Tag: real income

Since 2019, UK personal taxes (income tax and national insurance) have been increasing as a proportion of incomes and total tax revenues have been increasing as a proportion of GDP. However, in his Autumn Statement of 22 November, the Chancellor, Jeremy Hunt, announced a 2 percentage point cut in the national insurance rate for employees from 12% to 10%. The government hailed this as a significant tax cut. But, despite this, taxes are set to continue increasing. According to the Office for Budget Responsibility (OBR), from 2019/20 to 2028/29, taxes will have increased by 4.5 per cent of GDP (see chart below), raising an extra £44.6 billion per year by 2028/29. One third of this is the result of ‘fiscal drag’ from the freezing of tax thresholds.

According to the OBR

Fiscal drag is the process by which faster growth in earnings than in income tax thresholds results in more people being subject to income tax and more of their income being subject to higher tax rates, both of which raise the average tax rate on total incomes.

Income tax thresholds have been unchanged for the past three years and the current plan is that they will remain frozen until at least 2027/28. This is illustrated in the following table.

If there were no inflation, fiscal drag would still apply if real incomes rose. In other words, people would be paying a higher average rate of tax. Part of the reason is that some people on low incomes would be dragged into paying tax for the first time and more people would be paying taxes at higher rates. Even in the case of people whose income rise did not pull them into a higher tax bracket (i.e. they were paying the same marginal rate of tax), they would still be paying a higher average rate of tax as the personal allowance would account for a smaller proportion of their income.

Inflation compounds this effect. Tax bands are in nominal not real terms. Assume that real incomes stay the same and that tax bands are frozen. Nominal incomes will rise by the rate of inflation and thus fiscal drag will occur: the real value of the personal allowance will fall and a higher proportion of incomes will be paid at higher rates. Since 2021, some 2.2 million workers, who previously paid no income taxes as their incomes were below the personal allowance, are now paying tax on some of their wages at the 20% rate. A further 1.6 million workers have moved to the higher tax bracket with a marginal rate of 40%.

The net effect is that, although national insurance rates have been cut by 2 percentage points, the tax burden will continue rising. The OBR estimates that by 2027/28, tax revenues will be 37.4% of GDP; they were 33.1% in 2019/20. This is illustrated in the chart (click here for a PowerPoint).

Much of this rise will be the result of fiscal drag. According to the OBR, fiscal drag from freezing personal allowances, even after the cut in national insurance rates, will raise an extra £42.9 billion per year by 2027/28. This would be equivalent of the amount raised by a rise in national insurance rates of 10 percentage points. By comparison, the total cost to the government of the furlough scheme during the pandemic was £70 billion. For further analysis by the OBR of the magnitude of fiscal drag, see Box 3.1 (p 69) in the November 2023 edition of its Economic and fiscal outlook.

Political choices

Support measures during the pandemic and its aftermath and subsidies for energy bills have led to a rise in government debt. This has put a burden on public finances, compounded by sluggish growth and higher interest rates increasing the cost of servicing government debt. This leaves the government (and future governments) in a dilemma. It must either allow fiscal drag to take place by not raising allowances or even raise tax rates, cut government expenditure or increase borrowing; or it must try to stimulate economic growth to provide a larger tax base; or it must do some combination of all of these. These are not easy choices. Higher economic growth would be the best solution for the government, but it is difficult for governments to achieve. Spending on infrastructure, which would support growth, is planned to be cut in an attempt to reduce borrowing. According to the OBR, under current government plans, public-sector net investment is set to decline from 2.6% of GDP in 2023/24 to 1.8% by 2028/29.

The government is attempting to achieve growth by market-orientated supply-side measures, such as making permanent the current 100% corporation tax allowance for investment. Other measures include streamlining the planning system for commercial projects, a business rates support package for small businesses and targeted government support for specific sectors, such as digital technology. Critics argue that this will not be sufficient to offset the decline in public investment and renew crumbling infrastructure.

To support public finances, the government is using a combination of higher taxation, largely through fiscal drag, and cuts in government expenditure (from 44.8% of GDP in 2023/24 to a planned 42.7% by 2028/29). If the government succeeds in doing this, the OBR forecasts that public-sector net borrowing will fall from 4.5% of GDP in 2023/24 to 1.1% by 2028/29. But higher taxes and squeezed public expenditure will make many people feel worse off, especially those that rely on public services.

Videos

  • Fiscal drag
  • Sky News Politics Hub on X, Sophy Ridge (22/11/23)

  • Fiscal drag
  • Sky News Politics Hub on X, Beth Rigby (22/11/23)

Articles

Report and data from the OBR

Questions

  1. Would fiscal drag occur with frozen nominal tax bands if there were zero real growth in incomes? Explain.
  2. Examine the arguments for continuing to borrow to fund a Budget deficit over a number of years.
  3. When interest rates rise, how much does this affect the cost of servicing public-sector debt? Why is the effect likely to be greater in the long run than in the short run?
  4. If the government decides that it wishes to increase tax revenues as a proportion of GDP (for example, to fund increased government expenditure on infrastructure and socially desirable projects and benefits), examine the arguments for increasing personal allowances and tax bands in line with inflation but raising the rates of income tax in order to raise sufficient revenue?
  5. Distinguish between market-orientated and interventionist supply-side policies? Why do political parties differ in their approaches to supply-side 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.

The ONS has just published two of its major annual publications on income and expenditure in the UK. The first is the Annual Survey of Hours and Earnings (ASHE) and looks at earnings from 1998 to 2013. The second is Family Spending and looks at the level and pattern of household spending each year from 2001 to 2012.

Figures from the two publications show that average real incomes have fallen each year since 2008. This is illustrated in the first chart (click here for a PowerPoint of the chart). They also show that household expenditure in real terms is falling and is at the lowest level since 2006.

Overall picture
In 2012, households’ average weekly disposable income was £597. In 2012 prices, this was down from £621 in 2010 (after the recession) and £659 in 2008 (before the recession).

Household expenditure is at its lowest level in real terms for over a decade. In 2012 households spent on average £489.00 per week. In 2012 prices, this compares with £521.90 in 2001/2 and £533.80 in 2006 (the peak year).

Picture for particular income groups and products
Although average real incomes have fallen, not everyone has been affected the same. For example, not all occupations have seen a fall in incomes (see the table at the end of the BBC article, Earnings rise slower than inflation for fifth year running). Also, as income distribution has become less equal, so those in lower income groups have seen their real incomes fall the fastest. This is partly the result of nominal wages rising less fast for low-paid workers and partly the result of price increases for various essentials, such as food and power being greater than the rate of inflation, and these products constituting a higher proportion of expenditure for poor people than rich people (see Squeezed Britain 2013).

Likewise expenditure hasn’t fallen on all categories of product. Since 2006, real expenditure on clothing and footwear and on housing, fuel and power has risen. The second chart illustrates expenditure on some of the different categories and how the balance has changed (click here for a PowerPoint). This partly reflects the changes in prices of products, with some items, such as electricity, gas and rent having risen faster than the average, and with the demand for such items being relatively price inelastic.

The changing pattern is also partly the result of different income elasticities of demand for different items. Thus, with falling real incomes, the proportion of income spent on products with a low income elasticity of demand is likely to rise.

Expenditure also varies by income group. People on higher incomes tend to spend a greater proportion of their income on things such as leisure activities (e.g. eating out and holidays), motoring, and clothing and footwear. Poorer people tend to spend proportionately more on food and drink, and on electricity, gas and rent (even net of housing benefit). These differences are illustrated in the third chart which looks at certain categories of expenditure of three different disposable income groups: the poorest 10% (decile), the richest 10% and the 6th decile (i.e. the 6th group up from the bottom – the group with average or just above average income) (click here for a PowerPoint for the chart). Detailed figures can be found here, which is Table 3.2 from Family Spending.

Just as the time-series data looking at changing income and expenditure over time can illustrate the different income elasticities of demand for different products, so can the cross-sectional data in Tables 3.1 and 3.2 of Family Spending.

Articles

Earnings rise slower than inflation for fifth year running BBC News (12/12/13)
Energy and rent are now the biggest family bills The Telegraph, Steve Hawkes (11/12/13)
Families spend £489 each week – on what? The Guardian, Mona Chalabi (11/12/13)
Cost of energy hits family budgets, says ONS BBC News (11/12/13)
Family spending interactive: how has it changed? The Guardian Datastore, Mona Chalabi (11/12/13)

Data

Annual Survey of Hours and Earnings, 2013 Provisional Results ONS (12/12/13)
Annual Survey of Hours and Earnings, 2013 Provisional Results: Statistical Bulletin ONS (12/12/13)
Family Spending, 2013 Edition ONS (11/12/13)
Family spending in 2012: Infographic ONS (11/12/13)
Video Summary: Are you an average spender? ONS (11/12/13)
Household expenditure based on COICOP classification, 2001-02 to 2012 at 2012 prices: Table 4.1 of Family Spending ONS (11/12/13)
Detailed household expenditure as a percentage of total expenditure by disposable income decile group, 2012: Table 3.2 of Family Spending ONS (11/12/13)

Questions

  1. What are the determinants of the price elasticity of demand for a product?
  2. What are the limitations of using time-series data of prices and expenditure to estimate the price elasticity of demand for particular products?
  3. What are the determinants of the income elasticity of demand for a product?
  4. What are the limitations of using time-series data of incomes and expenditure to estimate the income elasticity of demand for particular products?
  5. What are the limitations of using cross-sectional data of expenditure of different income groups to estimate the income elasticity of demand for particular products?
  6. How do your answers to the above questions demonstrate the significance of the ceteris paribus (other things being equal) assumption?
  7. If real earnings are falling, why are people able to spend more in real terms?
  8. What are the macroeconomic implications of increased consumer spending at a time of falling real incomes?
  9. How could increased consumer spending help to reverse the fall in real incomes (a) in the short run (b) over a period of a few years? Distinguish between the effects on aggregate demand and aggregate supply.

According to a report just published by accountancy firm Deloitte, UK household real disposable incomes are set to fall for the fourth year in a row. What is to blame for this? According to Deloitte’s chief economic adviser, Roger Bootle, there are three main factors.

The first is the combination of tax rises and government expenditure cuts, which are now beginning to have a large impact. Part of this is the direct effect on consumer disposable incomes of higher taxes and reduced benefits. Part is the indirect effect on employment and wages of reduced public expenditure – both for public-sector employees and for those working for companies that supply the public sector.

The second is the rise in food, fuel and raw material prices, which have driven up the rate of inflation, thereby eroding real incomes. For most people, “pay growth is unlikely to catch up with inflation any time soon. Inflation is heading towards – and possibly above – 5%. Real earnings are therefore all but certain to fall for the fourth successive year in a row – the first time that this has occurred since the 1870s.”

The third is that demand in the private sector is unlikely to compensate for the fall in demand in the public sector. “I still doubt that the private sector can compensate for the cuts in public sector employment – which is already falling by 100,000 a year.

The upshot is that I expect households’ disposable incomes to fall by about 2% this year in real terms – equivalent to about £780 per household. And it will take until 2015 or so for incomes to get back to their 2009 peak.

… In terms of the year-on-year change in circumstances, although not the absolute level, that would make 2011 the worst year for households since 1977 (the depths of the recent recession aside). Were interest rates to rise too, conditions would arguably be the worst for households since 1952.”

Well, that’s a pretty gloomy forecast! The following articles examine the arguments and consider the likelihood of the forecasts coming true. They also look at the implications for monetary and fiscal policy.

Since I wrote the above, two more gloomy forecasts have been published: the first by the Institute for Fiscal Studies and the second by Ernst & Young’s Item Club. Both reports are linked to below.

Articles
Squeeze on incomes expected to rule out rate rise Guardian, Phillip Inman (3/5/11)
No rate rise until 2013, says Bootle MoneyMarketing, Steve Tolley (3/5/11)
UK households ‘face £780 drop in disposable incomes’ BBC News (3/5/11)
Why our purchasing power is set to suffer the biggest squeeze since 1870 The Telegraph, Ian Cowie (3/5/11)
2012 ‘worst year’ for household finances says Deloitte BBC News, Ian Stuart, Chief Economist with Deloitte (3/5/11)
Retailers expect sales gloom to continue Guardian, Graeme Wearden (3/5/11)
What makes consumers confident? BBC News, Shanaz Musafer (4/5/11)
Household incomes in UK ‘may return to 2004 levels’ BBC News (13/5/11)
Biggest squeeze on incomes since 1980s TotallyMoney, Michael Lloyd (13/5/11)
High street to endure decade of gloom, says Ernst & Young Item Club Guardian, Julia Kollewe (16/5/11)
Outlook for spending ‘bleak’ and road to recovery is long, Ernst & Young ITEM Club warns The Telegraph, James Hall (16/5/11)

Reports
Feeling the pinch: Overview Deloitte (3/5/11)
Feeling the pinch: Full Report Deloitte (3/5/11)
Long-term effects of recession on living standards yet to be felt IFS Press Release (13/5/11)
ITEM Club Spring 2011 forecast Ernst & Young
UK high street faces difficult decade as consumer squeeze intensifies and households focus on paying down debt, says ITEM Club Ernst & Young (16/5/11)

Data
Forecasts for Output, Prices and Jobs The Economist
Forecasts for the UK economy: a comparison of independent forecasts HM Treasury
Commodity Prices Index Mundi
Consumer Confidence Index Nationwide Building Society (Feb 2011)
Confidence indicators for EU countries Economic and Financial Affairs DG

Questions

  1. For what reasons may real household incomes fall by (a) more than and (b) less than the 2% forecast by Deloitte?
  2. What is likely to happen to commodity prices over the coming 24 months and why?
  3. With CPI inflation currently running at an annual rate of 4% (double the Bank of England’s target rate of 2%), consider whether it is now time for the Monetary Policy Committee to raise interest rates.
  4. For what reasons might households respond to falling real incomes by (a) running down savings; (b) building up savings?
  5. What are the implications of the report for tax revenues in the current financial year?
  6. What makes consumers confident?