Must-Read: Alisdair McKay and Ricardo Reis: Designing effective automatic stabilisers of the business cycle

Must_Read: Alisdair McKay and Ricardo Reis: Designing effective automatic stabilisers of the business cycle:

Brexit has raised the possibility of a recession on both sides of the Atlantic….

Unable to use traditional remedies like monetary or fiscal policy stimulus, policymakers may consider automatic fiscal stabilisers…. The social insurance system stands at the centre of automatic stabilisers, yet we still know too little about how it affects the macroeconomy (Blanchard et al. 2010)…. We focus on two key programmes: a progressive tax system, and unemployment insurance.  We find that unemployment insurance has a substantial stabilising effect on the business cycle, and as a result the optimal policy is to have a more generous unemployment benefit than would be optimal in a world without macroeconomic fluctuations.  On the other hand, the progressivity of the tax appears to have little effect on the business cycle….

[The] redistribution channel based on marginal propensities to consume is the classic explanation of how unemployment benefits function as an automatic stabiliser, we find that benefits have an even more important effect on the economy. Households face considerable uncertainty over employment and over the wages they earn when employed. The fear of losing their income because of an unemployment spell in the future leads workers to want to save, and so reduce their consumption.  That is, unemployment reduces aggregate consumption demand not just by reducing the current income of unemployed workers but also by inducing precautionary savings by all workers who fear the possibility of unemployment.  By making unemployment less painful, unemployment benefits reduce these concerns and give workers confidence to spend….

When we quantify our model, we find that business cycle stabilisation considerations increase the optimal unemployment benefit replacement quite substantially.  We find that in the optimal unemployment insurance replacement rate is 49%, while it would be 36% in the absence of business cycles…. The unemployment insurance system is very effective at stabilising the business cycle by dampening the cyclical swings in household precautionary savings motives…. Recessions have large welfare costs due to the increase in uninsurable risks that households face.

While similar arguments can be put forward for the benefit of more progressive income taxes, both in terms of redistributing resources in a recession and by lowering precautionary savings, progressive income taxes have a stronger negative effect on average economic activity and a more limited effect on volatility, because of the comparatively small variation in income of those continuously employed during the business cycle. Therefore, we find that considering automatic stabilisation has a negligible effect on the desired level of progressivity.