This article will help you to learn about the difference between discretionary fiscal policy and automatic fiscal policy.
Difference between Discretionary Fiscal Policy and Automatic Fiscal Policy
Discretionary Fiscal Policy:
The central government exercises discretionary fiscal policy when it identifies an unemployment or inflation problem, establishes a policy objective concerning that problem, and then deliberately adjusts taxes and/or spending accordingly.
Depending on the situation, the central government could, for example, institute a tax cut or raise the tax rate, change personal income tax exemptions or deductions, grant tax rebates or credits, levy surcharges, initiate or postpone transfer programmes, and either initiate or eliminate direct spending projects.
Automatic Fiscal Policy:
Another type of fiscal action — automatic stabilisation — takes place when changing economic conditions cause government expenditures and taxes to change automatically, which, in its turn, helps to combat unemployment or demand-pull inflation.
These adjustments in government expenditures and taxes occur without any deliberate legislative action, and stimulate aggregate spending in a recession and reduce aggregate spending during economic expansion. Two automatic fiscal policy stabilisers are of primary importance transfer payments, especially unemployment compensation, and the personal income tax.
To understand how automatic stabilisers work, consider a recession. During a downswing, when people lose their jobs and earned incomes are reduced, some important changes in government expenditures and taxes occur automatically.
Firstly, some unemployed individuals become eligible for a number of transfer payments, particularly unemployment benefit. Second, because the personal income tax is normally progressive tax with several rates, some of the unemployed experience a decline in the percentage of their income that is taxed, thus resulting in lower tax payments or a tax refund.
These responses to a downswing are automatic and provide additional money, through increased transfer payments and decreased taxes, to households for spending. Without these built-in stabilisers, or automatic responses, household spending would fall more sharply, and the economy would most likely fall into a deeper recession.
When the economy expands, unemployment falls, and incomes rise, the built-in stabilisers automatically remove spending from the economy to reduce demand-pull inflationary pressures. As more people are employed, the government provides less in transfer payments, and higher incomes push some individuals into higher tax brackets. Without this automatic removal of spending power as the economy heats up —particularly toward full employment — inflation could be worse.
Automatic stabilisers soften the impact of cyclical expansions and contractions. Without the help of any deliberate action they pump money into the economy during a downswing and decrease aggregate spending during an upswing. However, in the face of a sever; recession or inflation, automatic stabilisers alone would not be sufficient to correct the problem.