Final answer:
True, the income tax system acts as an automatic stabilizer by adjusting tax withholdings and government benefits automatically in response to economic changes, mitigating the effects of economic fluctuations.
Step-by-step explanation:
The income tax system does indeed serve as an automatic stabilizer over the course of the business cycle. The statement is true because when the economy experiences lower wages, a lesser amount of tax is withheld from paychecks, which provides a quick adjustment.
Conversely, during periods of higher unemployment or poverty, government spending, such as unemployment benefits, tends to increase as more people apply for assistance. Nevertheless, it is important to note that such automatic stabilizers only offset a part of the shifts in aggregate demand, historically about 10%. Although they do not fully counteract economic fluctuations, they are analogous to shock absorbers in a car; they help to dampen the impact of economic downturns, even if they don't eliminate them entirely.
An example of automatic stabilizers in action is how they contributed to the larger budget deficits during the economic downturn in 2020 caused by the pandemic. The rise in unemployment reduced tax revenues while triggering increased government spending on unemployment insurance without any new legislation. Despite concerns over budget deficits, most economists recognize the importance of automatic stabilizers during severe recessions.