Tag: inequality

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From Reaganomics to Trussonomics

In her bid to become Conservative party leader, Liz Truss promised to make achieving faster economic growth her number-one policy objective. This would involve pursuing market-orientated supply-side policies.

These policies would include lower taxes on individuals to encourage people to work harder and more efficiently, and lower taxes on business to encourage investment. The policy would also involve deregulation, which would again encourage investment, both domestic and inward investment from overseas. These proposals echoed the policies pursued in the 1980s by President Ronald Reagan in the USA and Margaret Thatcher in the UK.

On September 23, the new Chancellor, Kwasi Kwarteng, presented a ‘mini-Budget’ – although the size of the changes made it far from ‘mini’. This, as anticipated, included policies intended to boost growth, including scrapping the 45% top rate of income tax, which is currently paid by people earning over £150 000 (a policy withdrawn on 3 October after massive objections), cutting the basic rate of income tax from 20% to 19%, scrapping the planned rise in corporation tax from 19% to 25%, scrapping the planned rise in national insurance by 1.25 percentage points, a cut in the stamp duty on house purchase and scrapping the limit placed on bankers’ bonuses. In addition, he announced the introduction of an unlimited number of ‘investment zones’ which would have lower business taxes, streamlined planning rules and lower regulation. The policies would be funded largely from extra government borrowing.

Theoretically, the argument is simple. If people do work harder and firms do invest more, then potential GDP will rise – a rise in aggregate supply. This can be shown on an aggregate demand and supply diagram. If the policy works, the aggregate supply curve will shift to the right. Real GDP will rise and there will be downward pressure on prices. In Figure 1, real GDP will rise from Y0 to Y1 and the price level will fall from P0 to P1. However, things are not as simple as this. Indeed, there are two major problems.

The first concerns whether tax cuts will incentivise people to work harder. The second concerns what happens to aggregate demand. I addition to this, the policies are likely to have a profound effect on income distribution.

Tax cuts and incentives

Cutting the top rate of income tax would have immediately given people at the top of the income scale a rise in post-tax income. This would have created a substitution effect and an income effect. Each extra pound that such people earn would be worth more in post-tax income – 60p rather than 55p. This would provide an incentive for people to substitute work for leisure as work is now more rewarding. This is the substitution effect. On the other hand, with the windfall of extra income, they now would have needed to work less in order to maintain their post-tax income at its previous level. They may well indeed, therefore, have decided to work less and enjoy more leisure. This is the income effect.

With the diminishing marginal utility of income, generally the richer people are, the bigger will be the income effect and the smaller the substitution effect. Thus, cutting the top rate of income tax may well have led to richer people working less. There is no evidence that the substitution effect would be bigger.

If top rates of income tax are already at a very high level, then cutting then may well encourage more work. After all, there is little incentive to work more if the current rate of tax is over 90%, say. Cutting them to 80% could have a big effect. This was the point made by Art Laffer, one of Ronald Reagan’s advisors. He presented his arguments in terms of the now famous ‘Laffer curve’, shown in Figure 2. This shows the total tax revenue raised at different tax rates.

If the average tax rate were zero, no revenue would be raised. As the tax rate is raised above zero, tax revenues will increase. The curve will be upward sloping. Eventually, however, the curve will peak (at tax rate t1). Thereafter, tax rates become so high that the resulting fall in output more than offsets the rise in tax rate. When the tax rate reaches 100 per cent, the revenue will once more fall to zero, since no one will bother to work.

If the economy were currently to the right of t1, then cutting taxes would increase revenue as there would be a major substitution effect. However, most commentators argue that the UK economy is to the left of t1 and that cutting the top rate would reduce tax revenues. Analysis by the Office for Budget Responsibility in 2012 suggested that t1 for the top rate of income tax was at around 48% and that cutting the rate below that would reduce tax revenue. Clearly according to this analysis, 40% is considerably below t1.

As far as corporation tax is concerned, the 19% rate is the lowest in the G20 and yet the UK suffers from low rates of both domestic investment and inward direct investment. There is no evidence that raising it somewhat, as previously planned, will cut investment. And as far as individual entrepreneurs are concerned, cutting taxes is likely to have little effect on the desire to invest and expand businesses. The motivation of entrepreneurs is only partly to do with the money. A major motivation is the sense of achievement in building a successful business.

Creating investment zones with lower taxes, no business rates and lower regulations may encourage firms to set up there. But much of this could simply be diverted investment from elsewhere in the country, leaving overall investment little changed.

To assess these questions, the government needs to model the outcomes and draw on evidence from elsewhere. So far this does not seem to have happened. They government did not even present a forecast of the effects of its policies on the public finances, something that the OBR normally presents at Budget time. This was one of the reasons for the collapse in confidence of sterling and gilts (government bonds) in the days following the mini-Budget.

Effects on aggregate demand

Cutting taxes and financing them from borrowing will expand aggregate demand. In Figure 1, the AD curve will also shift to the right and this will push up prices. Inflation is already a serious problem in the economy and unfunded tax cuts will make it worse. Higher inflation will result in the Bank of England raising interest rates further to curb aggregate demand. But higher interest rates, by raising borrowing costs, are likely to reduce investment, which will have a negative supply-side effect.

The problem here is one of timing. Market-orientated supply-side policies, if they work to increase potential GDP, will take time – measured in years rather than months. The rise in aggregate demand will be much quicker and will thus precede the rise in supply. This could therefore effectively kill off the rise in supply as interest rates rise, the exchange rate falls and the economy is pushed towards recession. Indeed, the mini-Budget immediately sparked a run on the pound and the exchange rate fell.

The rising government debt may force the government to make cuts in public expenditure. Rather than cutting current expenditure on things such as nurses, teachers and benefits, it is easier to cut capital expenditure on things such as roads and other infrastructure. But this will have adverse supply-side effects.

Effects on income distribution

Those advocating market-orientated supply-side policies argue that, by making GDP bigger, everyone can gain. They prefer to focus on the size of the national ‘pie’ rather than its distribution. If the rich initially gain, the benefits will trickle down to the poorest in society. This trickle-down theory was popular in the 1980s with politicians such as Margaret Thatcher and Ronald Reagan and, more recently, with Republican presidents, such as Goerge W Bush and Donald Trump. There are two problems with this, however.

The first, which we have already seen, is whether such policies actually do increase the size of the ‘pie’.

The second is how much does trickle down. During the Thatcher years, income inequality in the UK grew, as it did in the USA under Ronald Reagan. According to an IMF study in 2015 (see the link to the IMF analysis below), policies that increase the income share of the poor and the middle class do increase growth, while those that raise the income share of the top 20 per cent result in lower growth.

After the mini-Budget was presented, the IMF criticised it for giving large untargeted tax cuts that would heighten inequality. The poor would gain little from the tax cuts. The changes to income tax and national insurance mean that someone earning £20 000 per year will gain just £167 per year, while someone earning £200 000 will gain £5220. What is more, the higher interest rates and higher prices resulting from the lower exchange rate are likely to wipe out the modest gains to the poor.

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Questions

  1. Distinguish between market-orientated supply-side policies and interventionist ones. Consider the advantages and disadvantages of each.
  2. Explain why bond prices fell after the mini-Budget. What was the Bank of England’s response and why did this run counter to its plan for quantitative tightening?
  3. How might a tax-cutting Budget be designed to help the poor rather than the rich? Would this have beneficial supply-side effects?
  4. Find out about the 1972 tax-cutting Budget of Anthony Barber, the Chancellor in Ted Heath’s government, that led to the ‘Barber boom’ and then rampant inflation. Are there any similarities between the 1972 Budget and the recent mini-Budget?
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Soaring gas prices (updated 1/10/22)

International wholesale gas prices have soared in recent months. This followed a cold winter in 2021/22 across Europe, the bounceback in demand as economies opened up after COVID and, more recently, pressure on supplies since the Russian invasion of Ukraine and the resulting restricted gas supplies from Russia. The price of gas traded on the UK wholesale market is shown in Chart 1 (click here for a PowerPoint). Analysts are forecasting that the wholesale price of gas will continue to rise for some time. The higher price of gas has had a knock-on effect on wholesale electricity prices, as gas-fired power stations are a major source of electricity generation and electricity prices.

In the UK, domestic fuel prices were capped by the regulator, Ofgem. The cap reflected wholesale prices and was designed to allow electricity suppliers to make reasonable but not excessive profits. The cap was adjusted every six months, but this was been reduced to three months to reflect the rapidly changing situation. Prices are capped for both gas and electricity for both the standing charge and the rate per kilowatt hour (kWh). This is illustrated in Chart 2 (click here for a PowerPoint).

The effects of the cap were then projected in terms of a total annual bill for a typical household consuming 12 000 kWh of gas and 2900 kWh of electricity. Chart 3 shows the typical fuel bill for the last four price caps and, prior to the mini-Budget of 23 September, the projected price caps for the first and second quarters of 2023 based on forecasts at the time of wholesale prices (click here for a PowerPoint). As you can see, wholesale gas and electricity prices account for an increasing proportion of the total bill. The remaining elements in cost consist of profits (1.9% assumed), VAT (5%), operating costs, grid connection costs and green levies (around £153). The chart shows that, without government support for prices, the price cap would have risen by 80.6% in October 2022 and was projected to rise by a further 51% in January 2023 and by another 23% in March 2023. If this were to have been the case, then prices would have risen by 481% between the summer of 2021 and March 2023.

This was leading to dire warnings of extreme fuel poverty, with huge consequences for people’s health and welfare, which would put extra demands on an already stretched health service. Many small businesses would not be able to survive the extra fuel costs, which would lead to bankruptcies and increased unemployment.

Future wholesale gas prices

Energy market analysts expect wholesale gas prices to remain high throughout 2023, with little likelihood that gas supplies from Russia will increase. Some European countries, such as Germany, have been buying large amounts of gas to fill storage facilities before winter and before prices rise further. This has added to demand.

The UK, however, has only limited storage facilities. Although it is not an importer of gas from Russia and so, in one sense, storage facilities are less important at the current time, wholesale gas prices reflect international demand and supply and thus gas prices in the UK will be directly affected by an overall global shortage of supply.

What would have been the response to the projected rise in gas prices? Eventually demand would fall as substitute fuels are used for electricity generation. But demand is highly inelastic. People cannot readily switch to alternative sources of heating. Most central heating is gas fired. People may reduce consumption of energy by turning down their heating or turning it off altogether, but such reductions are likely to be a much smaller percentage than the rise in price. Thus, despite some use of other fuels and despite people cutting their energy usage, people would still end up spending much more on energy.

Over the longer term, new sources of supply of gas, including liquified natural gas (LNG), may increase supply. And switching to green energy sources for electricity generation, may bring the price of electricity back down and lead to some substitution been gas and electricity in the home and businesses. Also improved home insulation and the installation of heat pumps and solar panels in homes, especially in new builds, may reduce the demand for gas. But these changes take time. Chart 4 illustrates the situation (click here for a PowerPoint).

Both demand and supply are relatively inelastic. The initial demand and supply curves are D1 and S1. Equilibrium price is P1 (point a). There is now a fall in supply. Supply shifts to S2. With an inelastic demand, there is a large rise in price to P2 (point b).

Over two or three years, there is a modest fall in demand (as described above) to D2 and a modest rise in supply to S3. Price falls back somewhat to P3 (point c). Over a longer period of time, these shifts would be greater and the price would fall further.

Possible policy responses

What could the government do to alleviate the problem? Consensus was that the new Conservative Prime Minister, Liz Truss, and her Chancellor, Kwasi Kwarteng, would have to take radical measures if many households were to avoid severe hardship and debt. One proposal was to reduce VAT on domestic energy from 5% to zero and to cut green levies. Although this would help, it would make only a relatively small dent in people’s rising bills.

Another proposal was to give people cash payments to help with their bills. The more generous and widespread these payments, the more costly they would be.

One solution here would be to impose larger windfall taxes on oil and gas producers (as opposed to retailers). Their profits have soared as oil and gas prices have soared. Such a move is generally resisted by those on the right of politics, arguing that it could discourage investment in energy production. Those on the centre and left of politics argue that the profits are the result of global factors and not because of wise business decisions by the energy producers. A windfall tax would only take away these excess profits.

The EU has agreed a tax on fossil fuel companies’ surplus profits made either this year or next. It is also introducing a levy on the excess revenues that other low-cost power producers make from higher electricity prices.

Another proposal was to freeze retail energy prices at the current or some other level. This would make it impossible for energy suppliers to cover their costs and so they would have to be subsidised. This again would be very expensive and would require substantially increased borrowing at a time when interest rates are rising, or increased taxation at a time when people’s finances are already squeezed by higher inflation. An alternative would be to cap the price North Sea producers receive. As around half of the UK’s gas consumption is from the North Sea, this would help considerably if it could be achieved, but it might be difficult to do so given that the gas is sold onto international markets.

One proposal that was gaining support from energy producers and suppliers is for the government to set up a ‘deficit fund’. Energy suppliers (retailers) would freeze energy prices for two years and take out state-backed loans from banks. These would then be paid back over time by prices being capped sufficiently high to cover costs (which, hopefully, by then would be lower) plus repayments.

Another policy response would be to decouple electricity prices from the wholesale price of gas. This is being urgently considered in the EU, and Ofgem is also consulting on such a measure. This could make wholesale electricity prices reflect the costs of the different means of generation, including wind, solar and nuclear, and would see a fall in wholesale electricity prices. At the moment, generators using these methods are making large profits.

The government’s response

On September 23, the government held a mini-Budget. One of its key elements was a capping of the unit price of energy for both households and firms. The government called this the Energy Price Guarantee. For example, those households on a variable dual-fuel, direct-debit tariff would pay no more than 34.0p/kWh for electricity and 10.3p/kWh for gas. Standing charges are capped at 46p per day for electricity and 28p per day for gas. These rates will apply for 2 years from 1/10/22 and should give an average annual household bill of £2500.

Although the government has widely referred to the ‘£2500 cap’, it is the unit price that is capped, not the annual bill. It is still the case that the more you consume, the more you will pay. As you can see from Chart 3, the average £2500 still represents an average increase per annum of just over £500 per household and is almost double the cap of £1277 a year ago. It will thus still put considerable strain on many household finances.

For businesses, prices will be capped for 6 months from 1 October at 21.1p per kWh for electricity and 7.5p per KWh for gas – considerably lower than for domestic consumers.

The government will pay subsidies to the retail energy companies to allow them to make sufficient, but not excess, profit. These subsidies are estimated to cost around £150 billion. This will be funded by borrowing, not by tax increases, with the government ruling out a windfall tax on North Sea oil and gas extracting companies. Indeed, the mini-Budget contained a number of tax reductions, including scrapping the 45% top rate of income tax, cutting the basic rate of income tax from 20% to 19% and scrapping the planned rise in corporation tax from 19% to 25%.

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Questions

  1. Why are the demand and supply of gas relatively inelastic with respect to price?
  2. Why are the long-run elasticities of demand and supply of gas likely to be greater than the short-run elasticities?
  3. Find out how wholesale electricity prices are determined. Is there a case for reforming the system and, if so, how?
  4. Identify ways in which people could be protected from rising energy bills.
  5. Assess these different methods in terms of (a) targeting help to those most in need; (b) economic efficiency.
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A Spring dose of fiscal policy

On March 23, Rishi Sunak, the UK’s Chancellor of the Exchequer, delivered his Spring Statement, in which he announced changes to various taxes and grants. These measures were made against the background of rising inflation and falling living standards.

CPI inflation, currently at 6.2%, is still rising and the Office for Budget Responsibility forecasts that inflation will average 7.4% this year. The poor spend a larger proportion of their income on energy and food than the rich. With inflation rates especially high for gas, electricity and basic foodstuffs, the poor have been seen their cost of living rise by considerably more than the overall inflation rate.

According to the OBR, the higher inflation, by reducing real income and consumption, is expected to reduce the growth in real GDP this year from the previously forecast 6% to 3.8% – a much smaller bounce back from the fall in output during the early stages of the pandemic. Despite this growth in GDP, real disposable incomes will fall by an average of £488 per person this year. As the OBR states:

With inflation outpacing growth in nominal earnings and net taxes due to rise in April, real living standards are set to fall by 2.2 per cent in 2022/23 – their largest financial year fall on record – and not recover their pre-pandemic level until 2024/25.

Fiscal measures

The Chancellor announced a number of measures, which, he argued, would provide relief from rises in the cost of living.

  • Previously, the Chancellor had announced that national insurance (NI) would rise by 1.25 percentage points this April. In the Statement he announced that the starting point for paying NI would rise from a previously planned £9880 to £12 570 (the same as the starting point for income tax). This will more than offset the rise in the NI rate for those earning below £32 000. This makes the NI system slightly more progressive than before. (Click here for a PowerPoint of the chart.)
  • A cut in fuel duty of 5p per litre. The main beneficiaries will be those who drive more and those with bigger cars – generally the better off. Those who cannot afford a car will not benefit at all, other than from lower transport costs being passed on in lower prices.
  • The 5% VAT on energy-saving household measures such as solar panels, insulation and heat pumps will be reduced to zero.
  • The government’s Household Support Fund will be doubled to £1bn. This provides money to local authorities to help vulnerable households with rising living costs.
  • Research and development tax credits for businesses will increase and small businesses will each get another £1000 per year in the form of employment allowances, which reduce their NI payments. He announced that taxes on business investment will be further cut in the Autumn Budget.
  • The main rate of income tax will be cut from 20% to 19% in two years’ time. Unlike the rise in NI, which only affects employment and self-employment income, the cut in income tax will apply to all incomes, including rental and savings income.

Fiscal drag

The Chancellor announced that public finances are stronger than previously forecast. The rapid growth in tax receipts has reduced public-sector borrowing from £322 billion (15.0 per cent of GDP) in 2020/21 to an expected £128 billion (5.4 per cent of GDP) in 2021/22, £55 billion less than the OBR forecast in October 2021. This reflects not only the growth in the economy, but also inflation, which results in fiscal drag.

Fiscal drag is where rises in nominal incomes mean that the average rate of income tax rises. As tax thresholds for 2022/23 are frozen at 2021/22 levels, a greater proportion of incomes will be taxed at higher rates and tax-free allowances will account for a smaller proportion of incomes. The higher the rate of increase in nominal incomes, the greater fiscal drag becomes. The higher average rate of tax drags on real incomes and spending. On the other hand, the extra tax revenue reduces government borrowing and gives the government more room for extra spending or tax cuts.

The growth in poverty

With incomes of the poor not keeping pace with inflation, many people are facing real hardship. While the Spring Statement will provide a small degree of support to the poor through cuts in fuel duty and the rise in the NI threshold, the measures are poorly targeted. Rather than cutting fuel duty by 5p, a move that is regressive, removing or reducing the 5% VAT on gas and electricity would have been a progressive move.

Benefits, such as Universal Credit and the State Pension, are uprated each April in line with inflation the previous September. When inflation is rising, this means that benefits will go up by less than the current rate of inflation. This April, benefits will rise by last September’s annual inflation rate of 3.1% – considerably below the current inflation rate of 6.2% and the forecast rate for this year of 7.4%. This will push many benefit recipients deeper into poverty.

One measure rejected by Rishi Sunak is to impose a temporary windfall tax on oil companies, which have profited from the higher global oil prices. Such taxes are used in Norway and are currently being considered by the EU. Tax revenues from such a windfall tax could be used to fund benefit increases or tax reductions elsewhere and these measures could be targeted on the poor.

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OBR data and analysis

Questions

  1. Are the changes made to national insurance by the Chancellor progressive or regressive? Could they have been made more progressive and, if so, how?
  2. What are the arguments for and against cutting income tax from 20% to 19% in two years’ time rather than reversing the current increases in national insurance at that point?
  3. What will determine how rapidly (if at all) public-sector borrowing decreases over the next few years?
  4. What are automatic fiscal stabilisers? How does their effect vary with the rate of inflation?
  5. Examine the public finances of another country. Are the issues similar to those in the UK? Recommend fiscal policy measures for your chosen country and provide a justification.
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Rise in the cost of living
Part 1: What are the distributional consequences?

Households are expected to see further rises in the cost of living after the annual inflation rate climbed for a 13th month to its highest point in almost 30 years. This will put further pressure on already stretched household budgets. The increase reflects a bounceback in demand for goods and services after lockdowns, when prices fell sharply. It also reflects the impact of supply-chain disruptions as Covid-19 hit factory production and global trade.

The biggest concern, however, is the impact it will have on those already hard-pressed families across the UK. According to official figures, prices are rising at similar rates for richer and poorer households. However, household income levels will determine personal experiences of inflation. Poorer households find it harder to cope than richer families as essentials, such as energy and food, form a larger proportion of their shopping basket than discretionary items. On average the lowest-income families spend twice as much proportionately on food and housing bills as the richest. So low-income households, if they are already spending mainly on essentials, will struggle to find where to cut back as prices rise.

Latest Inflation figures

Latest figures from the ONS show that the Consumer Prices Index (CPI) rose by 5.5% in the year to January 2022, with further increases in the rate expected over the next couple of months. In measuring inflation, the ONS takes a so-called ‘basket of goods, which is frequently updated to reflect changes in spending patterns. For example, in 2021, hand sanitiser and men’s loungewear bottoms were added, but sandwiches bought at work were removed.

Annual CPI inflation is announced each month, showing how much the weighted average of these prices has risen since the same date last year. The weighted average is expressed as an index, with the index set at 100 in the base year, which is currently 2015.

Consumers would not normally notice price rises from month to month. However, prices are now rising so quickly that it is clear for everyone to see. What is more, average pay is not keeping up. There are workers in a few sectors, such as lorry drivers, who are in high demand, and therefore their wages are rising faster than prices. But the majority of workers won’t see such increases in pay. In the 12 months to January, prices rose by 5.5% on average, but regular pay, excluding bonuses, on average rose by only 4.7%, meaning that they fell by 0.8% in real terms.

The Bank of England has warned that CPI inflation could rise to 7% this year and some economists are forecasting that it could be almost 8% in April.

Why are costs rising?

From the weekly food shop, to filling up cars, to heating our homes, the cost of living is rising sharply around the world. Global inflation is at its highest since 2008. Some of the reasons why include:

  • Rising energy and petrol prices
    Oil prices slumped at the start of the pandemic, but demand has rocketed back since, and oil prices have hit a seven-year high. The price of gas has also shot up, leaving people around the world with eye-watering central heating bills. Home energy bills in the UK are set to rise by 54% in April when Ofgem, the energy regulator, raises the price cap.
  • Goods shortages
    During the pandemic, prices of everyday consumer goods increased. Consumers spent more on household goods and home improvements because they were stuck at home, couldn’t go out to eat or go on holiday. Manufacturers in places such as Asia have struggled to keep up with the demand. This has led to shortages of materials such as plastic, concrete and steel, driving up prices. Timber cost as much as 80% more than usual in 2021 in the UK.
  • Shipping costs
    Global shipping companies have been overwhelmed by surging demand after the pandemic and have responded by raising shipping charges. Retailers are now having to pay a lot more to get goods into stores. These prices are now being passed on to consumers. Air freight fees have also increased, having been made worse by a lorry driver shortage in Europe.
  • Rising wages
    During the pandemic many people changed jobs, or even quit the workforce – a problem exacerbated in the UK by Brexit as many European workers returned to their home countries. Firms are now having problems recruiting staff such as drivers, food processors and restaurant waiters. This has resulted in companies putting up wages to attract and retain staff. Those extra costs to employers are again being passed on to consumers.
  • Extreme weather impact
    Extreme weather in many parts of the world has contributed to inflation. Global oil supplies took a hit from hurricanes which damaged US oil infrastructure. Fierce storms in Texas also worsened the problems in meeting the demand for microchips. The cost of coffee has also jumped after Brazil had a poor harvest following its most severe drought in almost a century.
  • Trade barriers
    More costly imports are also contributing to higher prices. New post-Brexit trading rules are estimated to have reduced imports from the EU to the UK by about a quarter in the first half of 2021. In the USA, import tariffs on Chinese goods have almost entirely been passed on to US customers in the form of higher prices. Chinese telecoms giant Huawei said last year that sanctions imposed on the company by the USA in 2019 were affecting US suppliers and global customers.
  • The end of pandemic support
    Governments are ending the support given to businesses during the pandemic. Public spending and borrowing increased across the world leading to tax rises. This has contributed to rises in the cost-of-living, while most people’s wages have lagged behind.

Main concerns for the UK inflation

With rapidly rising prices, the economic decisions people will have to make are much harder. The main concerns for UK households include increases in energy costs, food prices, rent and interest rates on borrowing. All of these concerns come at a time when the government prepares to increase national insurance contributions for workers in April. There has been some pressure from MPs to scrap the tax rise so as to ease the pressure on living costs. It can be argued that there are fairer ways to increase taxes than through national insurance. However, the plan is relatively progressive, and scrapping the rise could be a badly targeted way of helping the poorest households with their energy bills.

Energy Bills
Electricity and gas bills for a typical household are expected to increase on average by £693 a year in April, which, as we have seen, is a 54% increase. Around 18 million households on standard tariffs will see an average increase from £1277 to £1971 per year. And around 4.5 million prepayment customers will see an average increase of £708 – from £1309 to £2017. Energy bills won’t rise immediately for customers on fixed rates, but many are likely to see a significant increase when their deal ends.

Bills are going up because the energy price cap is being raised. The energy price cap is an example of a maximum price being imposed on the market; it is the maximum price suppliers in England, Wales and Scotland can charge households for their energy. Energy firms can increase bills by 54% when the new cap is introduced in April. The price cap is currently reviewed every 6 months and it is expected that that prices will rise again in October.

Energy price rises are likely to hit Britain’s poorest households the hardest as they spend proportionately more of their income on energy, a problem exacerbated by many living in poorly insulated homes. More people are thus expected to find themselves facing fuel poverty. This means that they spend a disproportionate amount of their income on energy and cannot afford to heat their homes adequately. According to the Resolution Foundation, the poorest will see their energy spend rise from 8.5% to 12% of their total household budget, three times the percentage for the richest.

The way fuel poverty is measured varies around the UK. In Scotland, a household is in fuel poverty if more than 10% of its income is spent on fuel and its remaining income isn’t enough to maintain an adequate standard of living. It is expected that the number of homes facing ‘fuel stress’ across the UK will treble to 6.3 million after April. It will, however, have the greatest impact on pensioners, people in local authority housing and low-income single-adult households who on average could be forced to spend over 50% of their income on gas and electricity. The Resolution Foundation thinktank has warned that UK households are facing a ‘cost of living catastrophe’.

Food
Low-income households also spend a larger proportion than average on food and will therefore be relatively more affected by increases in food prices. Food and non-alcoholic drink prices were up by 4.2% in the year to December 2021. The Monetary Policy Committee has stated that food price inflation is expected to increase in coming months, given higher input costs. It has been estimated by the thinktank, Food Foundation, that 4.7m Britons, equivalent to 8.8% of the population, are struggling to feed themselves and are regularly going a day without eating.

Supermarkets have also raised their concerns about future increases. Tesco’s chairman John Allan has predicted that the worst is yet to come, pointing to 5% as a likely figure for food price inflation by the spring. He cited high energy prices, both for Tesco and its suppliers, as a key factor behind the expected rise.

It has been observed that the Smart Price, Basics and Value range products offered by supermarkets as lower-cost alternatives are stealthily being extinguished from the shelves. This is leaving shoppers with no choice but to ‘level up’ to the supermarkets’ own better-quality branded goods – usually in smaller quantities at larger prices. The managing director of Iceland, Richard Walker, has stated that his stores are not losing customers to other competitors or to better offers, but to food banks and to hunger. This is a highly concerning statement given that 2.5m citizens were forced by an array of desperate circumstances to use food banks over the past year.

Rent
Private rents are also rising at their fastest rate in five years, intensifying the increase in the cost of living for millions of households. Data from the ONS reveal that the average cost of renting in the UK rose by 2% in 2021. This was the largest annual increase since 2017. The East Midlands had the biggest increase in average rental prices, with tenants paying 3.6% more than a year earlier. However, due to falling demand for city flats during lockdown, as people favoured working from home, London had the smallest increase at 0.1%. Nevertheless, as Covid restrictions are removed, renters, including office workers and students, are now returning back to cities. This is now pushing up rental prices with demand outpacing supply.

The property website Zoopla found newly advertised rental prices were rising much faster across the UK. It said the average rent jumped 8.3% in the final three months of 2021 to £969 a month. This increase in rental prices, combined with the general rise in prices will place additional pressure on the government to increase support for vulnerable families. The housing charity, Shelter, has reported an increase in people who are struggling to pay their rent and even pay their electricity. With Covid-era protections having ended, if people struggle to pay, they are faced with eviction or even homelessness. There are calls for the government to support such people by reversing welfare cuts.

Insurer, Legal & General, has announced an additional investment over the next 5 years of £2.5bn on its ‘build to rent’ schemes. The aim is to provide more than 7000 purpose-built rental homes in UK towns and cities. L&G claims that the additional homes are part of the solution to the rental problem, with rent increases being capped at 5% for five years. However, sceptics claim the company is simply trying to cash in on the booming market and there are calls for further government action. The Joseph Rowntree Foundation claim that renters will struggle as rents in some areas have risen as much as 8%. Despite this, housing benefit has been frozen for two years and therefore there are calls for government to urgently relink housing benefit to the real cost of renting.

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  1. What other measures of inflation are used beside CPI inflation? How do they differ?
  2. If all consumers are facing approximately the same price increases for any given good or service, why are poor people being disproportionately hit by rising prices?
  3. For what reasons might the rate of inflation (a) rise further; (b) begin to fall?
  4. Examine a developed country other than the UK and find out how inflation is affecting its population. Is its experience similar to that in the UK? Does it differ in any way?
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Inflationary growth, stagflation or recession? Looking ahead

Inflation across the world has been rising. This has been caused by a rise in aggregate demand as the global economy has ‘bounced back’ from the pandemic, while supply-chain disruptions and tight labour markets constrain the ability of aggregate supply to respond to the rise in demand.

But what of the coming months? Will supply become more able to respond to demand as supply-chain issues ease, allowing further economic growth and an easing of inflationary pressures?

Or will higher inflation and higher taxes dampen real demand and cause growth, or even output, to fall? Are we about to enter an era of ‘stagflation’, where economies experience rising inflation and economic stagnation? And will stagnation be made worse by central banks which raise interest rates to dampen the inflation but, in the process, dampen spending.

Despite the worries of central banks, with inflation being higher than forecast a few months ago, forecasts (e.g. the OECD’s) are still for inflation to peak fairly soon and then to fall back to around 2 to 3 per cent by the beginning of 2023 – close to central bank target rates.

In the UK, annual CPI inflation reached 5.4% in December 2021. The UK Treasury’s January 2022 new monthly forecasts for the UK economy by 15 independent institutions give an average forecast of 4.0% for CPI inflation for 2022. In the USA, annual consumer price inflation reached 7 per cent in December 2021, but is forecast to fall to just over the target rate of 2% by the end of 2022.

If central banks respond to the current high inflation by raising interest rates more than very slightly and by stopping quantitative easing (QE), or even engaging in quantitative tightening (selling assets purchased under previous QE schemes), there is a severe risk of a sharp slowdown in economic activity. Household budgets are already being squeezed by the higher prices, especially energy and food prices. And people will face higher taxes as governments seek to reduce their debts, which soared with the Covid support packages during the pandemic.

The Fed has signalled that it will end its bond buying (QE) programme in March 2022 and may well raise interest rates at the same time. Quantitative tightening may then follow. But although GDP growth is still strong in the USA, Fed policy and stretched household budgets could well see spending slow and growth fall. Stagflation is less likely in the USA than in the UK and many other countries, but there is still the danger of over-reaction by the Fed given the predicted fall in inflation.

But there are reasons to be confident that stagflation can be avoided. Supply-chain bottlenecks are likely to ease and are already showing signs of doing so, with manufacturing production recovering and hold-ups at docks easing. The danger may increasingly become one of demand being excessively dampened rather than supply being constrained. Under these circumstances, inflation could rapidly fall, as is being forecast.

Nevertheless, as Covid restrictions ease, the hospitality and leisure sector is likely to see a resurgence in demand, despite stagnant or falling real disposable incomes, and here there are supply constraints in the form of staffing shortages. This could well lead to higher wages and prices in the sector, but probably not enough to prevent the fall in inflation.

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Questions

  1. Under what circumstances would stagflation be (a) more likely; (b) less likely?
  2. Find out the causes of stagflation in the early/mid-1970s.
  3. Argue the case for and against the Fed raising interest rates and ending its asset buying programme.
  4. Why are labour shortages likely to be higher in the UK than in many other countries?
  5. Research what is likely to happen to fuel prices over the next two years. How is this likely to impact on inflation and economic growth?
  6. Is the rise in prices likely to increase or decrease real wage inequality? Explain.
  7. Distinguish between cost-push and demand-pull inflation. Which of the two is more likely to result in stagflation?
  8. Why are inflationary expectations a major determinant of actual inflation? What influences inflationary expectations?