Discussion Paper Details

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Title: Optimal Automatic Stabilizers

Author(s): Alisdair McKay and Ricardo Reis

Publication Date: June 2016

Keyword(s): Counter-cyclical fiscal policy, distortionary taxes and redistribution

Programme Area(s): Monetary Economics and Fluctuations

Abstract: Should the generosity of unemployment benefits and the progressivity of income taxes de- pend on the presence of business cycles? This paper proposes a tractable model where there is a role for social insurance against uninsurable shocks to income and unemployment, as well as inefficient business cycles driven by aggregate shocks through matching frictions and nominal rigidities. We derive an augmented Baily-Chetty formula showing that the optimal generosity and progressivity depend on a macroeconomic stabilization term. Using a series of analytical examples, we show that this term typically pushes for an increase in generosity and progressivity as long as slack is more responsive to social programs in recessions. A calibration to the U.S. economy shows that taking concerns for macroeconomic stabilization into account raises the optimal unemployment benefits replacement rate by 13 percentage points but has a negligible impact on the optimal progressivity of the income tax. More generally, the role of social insurance programs as automatic stabilizers affects their optimal design.

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Bibliographic Reference

McKay, A and Reis, R. 2016. 'Optimal Automatic Stabilizers'. London, Centre for Economic Policy Research.