One of the key areas discussed in the election was welfare and in particular what to do about those who remain long term dependent on welfare. How can the UK government encourage people back to work? A key issue is the poverty trap: some people are simply better off living on benefits than they are getting a job. Here, we’re talking about the marginal-tax-plus-lost-benefit rate. When you start earning, you get taxed, pay national insurance contributions and lose some of your benefits. All this leads to a situation where work doesn’t pay.
In a paper ‘Escaping the Poverty Trap’ by Lawrence Kay, he considered how much better off people are moving from different benefits into work, taking into account the high costs of actually finding a job and then starting work. He found that after 16 hours of work, someone on Job-seekers’ allowance would be £15.07 poorer and someone on Employment and Support Allowance would be £39.35 worse off. In many cases, people were facing a marginal effective tax rate in excess of 100%. Given this, it’s hardly surprising that Lawrence Kay found that ‘Long term welfare claims have been Britain’s blight for many years’.
However, the Coalition has plans to change this and make sure that those in work are paid more and are better off than those on benefits. By making working life a more attractive option, this should encourage those for whom work doesn’t pay to enter the labour force. This will obviously benefit them, increase the potential output of the economy (hence growth) and improve net taxes, as tax revenue rises and benefits expenditure falls. While this may not lead to tax cuts for those in work (as benefits spending falls), it may mean that more tax revenue is devoted to areas such as health and education or that the government can close the budget deficit.
The ‘universal credit’ aims to simplify the current system and make work pay, by re-introducing a culture of work in households. There is also a plan to place sanctions on those turning down work and place a cap on benefits to any single family. There was also be tax changes aimed at helping those moving into work keep more of their money, thereby removing, or at least reducing, the poverty trap. However, some families will lose out – as the IFS noted, any reform ‘creates winners and losers’. However, the reforms are a step in the right direction. As David Cameron said:
“I think that will, over time, solve the whole poverty trap issue that has bedeviled governments of all colours.”
The Labour party does back some of the changes, but questions whether there is enough help for people finding work. Another issue that must be considered is while it is undoubtedly a good plan to encourage more people to move into work and off benefits, which jobs will they move into? With unemployment still high, now is not exactly the best time to be looking for a job. However, whatever the state of the economy, providing incentives for people to move from benefits into work is definitely a good plan, but of course the methods used will be under constant scrutiny.
Articles
Iain Duncan Smith sets out Welfare Reform Bill plans BBC News (17/2/11)
Bill ditches housing benefit cut The Press Association (17/2/11)
Life on benefits is no longer an option Mail Online, James Chapman (17/2/11)
Universal Credit welfare switch ‘to hit 1.4m homes’ BBC News (12/1/11)
Nick Clegg blocks housing benefit cut for jobless Guardian, Patrick Wintour (17/2/11)
It’s time to end this addiction to benefits Telegraph (17/2/11)
Report
Escaping the Poverty Trap Policy Exchange, Lawrence Kay 2010
Questions
- What is the poverty trap? Which factors make it worse?
- Why does the poverty trap act as a labour supply disincentive for those on benefits?
- If taxes of those in work have to be increased, what happens to their incentive to work more hours? Think about the income and substitution effects of a real wage change.
- Why is it that working may not pay?
- How does the Universal Credit aim to alleviate the poverty trap? Who are likely to be the winners and losers from the government’s proposed welfare reforms?
- What is a marginal-tax-plus-lost-benefit rate? How do you calculate it?
- Are there any other policies that could also reduce the poverty trap? How effective are they likely to be?
Every quarter, the Bank of England publishes its Inflation Report. This analyses developments in the macroeconomy and gives forecasts for inflation and GDP growth over the following 12 quarters. It is on the forecast for inflation in 8 quarters’ time that the Bank of England’s Monetary Policy Committee primarily bases its interest rate decision.
According to the February 2011 Inflation Report forecast, CPI inflation is expected to be at or slightly below its 2% target in two year’s time, but there is considerable uncertainty about this, as shown in the fan diagram in Chart 3 of the Overview. What is more, inflation is likely to rise considerably before it falls back. As the Report states:
CPI inflation is likely to pick up to between 4% and 5% in the near term and to remain well above the 2% target over the next year or so, reflecting in part the recent increase in VAT. The near-term profile is markedly higher than in November, largely reflecting further rises in commodity and import prices since then. Further ahead, inflation is likely to fall back, as those effects diminish and downward pressure from spare capacity persists. But both the timing and extent of that decline in inflation are uncertain.
It is interesting to look back at the Inflation Reports of a year ago and two years ago to see what was being forecast then and to compare them with what has actually happened. It’s not too difficult to explain why the forecasts have turned out to be wrong. Hindsight is a wonderful thing. Unfortunately, foresight is less wonderful.
Articles
BoE forecasts pave way to rate rise, but King cautious Reuters, Matt Falloon and Fiona Shaikh (16/2/11)
Inflation report: what the economists say Guardian (16/2/11)
Inflation will rise sharply, says Mervyn King BBC News (16/2/11)
The unrepentant governor BBC News blogs: Stephanomics, Stephanie Flanders (16/2/11)
Inflation: Mervyn and me BBC News blogs: Idle Scrawl, Paul Mason (16/2/11)
What would Milton do? The Economist, Buttonwood (16/2/11)
Why inflation hawks are still grounded Fortune, Colin Barr (16/2/11)
Podcast and Webcast
Bank of England Press conference: Podcast (16/2/11)
Bank of England Press conference: Webcast (16/2/11)
Inflation Report
Inflation Report, portal page for latest report and sections, Bank of England
Inflation Report, February 2011: full report, Bank of England
Data
Forecasts for the UK economy: a comparison of independent forecasts, HM Treasury
Prospects for the UK economy, National Institute of Economic and Social Research press release (1/2/11)
Output, Prices and Jobs, The Economist (10/2/11)
Questions
- Examine the forecasts for UK inflation and GDP for 2010 made in the February 2009 and February 2010 Bank of England Inflation Reports. How accurate were they?
- Explain the difference between the forecasts and the outturn.
- Why is it particularly difficult to forecast inflation and GDP growth at the present time for two years hence?
- What are the advantages of the Bank of England using a forward-looking rule as opposed to basing interest rate decisions solely on current circumstances?
- Explain whether or not it is desirable for interest rates to be adjusted in response to external shocks, such as commodity price increases?
- What do you understand by the term ‘core’ inflation? Is this the same thing as demand-pull inflation?
- How is the Bank of England’s policy on interest rates likely to affect expectations? What expectations are particularly important here?
- Explain whether or not it is desirable for interest rates to be adjusted in response to external shocks, such as commodity price increases?
In a statement to the House of Commons on 9 February 2011, the Chancellor announced that banks would extend their new lending to SMEs (Small and Medium-Sized Enterprises) from £179 billion in 2010 to £190 billion in 2011. An important question is the extent to which this initiative, which forms part of a series of initiatives in conjunction with the banking sector known as Project Merlin, will impact on economic activity.
Let’s begin by thinking about the role that credit plays in an economy. Firstly, it serves a short-term role by enabling individuals and firms to ‘bridge the gap’ between their income and their spending. Secondly, it can, depending on the size and terms of the credit, help to fund longer-term investments. In the case of firms, for instance, it can help to fund capital projects such as an expansion of premises or the installation of new equipment or production processes.
The extension of credit is the main source of growth in the money supply. If the credit which is extended by financial institutions is spent it increases economic activity. The size of the increase in economic activity will depend on how many times the credit is passed on from one firm or individual to the next. In other words, it depends on the velocity of circulation of money – often referred to simply as V. If the initial credit funds a series of purchases and the recipients of these monies, i.e. those from whom the purchases are made, then use their increased deposits to fund purchases themselves, the expansion could be sizeable.
There is every indication that the additional credit for SMEs will be welcome and it seems reasonable to assume that this will positively impact on spending. But, by how much is not entirely clear. This is what fascinates me about macroeconomics, but, perhaps understandably, may well frustrate others! Once the payments for the purchases made using the newly available credit become new deposits, how will these recipients respond? Will other credit-constrained firms use this liquidity to engage in purchases themselves? But, what if these recipients use the monies to increase or rebuild their own financial wealth? In this last scenario – a pessimistic scenario – the velocity of circulation will increase relatively little and economic activity little too.
The corporate sector, of course, does not exist in isolation of other sectors of the economy and, in particular, of the household sector. As some of the income from the expanded credit flows to them in the form of factor payments (i.e. wages and profits) – though by how much is itself debtable – how will they respond? Again will credit-constrained households look to spend? Alternatively, will they hold on to these liquid balances perhaps using them as buffer-stock savings? This is not an unrealistic possibility given the leverage of households and the need to rebuild wealth, especially so in times of incredible economic uncertainty? But, who knows!
So while Merlin may have waved his wand, the full extent of its impact, though probably positive, is far from clear. Time will tell. Isn’t macroeconomics wonderful!
HM Treasury Press Release
Government welcomes banks’ statement on lending by 15% more to SMEs, and on pay and support for regional growth, HM Treasury, 9 February 2011
Statement to the House of Commons by the Chancellor
Statement on banking by the Chancellor of the Exchequer 9 February 2011
Articles
Banks sign lending and bonus deal BBC News (9/2/11)
Banks agree Project Merlin lending and bonus deal BBC News (9/2/11)
Osborne’s plans arrive too late for the economy Independent, Sean O’Grady (11/2/11)
Project Merlin ‘could weaken UK banks’ Telegraph, Harry Wilson (11/2/11)
Nothing wizard about Project Merlin Guardian UK, Nils Pratley (7/2/11)
Softball: Britain’s banks make peace with the government – for now The Economist (10/2/11)
Smaller firms insist banks must change their attitude The Herald (11/2/11)
Questions
- Detail the various roles that financial institutions play in a modern-day economy.
- Do the activities of banks carry with them any risks? How might such risks be reduced?
- What is meant by the velocity of circulation or the velocity of money?
- What factors do you think could affect the velocity of money?
- How does credit creation affect the growth of the money supply?
- What do you understand by individuals or firms being credit-constrained?
- What factors are likely to affect how credit-constrained an individual household is?
- What do you think might be meant by buffer-stock saving? What might affect the size of the buffer-stock held by a household?
Nokia and Microsoft have announced that they are to form a strategic alliance. This will see Nokia using Windows Phone as the software platform for its smartphones. This follows problems with Nokia’s own Symbian software and the success of Apple’s iPhone and Google’s Android software.
Recognising the depth of Nokia’s problems, its new boss, Stephen Elop, sent a memo to staff with apocalyptic warnings. He likened Nokia’s position to one of standing on a burning oil platform about to be engulfed with flames.
So is the alliance with Microsoft the way out of Nokia’s problems? Will it bring problems of its own? The following articles look at the issues.
Nokia to Use Microsoft Software in Smartphones New York Times, Kevin J. O’Brien (11/2/11)
Nokia, Microsoft to Join Forces to Challenge Apple Dominance Bloomberg, Diana ben-Aaron (11/2/11)
Nokia: ELOP’s challenge Bloomberg, Martin Garner (11/2/11)
Nokia falls into the arms of Microsoft The Economist: Newsbook blog (11/2/11)
Nokia and Microsoft sign strategic tie-up Guardian, Graeme Wearden (11/2/11)
Nokia and Microsoft form partnership BBC News (11/2/11)
Is the Nokia/Microsoft horse a stallion or a tired nag? BBC News blogs: Peston’s Picks, Robert Peston (11/2/11)
Microsoft and Nokia announce my dream partnership so why aren’t you all happy? ZDNet (CBS), Matthew Miller (11/2/11)
Questions
- What is meant by a strategic alliance? What forms can a strategic alliance take?
- For what reasons are Microsoft and Nokia forming a strategic alliance?
- How does Nokia hope to benefit from the alliance?
- How does Microsoft hope to benefit from the alliance?
- Why is Nokia’s share of world profits in the mobile handset market much less than its share of total handset sales (see The Economist article above)? Conversely, why has Apple such a large share of world profits in the handset market (just over 50%) and yet only a tiny market share?
With the UK economy borrowing 11% of GDP, it is undeniable that spending cuts are needed. Of course, the big question is should they be occurring now or delayed until the recovery is more stable. However, another question is now being asked. Should taxes be cut to help the worse off? David Cameron says that this is out of the question. While he is a ‘tax-cutting Tory’ who ‘believes in tax cuts’, any significant cuts in taxes specifically aimed at the poor would simply make matters worse, especially as the Coalition government is already helping to move thousands of families out of taxation altogether, albeit by increasing taxes on the better off.
“It’s no good saying we’re going to deal with the deficit by cutting spending, but then we’re going to make things worse again by cutting taxes. I’m afraid it doesn’t add up.”
Those in favour of cutting taxes include John Redwood, the head of the Tory’s economic affairs committee, who argues that they would help to boost the economy, by ‘encouraging the wealth creators and the private sector’. By reducing the burden on residents, disposable income will increase, helping to stimulate consumption and investment, which should in turn boost aggregate demand. This would be a much needed stimulus following the latest data which showed: a shrinking economy once again in the last quarter of 2010, consumer confidence at its lowest level in the past 20 years, the possibility of unstable markets should the government be seen to ‘twitch’ on the austerity drive and 57% in a YouGov poll saying that the cuts are ‘being imposed unfairly’. Public approval for the Coalition’s budget deficit reduction strategy has fallen from 53% in June 2010 to 38% in February 2010. Add to this rising inflation and unemployment and the last thing people want to hear is surely ‘No big tax cuts’.
However, the budget deficit must be tackled: now or later. Whenever it happens and whichever party is in power, spending must be cut and/or tax revenues must rise and everyone will have to play their part.
Cameron: ‘Tax cuts impossible right now’ Sky News (6/2/11)
David Cameron says major tax cuts not possible BBC News (6/2/11)
Cameron vows ‘No to big tax cuts’ The Press Association (6/2/11)
David Cameron: Sorry, but we can’t afford tax cuts Telegraph, Patrick Hennessy (5/2/11)
George Osborne faces Conservative pressure for tax cuts BBC News (1/2/11)
Nick Clegg’s tax cuts will cost £4.3 billion, says IFS Telegraph, James Kirkup (2/2/11)
Doubts mount over Cameron’s austerity drive Associated Press (6/2/11)
Sorry it is so complicated BBC 2, Daily Politics, Stephanie Flanders (14/6/10)
Questions
- What is government borrowing? Who does the government borrow from?
- Analyse the impact of tax cuts on the economy. Think about which groups will be affected the most and in what ways.
- Which components of aggregate demand will be affected by cuts in spending and rising taxes?
- ’Cuts in taxation would boost the economy.’ To what extent do you agree with this statement?
- What will be the impact of tas cuts on the government’s macroeconomic objectives, given your answer to question 3?
- What are the arguments (a) for cutting the budget deficit now and (b) for cutting the budget deficit later?