Inflation hits work incentives

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New inflation stats are out tomorrow and they’re expected to show further rises in CPI and RPI. Aside from their brief peak in 2008, headline rates of inflation are now at their highest levels for 19 years. That’s prompting more discussion about the way rising prices are playing out for Britain’s households, from a nice graphic in today’s Times (£) to a new report due out tomorrow from the IFS. But one implication of today’s higher inflation environment is receiving less attention – the impact of rising prices on work incentives.

Inflation and work incentives aren’t often mentioned in the same breath. But when work-related costs rise more quickly than headline inflation – and particularly than wages – there’s clearly an impact on the incentive to work. In recent years, the costs of childcare have significantly outpaced both headline inflation and earnings. And transport costs – both road and rail – have also risen much faster than average prices, as the chart below shows.

Chart1

Put together, that’s particularly problematic for families looking to get a second adult into work. The key statistic here is the ‘marginal withdrawal rate’ that’s faced by a second earner. It tells us how much of the additional earnings from work people are able to keep for themselves. The trouble is most analysis of withdrawal rates – including the government’s own calculations in the Budget – are based simply on the impact of taxes and withdrawn benefits. That doesn’t pick up on changes to other directly work-related costs. Yet if those costs are genuinely ‘additional’ and essential or ‘non-discretionary’, they too will have a dampening effect on the incentive to enter work.

Earlier this month, a new report (£) from the OECD revealed quite how important these costs have now become. It calculated that the marginal tax rate on an average UK second earner is now 27 percent – much better than the OECD average of 34 percent. But when childcare costs (higher in the UK than in any other OECD country) are included, the withdrawal rate rises to 68 percent, much higher than the OECD average. For lower income households that figure rises to 88 percent.

Chart 2

Even these calculations don’t capture other costs of working such as transport. Add those in, and it’s likely that many households are now facing effective marginal withdrawal rates in excess of 100 percent on a second income.

Understandably, it’s only as headline rates of inflation have soared that these more complicated aspects of inflation have begun to receive attention. At the Resolution Foundation, we’ll be looking at them in much more detail in a new report in the coming months. From plans for the Universal Credit (which our analysis shows will reduce work incentives for some on low-to-middle incomes) to the Chancellor’s overreliance on somewhat clumsy gestures like reductions in fuel tax, it seems the new inflation environment has caught policymakers flat-footed. If recent trends in prices persist, much more sophisticated responses will be needed.

This blog first appeared on Coffeehouse, The Spectator blog