The economic impact of uprating policy

[This article, an expansion of my earlier blog, was written for the Child Poverty Action Group (CPAG) report "The Double Lockout".  Obviously I do not necessarily share or endorse the views expressed by CPAG or by other authors whose chapters are included in the report (or they mine)]. 

Leaving aside normative questions about the "appropriate" or "fair" level of benefits for those who are out of work, disabled, or on low incomes, there are two principal issues raised by the Coalition Government’s decision to cut most working age welfare benefits in real terms over the next three years:

• First, macroeconomic; is this sensible and/or necessary given the short-run prospects for the public finances?

• Second, long-term sustainability; is this sensible and/or necessary given long-run trends on benefit expenditure and rates?

On the first, the key point is that not only is cutting benefits not necessary in order to stick to Plan A – the Chancellor’s deficit reduction plan – it directly contradicts the original plan, now in any case largely abandoned. Tax credits and social security benefits rise faster in a downturn than when the economy is doing well. And that is one of the main reasons why the deficit has fallen so much more slowly than the government had hoped two years ago. But that's not a bug; it's a feature; the "automatic stabilisers", as they are known to economists, help dampen the economy in booms and boost it in recessions. So the Chancellor has consistently, and sensibly, argued

"That is why the automatic stabilisers and the ability of monetary policy to respond are key parts of the flexibility built in to our plan."

That flexibility has helped up to now; the reason why countries like Spain and Greece have seen a “death spiral” of austerity, slow growth, higher unemployment and lower tax revenues, higher deficits, and then yet more austerity, is precisely because, constrained by euro membership and the economic errors of Eurozone policymakers, they have not allowed the automatic stabilisers to operate. 

By contrast, though UK economic performance has been dismal, to a large extent as a consequence of premature fiscal consolidation, the Chancellor’s “flexibility” has indeed ensured we avoid those mistakes. Without the automatic stabilisers, things would have been much worse. But cutting welfare benefits deliberately negates, as a matter of policy, the operation of the automatic stabilisers; it is a reduction in flexibility, not an increase. 

It is unclear why the Chancellor has suddenly chosen to disregard his own advice - and indeed that of the IMF, which has argued repeatedly for the "free operation of the automatic fiscal stabilisers."  Certainly it makes little or no sense macroeconomically.

So what about the second point; long terms trends in benefits compared to earnings, and the implication for the sustainability of the welfare system? Clearly it is unsustainable if benefits (paid for from tax revenues) rise faster than earnings (from which most tax revenues must come) over a very long period. Moreover, while there is considerable controversy about the incentive impacts of the benefit system in practice, it must surely be the case that a large and sustained rise in out-of work-benefits relative to earnings would damage work incentives and hence have economic and social costs.

Do these factors provide a justification for cutting benefits? The Chancellor argued:

"… we have to acknowledge that over the last five years those on out of work benefits have seen their incomes rise twice as fast as those in work. With pay restraint in businesses and government, average earnings have risen by around 10 per cent since 2007. Out-of-work benefits have gone up by around 20 per cent. That’s not fair to working people who pay the taxes that fund them. Those working in the public services, who have seen their basic pay frozen, will now see it rise by an average of 1 per cent. A similar approach of a 1 per cent rise should apply to those in receipt of benefits. That’s fair and it will ensure that we have a welfare system that Britain can afford."

David Smith, writing in the Sunday Times, repeated the Chancellor's argument verbatim and stated that: 

"In five years, out of work benefits have risen 20%, earnings 10%. That is unsustainable."

The numbers are correct: but they are highly selective, and David's conclusion is simply wrong. The value of out–of-work benefits relative to average earnings (and more broadly the incomes of those in work) has fallen steadily over the past three decades, until the recent slight uptick resulting from the recession:

In 1979, unemployment benefit (the predecessor to jobseeker’s allowance (JSA)) was about 22 per cent of average weekly earnings; today it is about 15 per cent, a relative decline of about a third. So benefits have been consistently falling in value relative to earnings over the last three decades, improving both affordability and work incentives. What’s going on? Simple: JSA (and most other working age benefits, although not always tax credits) has been indexed to inflation. In normal times, earnings rise faster than prices, as workers become more productive and the economy grows; this chart shows the cash value of both JSA and average weekly earnings:

So indexing benefits to prices has been far from unsustainable, or "unfair" to working people, over the last 30 years. Indeed it has resulted in a substantial reduction in spending on out of work benefits as a proportion of GDP, compared to the alternative of indexing benefits to earnings; while the incentive to work, as measured by (falling) replacement rates (the ratio of out of work benefits to earnings) has risen sharply. 

As a result, we already have ‘a welfare system that Britain can afford’, at least for those of working age. Declan Gaffney et al note that all out-of-work benefit spending only amounts to some 3 per cent of GDP. And even overall benefit spending, which has to accommodate the growing number of pensioners, has levelled off, as Chris Dillow has pointed out.

There is nothing remotely unsustainable about any of this.

In the last five years, however, earnings have risen much more slowly than prices, as the Chancellor points out. But this is the temporary consequence of recession, not a permanent state; it is highly unlikely to persist. The government certainly doesn’t expect it to: the Office of Budget Responsibility's forecast, which is not particularly optimistic about growth over the near term, suggests that earnings will rise about five per cent faster than prices over the forecast period (see table 1.1).

So unless we are stuck in permanent depression, even a modest recovery will in time lead to earnings rising significantly faster than prices, and the relative value of out of work benefits will decline again. No policy action is required to ensure this (although economic recovery would help!).

So unless the OBR is completely wrong, and the economy flatlines for the foreseeable future, with no or negative growth in earnings relative to prices (and even at my most pessimistic I don't think that's likely) then the idea that benefits need to be cut in real terms in order to ensure either that their value doesn’t outpace earnings, or the long-term sustainability of the welfare system, is wrong. To conclude, the purely economic arguments – macroeconomic or long-term – for cutting benefits are rather weak.