Towards a quantitative theory of automatic stabilizers: The role of demographics

• We propose a quantitative theory of automatic stabilizers based on demographics.
• In economies with high tax rates, the share of young and older workers in total employment is low.
• The volatility of employment is larger among young and older workers.
• Thus, distortionary taxation lowers aggregate volatility.
• Under the baseline calibration the model explains 75% of the relationship between output volatility and government size.

Employment volatility is larger for young and old workers than for the prime aged. At the same time, in countries with high tax rates, the share of total hours supplied by young/old workers is lower. These two observations imply a negative correlation between government size and business cycle volatility. This paper assesses in a heterogeneous agent OLG model the quantitative importance of these two facts to account for the empirical relation between government size and macroeconomic stability.