous change of the budget balance as a reaction to the economic cycle but also contribute to further adjustments in later years.

According to ESCB estimates, the standardised cumulative size of automatic stabiliser is 0.48 in the euro area but there is a large heterogeneity among the euro area countries (Chart 2).^[18],^[19] In general, across all countries, the bulk of automatic stabilisation is provided by non-cyclical expenditures, i.e. reflecting spending inertia. The amount of stabilisation is larger in the western European countries such as Belgium or France, while it is noticeably smaller in the central and eastern European countries, e.g. Slovakia or Latvia. The larger size of automatic fiscal stabilisers in western and, to some extent, southern European countries is a consequence of three main factors: (i) larger size of government; (ii) more generous social security system; and (iii) more progressive direct taxes. The generosity of unemployment benefits partly explains the observed cross-country differences in the contribution of this expenditure to the overall semi-elasticity, which is marginal in central and eastern European countries and largest in the case of Belgium. Other aspects of automatic fiscal stabilisers are the progressivity of tax systems and the cyclicality of social security contributions. For example, even if the progressivity of tax systems is comparable among countries, the stabilisation properties of personal income tax could still differ due to the existence of collective wage bargaining, which could increase wage rigidity. Relative stability of wages and employment, as well as a tendency of households to smoothen their consumption over the business cycle, can partly explain the negative impact of cyclical revenues in some countries, such as Germany or Italy.

Automatic fiscal stabilisers during the COVID-19 crisis are expected to be sizeable on in the euro area as a consequence of the significant size of the shock. Automatic stabilisers are forecasted to account for around one-third of the large budget deficit in 2020, namely 2.8% out of 8.5% of GDP. This rises to 5.2% of GDP cumulatively over the 2020-21 period (Chart 3).^[20] Most of the size of automatic fiscal stabilisers is accounted for by the inertia of non-cyclical public expenditure, while revenues reduce the overall impact. This is partly explained by lower-than-unity elasticity of social security contributions to output in most euro area countries more than counter-balancing the stabilising effect of the progressivity of income taxes.

In the wake of a severe economic downturn, the precision of the estimated size of automatic stabilisers should be carefully assessed. First, the estimation of the cyclical component relies on one synthetic measure of the business cycle, i.e. the output gap, which is surrounded by uncertainty, notably in real time.^[21] Second, the nature of the initial shock may lead to differentiated reaction from the main macroeconomic bases used for the fiscal revenues. Third, as semi-elasticities are estimated based on the past data, these reflect the typical reaction of a general government budget to economic cyclical fluctuations. In the current crisis, the unusual nature of the initial shock, its size and its implication for different macroeconomic variables invite prudency regarding the estimated size of the automatic stabilisers.

4 The effectiveness of automatic fiscal stabilisers for macroeconomic stabilisation

Automatic fiscal stabilisers typically translate into the effective cushioning of economic fluctuations by stabilising aggregate demand. The degree to which these automatic fiscal stabilisers translate into demand stabilisation depends on the behaviour of economic agents. Households’ propensity to consume plays an important role. Whether and how individuals adjust their consumption to fluctuations in their disposable income depends on the share of liquidity-constrained and credit-constrained households. Only households limited in their ability to borrow in the market reduce their spending one-for-one in reaction to a temporary fall in income, while an income shock does not affect the consumption behaviour of households without liquidity constraints.

Model simulations for the euro area suggest that automatic fiscal stabilisers cushion around 10 to 30% of a standard GDP shock (see Box 2). That is, the euro area aggregate automatic fiscal stabiliser of 0.48 implies that between 10% and 30% of a standardised shock to the economy is cushioned. The bounds of this range of estimates are determined first and foremost by which elements of automatic fiscal stabilisation are included in the analysis. Including only the cyclical elements of automatic stabilisation reduces the macroeconomic stabilisation significantly vis-à-vis an analysis that also includes the (larger) non-cyclical elements of automatic stabilisation. Further modelling uncertainty arises from the state-dependent nature of economic variables. For example, the share of liquidity-constrained households is not independent of the state of the economy and may increase during a crisis.

Most estimates of the output smoothing effect of automatic fiscal stabilisers in advanced economies fall within the range presented in this article. Estimates depend on the source of the initial shock (e.g. external versus domestic demand). In general, an export-led shock is less tax-rich and, thus, less stabilised by the budget in most models. Automatic stabilisers tend to absorb a private consumption shock much more strongly than a private investment shock and an export shock.^[29] Estimates also depend on the model-specific budget elasticities (reaction of budget components to macroeconomic bases) and the embedded fiscal multipliers (reaction of output to a fiscal shock).^[30] In addition, estimates depend, not least, on the definition of automatic fiscal stabilisers used (which determines the counterfactual scenario without automatic fiscal stabilisers). According to the cyclical view of automatic fiscal stabilisers, in which taxes and transfers to households play the stabilising role, the degree of output smoothing after the shock is found to be at around 9% to 17%. For a size-of-government view of automatic fiscal stabilisers, assuming that mostly the expenditure side plays the stabilising role, the degree of output smoothing is found to be at 25% to 27%.^[31]

The nature of the economic shock has implications for the effectiveness of automatic fiscal stabilisers. The contraction in the COVID-19 crisis is not only faster, and its magnitude greater, than during the great financial crisis, but the current downturn is also of a different nature than in the past. Historically, recessions typically result from economic and financial imbalances. The correction of these imbalances is associated with a drop in economic aggregate demand on account of price and income adjustments, and on account of economic uncertainty. In this situation, a stabilisation of household income through the tax and benefit system in particular can help prop up economic demand. By contrast, the COVID-19 crisis is largely an exogenous shock with strong repercussions not only for demand but also for supply in the economy. In the first phase of the crisis, governments introduced severe restrictions on social and economic activities to contain the spread of the virus. This put severe constraints on the supply side of the economy, where, for example, border closures disrupted global supply chains, factory closures exhausted product stockpiles and the lockdown curtailed high-street retail. As a result, income stabilisation, supported by both automatic stabilisers and discretionary government measures, have not translated into stabilising consumption and investment to the same extent as in past downturns but have instead led to a temporary increase in the private sector’s saving rate. For example, household consumption stabilisation was temporarily inhibited, as even liquidity-constrained households were forced to change their consumption behaviour and increase their savings rate. At the same time, governments in some countries were forced to suspend their investments due to, among others things, restrictions that were introduced on the movement of people.

As the lockdown lifts in most euro area countries, automatic fiscal stabilisers should regain their normal effectiveness. On the one hand, as much of the supply-side and lockdown restrictions on the economy are lifted, households are expected to consume the part of the disposable income they were forced to save during the lockdown. Private and government investment that might have been impaired during that phase are also expected to resume. On the other hand, even if the precautionary saving motive related to the large uncertainty induced by the crisis may persist for longer, the presence of automatic fiscal stabilisers (and other supporting government measures) should cushion such effects.

It should be noted that the COVID-19 crisis may leave a lasting mark on the size of fiscal stabilisers. Tax bases and spending profiles may have shifted with the structure of the economy or in the social security system. For example, the COVID-19 crisis could in many countries act as a catalyst for a quicker digitalisation, which in turn may result in changes in the employment structure of the economy. Some measures implemented by governments – such as short-term work schemes – may remain in place after the crisis, which could have a lasting positive impact on the effectiveness of automatic fiscal stabilisers in stabilising the economy.

5 Towards a second generation of automatic fiscal stabilisers

The COVID-19 crisis gives cause to review the role of fiscal policy in a severe economic downturn. On the one hand, monetary policy remains close to the effective lower bound, which would motivate a stronger role for fiscal policy.^[38] On the other hand, traditional automatic fiscal stabilisers might be too small to counterbalance the sharp economic downturn and less effective than under normal circumstances. Also, automatic fiscal stabilisers are quite heterogeneous across euro area countries in terms of size and composition. At the same time, discretionary policy measures may react too slowly to sufficiently cushion a massive economic downturn, such as the one experienced as a result of the pandemic, and avoid hysteresis effects. These considerations have led to proposals to strengthen quasi-automatic fiscal instruments.^[39]

So-called second generation automatic fiscal stabilisers could help deliver more timely, targeted and sizeable policy responses. In contrast to traditional automatic fiscal stabilisers, which are mostly a by-product of the structure and size-of-government revenues and expenditures, second generation automatic fiscal stabilisers – also referred to as “asymmetric” or “quasi-automatic” fiscal stabilisers – are fiscal tools specifically designed and implemented to provide macroeconomic stabilisation. Second-generation automatic stabilisers work as programmes that only turn active when the economy heads into deep recession and automatically revert to normal levels once specific indicators are back to pre-crisis levels. They are automatic in that their activation is rules-based rather than subject to a government decision. In contrast to traditional automatic stabilisers, they are asymmetric in that they are activated only in case of a severe downturn of the economy.^[40]

Two types of asymmetric automatic fiscal stabilisers can be identified, depending on whether they work via public expenditure or via revenues. First, on the expenditure side, asymmetric automatic fiscal stabilisers can mainly help to stabilise household spending, e.g. through higher or longer individual unemployment benefit or social assistance payments once a certain pre-defined threshold is reached.^[41] Short-time work schemes that activate in deep recessions are a notable example. Alternatively, asymmetric automatic fiscal stabilisers can work directly through higher government spending, e.g. on infrastructure investment projects.^[42] Second, asymmetric stabilisers that work via the revenue side can influence the timing of household spending through intertemporal substitution effects. Typical examples are temporary tax deferrals or tax credits, such as a temporary decrease in the VAT rate to boost consumption in the short run.^[43]

The design of quasi-automatic fiscal stabilisers influences their effectiveness. Crucial choices relate to the economic indicators and the threshold that triggers the activation of the programme, as well as the design of the spending programmes or temporary tax cuts. For asymmetric stabilisers via unemployment benefit payments, Blanchard and Summers suggest basing the trigger on the unemployment rate rather than on output movements, as the latter might also be driven by shocks related to potential output.^[44]

If well designed, asymmetric automatic fiscal stabilisers could be a powerful instrument to effectively cushion a severe economic downturn. They are likely to be more effective than traditional stabilisers in that they are specifically designed to provide macroeconomic stabilisation in a downturn. While asymmetric automatic stabilisers usually do not respond to normal cyclical developments, they are of a much larger scale once they are activated. As such, they do not contribute to a further, permanent increase of the size of the government. Using a stylised counterfactual analysis, Blanchard and Summers show that asymmetric automatic stabilisers can be successful in limiting the impact of a recession, although the results are contingent on the role of discretionary measures and the length of the automatic stimulus period.^[45] The IMF argues that countries with a relatively small tax and benefit system could benefit from the introduction of asymmetric automatic fiscal stabilisers.^[46]

At the same time, asymmetric automatic fiscal stabilisers do not come without limitations. This is for at least three reasons: (i) they might lower incentives to take up necessary adjustments of the economy, in particular if a crisis results from the build-up of economic and financial imbalances, as was the case during the financial crisis; (ii) due to the asymmetry embedded in these instruments they do not automatically contribute to fiscal consolidation during good economic times, as countries have moved to a high debt trajectory during the downturn – to mitigate sustainability risks, it is important that countries build up fiscal buffer in good economic times; and (iii) as these instruments are meant to be sizeable, they might de facto not be available for countries with high debt levels, facing difficulties in accessing financial markets.

Until recently only a few examples of asymmetric automatic fiscal stabilisers existed in practice. In the United States, the length of unemployment benefit payments automatically increases as soon as the unemployment rate exceeds a certain threshold. Also social payments in kind, such as food stamps, automatically rise once a threshold is hit.

During the COVID-19 crisis, most euro area countries relied, to a large extent, on quasi-automatic discretionary fiscal instruments, which closely resemble asymmetric automatic stabilisers. In particular, short-time work schemes as well as temporary tax deferrals and tax credits have been widely used.^[47] Short-time work schemes involve compensation payments, in the form of subsidies or grants to firms, that are contingent on firms not laying off workers who may otherwise have been made temporarily redundant due to the economic crisis. The aim is to limit households’ loss of income and firms’ wage costs. Short-time work schemes already existed in several countries, notably in Germany, France and Belgium, although legislation was required for their activation and for the instrument to be stepped up.^[48] The scheme was newly introduced in several countries during the COVID-19 crisis. Tax deferrals and temporary VAT cuts have also been widely employed by most euro area countries.

6 Conclusions

In normal times automatic fiscal stabilisers play an important role for macroeconomic stabilisation in the euro area. According to ESCB estimates, automatic fiscal stabilisers are generally sizeable in the euro area, but vary significantly across Member States. They are particularly sizeable in some western European countries, which typically have in place more generous transfer schemes and a larger size of the government sector. In normal times they seem sufficient to cushion between 10% and 30% of an economic shock.

The effectiveness of automatic fiscal stabilisers in cushioning the economy is less apparent during the COVID-19 crisis, especially during the lockdown phase. Due to the massive economic downturn experienced by the euro area, and with monetary policy close to the effective lower bound, this gives cause to review the role of fiscal policy. So-called second generation automatic fiscal stabilisers could help deliver more timely, targeted and sizeable policy responses to preserve potential growth and avoid hysteresis effects. During the COVID-19 crisis, most euro area countries adopted measures aimed at protecting potential output by preserving those economic structures expected to remain viable after the crisis. More specifically, authorities in some countries provided short-time work schemes to keep employees in their jobs and offered liquidity support to firms to prevent them from going out of business.

Looking ahead, there are strong arguments for efficient second generation automatic fiscal stabilisers to play a more prominent role. The institutionalisation of asymmetric automatic fiscal stabilisers – such as a statutory short-time work schemes – could provide for more macroeconomic stability without overburdening the government sector. However, such instruments would need to be well designed to ensure that incentive structures are in place. Moreover, to mitigate sustainability risk, it is important that all euro area countries build up fiscal buffer in good times.