Tag: inflation

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The UK Autumn Statement 2022

The Autumn Statement was announced by Jeremy Hunt in Parliament on Thursday 17th November. This was Hunt’s first big speech since becoming Chancellor or the Exchequer a few weeks ago. He revealed to the House of Commons that there will be tax rises and spending cuts worth billions of pounds, aimed at mending the nation’s finances. It is hoped that the new plans will restore market confidence shaken by his predecessor’s mini-Budget. He claimed that the mixture of tax rises and spending cuts would be distributed fairly.

What is the Autumn statement?

The March Budget is the government’s main financial plan, where it decides how much money people will be taxed and where that money will be spent. The Autumn Statement is like a second Budget. This is an update half a year later on how things are going. However, that doesn’t mean it is not as important. This year’s Autumn Statement is especially important given the number of changes in government in recent months. The Statement unfortunately comes at a time when the cost of living is rising at its fastest rate for 41 years, meaning that it is going to be a tough winter for many people.

Statement overview

It was expected that the Statement was not going to be one to celebrate, given that the UK is now believed to be in a recession. The Office for Budget Responsibility (OBR) forecasts that the UK economy will shrink by 1.4% next year. However, Hunt said that his focus was on stability and ensuring a shallower downturn. The Chancellor outlined his ‘plan for stability’ by announcing deep spending cuts and tax rises in the autumn statement. He said that half of his £55bn plan would come from tax rises, and the rest from spending cuts.

The Chancellor plans to tackle rising prices and restore the UK’s credibility with international markets. He said that it will be a balanced path to stability, with the need to tackle inflation to bring down the cost of living while also supporting the economy on a path to sustainable growth. It will mean further concerns for many, but the Chancellor argued that the most vulnerable in society are being protected. He stated that despite difficult decisions being made, the plan was fair.

What was announced?

The government’s overall strategy appears to assume that, by tightening fiscal policy, monetary policy will not have to tighten as much. The hopeful consequence of which is that interest rates will be lower than they otherwise would have been. This means interest-rate sensitive parts of the economy, the housing sector in particular, are more protected than it would have been.

The following are some of the key measures announced:

  • Tax thresholds will be frozen until April 2028, meaning millions will pay more tax as their nominal incomes rise.
  • Spending on public services in England will rise more slowly than planned – with some departments facing cuts after the next election.
  • The state pensions triple lock will be kept, meaning pensioners will see a 10.1% rise in weekly payments.
  • The household energy price cap per unit of gas and electricity has been extended for one year beyond April but made less generous, with typical bills then being £3000 a year instead of £2500.
  • There will be additional cost-of-living payments for the ‘most vulnerable’, with £900 for those on benefits, and £300 for pensioners.
  • The top 45% additional rate of income tax will be paid on earnings over £125 140 instead of £150 000.
  • The UK minimum wage (or ‘National Living Wage’ as the government calls it) for people over 23 will increase from £9.50 to £10.42 per hour.
  • The windfall tax on oil and gas firms will increase from 25% to 35%, raising £55bn over the period from now until 2028.

The public finances

A key feature of the Autumn Statement was the Chancellor’s attempt to tackle the deteriorating public finances and to reduce the public-sector deficit and debt. The following three charts are based on data from the OBR (see data links below). They all show data for financial years beginning in the year shown. They all include OBR forecasts up to 2025/26, with the forecasts being based on the measures announced in the Autumn Statement.

Figure 1 shows public-sector current expenditure and receipts and the balance between them, giving the current deficit (or surplus), shown by the green bars. Current expenditure excludes capital expenditure on things such as hospitals, schools and roads. Since 1973, there has been a current deficit in most years. However, the deficit of 11.5% of GDP in 2020/21 was exceptional given government support measures for households and business during the pandemic. The deficit fell to 3.3% in 2021/22, but is forecast to grow to 4.6% in 2022/23 thanks to government subsidies to energy suppliers to allow energy prices to be capped. (Click here for a PowerPoint of this chart.)

Figure 2 shows public-sector expenditure (current plus capital) from 1950. You can see the spike after the financial crisis of 2007–8 when the government introduced various measures to support the banking system. You can also see the bigger spike in 2020/21 when pandemic support measures saw government expenditure rise to a record 53.0% of GDP. It has risen again this financial year to a predicted to 47.3% of GDP from 44.7% last financial year. It is forecast to fall only slightly, to 47.2%, in 2023/24, before then falling more substantially as the tax rises and spending cuts announced in the Autumn Statement start to take effect. (Click here for a PowerPoint of this chart.)

Figure 3 shows public-sector debt since 1975. COVID support measures, capping energy prices and a slow growing or falling GDP have contributed to a rise in debt as a proportion of GDP since 2020/21. Debt is forecast to peak in 2023/24 at a record 106.7% of GDP. During the 20 years from 1988/89 to 2007/8 it averaged just 30.9% of GDP. After the financial crisis of 2007–8 it rose to 81.6% by 2014/15 and then averaged 82.2% between 2014/15 and 2019/20. (Click here for a PowerPoint of this chart.)

Criticism

The government has been keen to stress that Mr Hunt’s statement does not amount to a return to the austerity policies of the Conservative-Liberal Democrat coalition government, in office between 2010 and 2015. However, Labour Shadow Chancellor, Rachel Reeves, said Mr Hunt’s Autumn Statement was an ‘invoice for the economic carnage’ the Conservative government had created. There have also been some comments raised by economists questioning the need for spending cuts and tax rises on this scale, with some saying that the decisions being made are political.

Paul Johnson, the director of the Institute for Fiscal Studies has commented on the plans, stating that the British people ‘just got a lot poorer’ after a series of ‘economic own goals’ that have made a recovery much harder than it might have been. He went on to say that the government was ‘reaping the costs of a long-term failure to grow the economy’, along with an ageing population and high levels of historic borrowing.

Disapproval also came from Conservative MP, Jacob Rees-Mogg, who criticised the government’s tax increases. He raised concerns about the government’s plans to increase taxation when the economy is entering a recession. He said, ’You would normally expect there to be some fiscal support for an economy in recession.’

Economic Outlook

High inflation and rising interest rates will lead to consumers spending less, tipping the UK’s economy into a recession, which the OBR expects to last for just over a year. Its forecasts show that the economy will grow by 4.2% this year but will shrink by 1.4% in 2023, before growth slowly picks up again. GDP should then rise by 1.3% in 2024, 2.6% in 2025 and 2.7% in 2026.

The OBR predicts that there will be 3.2 million more people paying income tax between 2021/22 and 2027/28 as a result of the new tax policy and many more paying higher taxes as a proportion of their income. This is because they will be dragged into higher tax bands as thresholds and allowances on income tax, national insurance and inheritance tax have been frozen until 2028. Government documents said these decisions on personal taxes would raise an additional £3.5bn by 2028 – the consequence of ‘fiscal drag’ pulling more Britons into higher tax brackets. The OBR expects that there will be an extra 2.6 million paying tax at the higher, 40% rate. This is going to put more pressure on households who are already feeling the impact of inflation on their disposable income.

However, this pressure on incomes is set to continue, with real incomes falling by the largest amount since records began in 1956. Real household incomes are forecast to fall by 7% in the next few years, which even after the support from the government, is the equivalent of £1700 per year on average. And the number unemployed is expected to rise by more than 500 000. Senior research economist at the IFS, Xiaowei Xu, described the UK as heading for another lost decade of income growth.

There may be some good news for inflation, with suggestions that it has now peaked. The OBR forecasts that the inflation rate will drop to 7.4% next year. This is still a concern, however, given that the target set for inflation is 2%. Despite the inflation rate potentially peaking, the impact on households has not. The fall in the inflation rate does not mean that prices in the shops will be going down. It just means that they will be going up more slowly than now. The OBR expects that prices will not start to fall (inflation becoming negative) until late 2024.

Conclusion

The overall tone of the government’s announcements was no surprise and policies were largely expected by the markets, hence their muted response. However, this did not make them any less economically painful. There are major concerns for households over what they now face over the next few years, something that the government has not denied.

It has been suggested that this situation, however, has been made worse by historic choices, including cutting state capital spending, cuts in the budget for vocational education, Brexit and Kwasi Kwarteng’s mini-Budget. It is evident that Britons have a tough time ahead in the next year or so. The UK has already had one lost decade of flatlining living standards since the global financial crisis and is now heading for another one with the cost of living crisis.

Articles

Videos

Analysis

  • Autumn Statement 2022 response

    • Institute for Fiscal Studies, Stuart Adam, Carl Emmerson, Paul Johnson, Robert Joyce, Heidi Karjalainen, Peter Levell, Isabel Stockton, Tom Waters, Thomas Wernham, Xiaowei Xu and Ben Zaranko (17/11/22)

  • Help today, squeeze tomorrow: Putting the 2022 Autumn Statement in context

    • Resolution Foundation, Torsten Bell, Mike Brewer, Molly Broome, Nye Cominetti, Adam Corlett, Emily Fry, Sophie Hale, Karl Handscomb, Jack Leslie, Jonathan Marshall, Charlie McCurdy, Krishan Shah, James Smith,
    Gregory Thwaites & Lalitha Try (18/11/22)

Government documentation

Data

Questions

  1. What do you understand by the term ‘fiscal drag’?
  2. Provide a critique of the Autumn Statement from the left.
  3. Provide a critique of the Autumn Statement from the right.
  4. What are the concerns about raising taxation during a recession?
  5. Define the term ‘windfall tax’. What are the advantages and disadvantages of imposing/increasing windfall taxes on energy producers in the current situation?
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Interest rates and the impending recession

On 3 November, the Bank of England announced the highest interest rate rise in 33 years. It warned that the UK is facing the longest recession since records began. With the downturn starting earlier than expected and predicted to last for longer, households, businesses and the government are braced for a challenging few years ahead.

Interest rates

The Monetary Policy Committee increased Bank Rate to 3% from the previous rate of 2.25%. This 75-basis point increase is the largest since 1989 and is the eighth rise since December. What is more, the Bank has warned that it will not stop there. These increases in interest rates are there to try to tackle inflation, which rose to 10.1% in September and is expected to be 11% for the final quarter of this year. Soaring prices are a growing concern for UK households, with the cost of living rising at the fastest rate for 40 years. It is feared that such increases in the Bank’s base rate will only worsen household circumstances.

There are various causes of the current cost-of-living crisis. These include the pandemic’s effect on production, the aftermath in terms of supply-chain problems and labour shortages, the war in Ukraine and its effect on energy and food prices, and poor harvests in many parts of the world, including many European countries. It has been reported that grocery prices in October were 4.7% higher than in October 2021. This is the highest rate of food price inflation on record and means shoppers could face paying an extra £682 per year on average.

There is real concern about the impact of the interest rates rise on the overall economy but, in particular, on peoples’ mortgages. Bank of England Governor, Andrew Bailey, warned of a ‘tough road ahead’ for UK households, but said that the MPC had to act forcefully now or things ‘will be worse later on’.

However, it could be argued that there was a silver lining in Thursday’s announcement. The future rises in interest rates are predicted to peak at a lower rate than previously thought. Amongst all the mini-budget chaos, there was concern that rates could surpass the 6% mark. Now the Bank of England has given the assurance that future rate rises will be limited and that Bank Rate should not increase beyond 5% by next autumn. The Bank was keen to reassure markets of this by making clear the thinking behind the decision in the published minutes of MPC meeting.

Recession

With the Bank warning of the longest recession since records began, what does this actually mean? Economies experience periods of growth and periods of slowdown or even decline in real GDP. However, a recession is defined as when a country’s economy shrinks for two three-month periods (quarters) in a row. The last time the UK experienced a recession was in 2020 during the height of the pandemic. During a recession, businesses typically make less profits, pay falls, some people may lose their jobs and unemployment rises. This means that the government receives less money in taxation to use on public services such as health and education. Graduates and school leavers could find it harder to get their first job, while others may find it harder to be promoted or to get big enough pay rises to keep pace with price increases. However, the pain of a recession is typically not felt equally across society, and inequality can increase.

The Bank had previously expected the UK to fall into recession at the end of this year but the latest data from the Office for National Statistics (ONS) show that GDP fell by 0.3% in the three months to August. The Bank is predicting that GDP will shrink by 0.5% between May and August 2023, followed by a further fall of 0.3% between September and December. The Bank then expects the UK economy to remain in recession throughout 2023 and the first half of 2024.

With the higher interest rates, borrowing costs are now at their highest since 2008, when the UK banking system faced collapse in the wake of the global financial crisis. The Bank believes that by raising interest rates it will make it more expensive to borrow and encourage people not to spend money, easing the pressure on prices in the process. It does, however, mean that savers will start to benefit from higher rates (but still negative real rates), but it will have a knock-on effect on those with mortgages, credit card debt and bank loans.

The recession in 2020 only lasted for six months, although the 20.4% reduction in the UK economy between April and June that year was the largest on record. The one before that started in 2008 with the global financial crisis and went on for five quarters. Whilst it will not be the UK’s deepest downturn, the Bank stressed that it will be the longest since records began in the 1920s.

Mortgages

Those with mortgages are rightly feeling nervous about the impact that further increases in mortgage interest rates will have on their budgets. Variable mortgage rates and new fixed rates have been rising for several months because of this year’s run of rate rises but they shot up after the mini-Budget. The Bank forecasts that if interest rates continue to rise, those whose fixed rate deals are coming to an end could see their annual payments soar by an average of £3000.

Homebuyers with tracker or variable rate mortgages will feel the pain of the rate rise immediately, while the estimated 300 000 people who must re-mortgage this month will find that two-year and five-year fixed rates remain at levels not seen since the 2008 financial crisis. However, the Bank said that the cost of fixed-rate mortgages had already come down from the levels seen at the height of the panic in the wake of Kwasi Kwarteng’s mini-Budget, which sent them soaring above 6%.

There is a fear of the devastating impact on those who simply cannot afford further increases in payments. The Joseph Rowntree Foundation (JRF) said an extra 120 000 households in the UK, the equivalent of 400 000 people, will be plunged into poverty when their current mortgage deal ends. The analysis assumes that mortgage rates remain high, with homeowners forced to move to an interest rate of around 5.5%. For people currently on fixed rates typically of around of 2% which are due to expire, this change would mean a huge increase. Such people, on average, would find the proportion of their monthly income going on housing costs rising from 38% to 54%. In cash terms this equates to an average increase of £250, from £610 a month to £860 a month.

In addition to these higher monthly home-loan costs threatening to pull another 400 000 people into poverty, such turmoil in the mortgage market would increase competition for rental properties and could result in rents for new lets rising sharply as the extra demand allows buy-to-let landlords to pass on their higher loan costs (or more).

Unemployment

Since the mini-Budget, the level of the pound and government borrowing costs have somewhat recovered. However, mortgage markets and business loans are still showing signs of stress, adding to the prolonged hit to the economy. The Bank now forecasts that the unemployment rate will rise, while household incomes will come down too. The unemployment rate is currently at its lowest for 50 years, but it is expected to rise to nearly 6.5%.

Looking to the future

It is the case that the lasting effects of the pandemic, the war in Ukraine and the energy shock have all played their part in the current economic climate. However, it could be argued that the Bank and the government are now making decisions that will inflict further pain and sacrifice for millions of households, who are already facing multi-thousand-pound increases in mortgage, energy and food bills.

There have been further concerns raised about the possible tax rises planned by the Chancellor Jeremy Hunt. If large tax rises and spending cuts are set out in the Autumn Statement of 17 November, the Bank of England’s chief economist has warned that Britain risks a deeper than expected economic slowdown. This could weigh on the British economy by more than the central bank currently anticipates, in a development that would force it to rethink its approach to setting interest rates.

There is no doubt that the future economic picture looks painful, with the UK performing worse than the USA and the eurozone. The Bank Governor, Andrew Bailey, believes that the mini-Budget had damaged the UK’s reputation internationally, stating, ‘it was very apparent to me that the UK’s position and the UK’s standing had been damaged’. However, both the Governor and the Chancellor or the Exchequer agree that action needs to be taken now in order for the economy to stabilise long term.

Jeremey Hunt, the Chancellor, explained that the most important thing the British government can do right now is to restore stability, sort out the public finances and get debt falling so that interest rate rises are kept as low as possible. This echoes the Bank’s belief in the importance of acting forcefully now in order to prevent things being much worse later on. With the recession predicted to last into 2024, the same year as a possible general election, the Conservatives face campaigning to remain in government at the tail end of a prolonged slump.

Report

Articles

Questions

  1. Define the term ‘recession’ and how is it measured.
  2. Explain what happens to the key macroeconomic indicators during this period of the business cycle.
  3. Which policies would governments normally implement to get a economy into the
  4. expansionary/recovery phase of the business cycle and how do they work?
  5. What is the issue of raising interest rates during a downturn or recession?
  6. With unemployment expected to rise, explain what type of unemployment this is. What policies could be introduced to reduce this type of unemployment?
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Looming stagflation


Aggregate demand has been booming as the world bounces back from the pandemic. At the same time, aggregate supply is severely constrained. These supply constraints are making potential national income smaller – at least temporarily. The result is that many countries are heading for recession.

At the same time, supply constraints are causing prices to rise, especially energy and food prices. This cost-push inflation is made worse by the rises in aggregate demand.

The result is ‘stagflation’ – a recession, or stagnation, accompanied by high inflation. In the UK, the latest Bank of England Monetary Policy Report forecast that by the end of 2022, CPI inflation would be 13.1% and that in 2023, real GDP would fall by 1.5%.

This effect of an adverse supply shock accompanied by relatively buoyant aggregate demand (at least initially) can be illustrated with an aggregate demand and supply diagram. The supply shock is illustrated by an upward shift to the left of the short-run aggregate supply curve (SRAS). (If the shock is a direct rise in prices, then it can be seen as a vertical upward shift. If it is a fall in the total amount supplied, then it can be seen as a horizontal leftward shift.) In the diagram, aggregate supply shifts from SRAS1 to SRAS2. The price level rises from P1 to P2. If costs go on rising or supply goes on falling then the curve will go on shifting upwards to the left.

If the government responds by increasing benefits or reducing taxes, then, other things being
equal, aggregate demand will rise. In the diagram, the AD curve will shift to the right, e.g. from AD1 to AD2. Real GDP only falls to Y3 not Y2. However, the price level rises further: from P2 to P3.

Why has aggregate supply fallen?

There are several factors that have contributed to the fall in aggregate supply/rise in costs.

  • Stretched supply chains, which had been adversely affected by Covid. Congestion at container ports has led to delays, with warehouses and shops being short of stock.
  • Labour shortages, with many people not returning to the labour force after being laid off or furloughed, or only returning part time, leaving firms needing more people. The problem has been particularly acute in the UK, with many EU citizens having returned to the EU after Brexit and the UK having to rely increasingly on staff from outside the EU.
  • The war in Ukraine. This has had a major impact on the supply of natural gas and oil. The war has also led to a fall in grain and other food supplies from Ukraine, as ports have been blockaded and there have been disruptions to planting and harvesting.
  • Climate change is causing more severe weather events, such as droughts in Europe and western USA. The droughts of 2022 will compound the problem of food shortages and food price inflation.
  • In the UK, Brexit costs, such as increased administrative burdens and difficulties in both exporting and importing, have dampened production and hence adversely impacted on aggregate supply.
  • Increased industrial action. As the cost of living soars, unions are demanding pay increases to match the rise in the cost of living. Pay rises further increase firms’ costs – and the bigger the pay rises, the bigger the rise in costs.

The problem with a fall in aggregate supply is that it reduces real GDP. People as a whole are poorer. To use a common analogy, the national ‘pie’ has shrunk. Giving everyone a bigger knife and fork (i.e. a rise in nominal aggregate demand) will not make people better off. It just compounds the problem of rising prices, as the diagram shows.

In the short term, with GDP shrinking, there is a major issue of distribution. If the poor are to be given help so that they are not made even poorer, then other people will have been made worse off. In other words, their nominal incomes must rise more slowly than prices.

Monetary policy

Central banks generally have a mandate of keeping inflation close to 2% over the medium term. Their levers are changes in interest rates, underpinned by changes in the money supply – in extreme times by quantitative easing (creating money by buying assets with newly created money) or quantitative tightening (withdrawing money from the economy by selling assets). Central banks, faced by soaring inflation, have been raising interest rates. The Fed has recently raised the Federal Funds rate by 0.75 percentage points (75 basis points) and the Bank of England and the European Central Bank by 0.5 percentage points (50 basis points).

Raising interest rates reduces inflation by dampening aggregate demand. In the diagram, the AD curve shifts to the left (or shifts to the right less quickly). This will dampen inflation, as falling real demand will force firms to cut prices. But it will also force them to cut output and employment, thereby worsening the recession.

Central banks recognise this dilemma, but also recognise that if inflation is not brought rapidly under control, it could spiral upwards, with wages and prices chasing each other in a wage–price spiral, which only gets worse as inflationary expectations rise. The short-term pain of falling real income is a price worth paying for getting inflation under control.

Fiscal policy

In the short term, there is little that fiscal policy can do to raise real GDP. The focus, as it was during the pandemic, must therefore be in providing relief to those most in need.

In the UK, the energy price cap set by Ofgem will see likely energy bills for the typical household quadruple in just a year, from a little over £1000 per annum at January 2021 prices to over £4200 in predicted January 2023 prices. These higher prices partly reflect rising wholesale energy costs and partly the need for energy companies, in a process known as ‘backwardation’, to recoup hedging costs they have incurred so as not to be forced out of business.

Relief for consumers can be in various forms. For example, the government could pay subsidies to energy suppliers to cap prices at a lower level, perhaps just for the poorest households. Or it could pay grants to help people with their bills. Again, these could be targeted to the poorest families, or paid on a sliding scale according to income. Or VAT on gas and electricity could be scrapped.

Generally the more people are entitled to help, the more expensive it is for the government and hence the less generous the help per family is likely to be.

Then there is the question of whether such measures should be accompanied by a rise in broadly-based tax, such as income tax, or whether the government should borrow more, which would be likely to push up interest rates and increase the cost of servicing government debt.

One topic of debate in the Conservative leadership contest is whether taxes should be cut to help people struggling with the cost of living. Whilst such a policy, if carefully targeted to investment, might increase aggregate supply over the longer term, in the short term it will increase aggregate demand and will add to inflationary pressures.

Targeting tax cuts to the poor is difficult. Cutting income tax rates has the opposite effect. The rich pay more income tax than the poor and will benefit most from a cut in rates. An alternative is to raise personal allowances. This will provide a bigger percentage help to income taxpayers on lower incomes, but provides no help at all for the poorest people who currently pay no income tax.

Conclusion

The supply shocks are making countries poorer. The focus in the short term, therefore, needs to be on income distribution and how to help those suffering the most.

To end on a note of optimism: the energy shocks are causing governments to invest in alternative sources, such as wind, solar and nuclear. When these come on line, it is expected that energy prices will fall.

As far as overall inflation is concerned, although the Bank of England is forecasting CPI inflation of 13.1% by Q4 2022, it is also forecasting that this will have fallen to 5.5% by Q4 2023 and to just 0.8% by Q3 2024. Fingers crossed.

Articles

Reports etc.

Questions

  1. What are the most efficient policies for helping those in energy poverty?
  2. Why is inflation forecast to fall later in 2023?
  3. What determines the shape of the short-run aggregate supply curve?
  4. What government policies would support (a) labour productivity; (b) investment?
  5. How might the market solve the problem of supply shortages?
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A confluence of calamities

World politicians, business leaders, charities and pressure groups are meeting in Davos at the 2022 World Economic Forum. Normally this event takes place in January each year, but it was postponed to this May because of Covid-19 and is the first face-to-face meeting since January 2020.

The meeting takes place amid a series of crises facing the world economy. The IMF’s Managing Director, Kristalina Georgieva, described the current situation as a ‘confluence of calamities’. Problems include:

  • Continuing hangovers from Covid have caused economic difficulties in many countries.
  • The bounceback from Covid has led to demand outpacing supply. The world is suffering from a range of supply-chain problems and shortages of key materials and components, such as computer chips.
  • The war in Ukraine has not only caused suffering in Ukraine itself, but has led to huge energy and food price increases as a result of sanctions and the difficulties in exporting wheat, sunflower oil and other foodstuffs.
  • Supply shocks have led to rising global inflation. This will feed into higher inflationary expectations, which will compound the problem if they result in higher prices and wages in response to higher costs.
  • Central banks have responded by raising interest rates. These dampen an already weakened global economy and could push the world into recession.
  • Global inequality is rising rapidly, both within countries and between countries, as Covid disruptions and higher food and energy prices hit the poor disproportionately. Poor people and countries also have a higher proportion of debt and are thus hit especially hard by higher interest rates.
  • Global warming is having increasing effects, with a growing incidence of floods, droughts and hurricanes. These lead to crop failures and the displacement of people.
  • Countries are increasingly resorting to trade restrictions as they seek to protect their own economies. These slow economic growth.

World leaders at Davos will be debating what can be done. One approach is to use fiscal policy. Indeed, Kristalina Georgieva said that her ‘main message is to recognise that the world must spend the billions necessary to contain Covid in order to gain trillions in output as a result’. But unless the increased expenditure is aimed specifically at tackling supply shortages and bottlenecks, it could simply add to rising inflation. Increasing aggregate demand in the context of supply shortages is not the solution.

In the long run, supply bottlenecks can be overcome with appropriate investment. This may require both greater globalisation and greater localisation, with investment in supply chains that use both local and international sources.

International sources can be widened with greater investment in manufacturing in some of the poorer developing countries. This would also help to tackle global inequality. Greater localisation for some inputs, especially heavier or more bulky ones, would help to reduce transport costs and the consumption of fuel.

With severe supply shocks, there are no simple solutions. With less supply, the world produces less and becomes poorer – at least temporarily until supply can increase again.

Articles

Discussion (video)

Report

Questions

  1. Draw an aggregate demand and supply diagram (AD/AS or DAD/DAS) to illustrate the effect of a supply shock on output and prices.
  2. Give some examples of supply-side policies that could help in the current situation.
  3. What are the arguments for and against countries using protectionist policies at the current time?
  4. What policies could countries adopt to alleviate rapid rises in the cost of living for people on low incomes? What problems do these policies pose?
  5. What are the arguments for and against imposing a windfall tax on energy companies and using the money to support poor people?
  6. If the world slips into recession, should central banks and governments use expansionary monetary and fiscal policies?
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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.

Articles

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.