Crowd-pleasing cost of living measures risk being self-defeating

Ruth Curtice and James Smith outline the potential pitfalls of blanket cost of living support at a time of high borrowing costs and pacey price rises.

Andy Burnham came into office promising to find “breathing space” for families struggling with the cost of living, and backed it with a (temporary?) VAT cut to energy bills. But having admitted more is needed, and as wholesale energy prices once again peak, expectations are running high for future announcements in the upcoming Budget.

As a thinktank dedicated to lifting living standards, this cost of living focus should be music to our ears. But we also know that policies don’t always live up to their promise. Given the tight fiscal constraints the Chancellor is under, we find ourselves worrying…

Could fresh cost of living support actually prove counter-productive?

How cost of living support can backfire

The outlook ahead of the Budget is bleak. Conflict in the Middle East and global shifts in the cost of government debt mean the Chancellor will likely receive a deteriorating forecast for the public finances, with the increase in the cost of government borrowing alone costing him over £10 billion.

He must tread carefully. In particular, if the Government increases borrowing to provide cost of living support, it can be self-defeating in two ways.

First, while government support can lower consumer costs directly, government borrowing pushes in the other direction. Additional borrowing adds to demand in the economy and so, in the current context of high inflation, puts upward pressure on short-term interest rates set by the Bank of England, which then feed through into higher mortgage rates for families (among other things). Indeed, the Treasury has previously estimated that additional borrowing of 1 per cent of GDP – around £30bn – can increase rates in the short-term by 50 to 125bps. The circumstances matter. But experiencing a global price shock without much spare capacity in the economy, during a period of sovereign debt market wobbles are precisely the circumstances in which increasing borrowing can do more harm than good. In short, fresh support must be fully funded.

Second, temporary support can lead to a higher inflation rate in the future. Some argue that fiscal measures which directly bring down headline inflation will reduce pressure on interest rates and so might not need to be funded in the same way as other moves. We disagree. It is true that a fiscal measure (like a VAT cut) which bring down prices will reduce measured inflation rates for a year while it comes in. In normal times this would not be expected to affect monetary policy but right now, some MPC members are suggesting that headline inflation may affect the extent of the second-round effects on wages, and become relevant to their decision making.

However, those who claim this allows for unfunded cost of living support miss what happens after a year. If support is temporary then it will lead to upward pressure on inflation when it is removed. This can push back the point at which inflation returns to target, risking precisely the opposite effect to the one desired.

What would an effective cost of living package look like?

The VAT cut on electricity bills made good early headlines, but there are better ways to bring down energy bills particularly for poorer households, for whom those bills represent a far larger share of the family budget. Because the VAT giveaway goes to everyone, the support is thinly spread; better off households will actually gain more in cash terms.

Instead, we propose providing support for households where no-one has income higher than £24,000 a year. This would reach two-in-five households and cover three-quarters of those in the poorest four income deciles. A £2 billion scheme could be skewed such that £220 goes to those with incomes below £18,000, and £85 to those above. It could be made temporary if it were expressly triggered by a particular (and hopefully passing) high level of the price cap.

Beyond action on bills, the most powerful single measure to support lower-income households would be to relink Local Housing Allowance to local rents. The typical shortfall for a claimant renting a two-bedroom property is now around £160 per month and will reach a record high this autumn. Restoring the previous link with rents at the 30^th percentile would cost £2.5bn in 2029-30. It may make sense politically to fund this expressly from within the working-age welfare budget. If so, it can be done by increasing the ‘taper’ on Universal Credit from 55 to 59 per cent.

The Chancellor can also help younger families with their perennial struggle to get onto the housing ladder with a new well-targeted, low-cost Starter Deposit Scheme. This would come with a negligible fiscal cost – ideal in these straitened times.

Budget measures must be well targeted and fully funded

Fresh cost of living support should feature in the upcoming Budget, but it is not without risks. Expensive universal support that is not properly funded risks causing harm than good – raising interest rates and further weakening our fiscal credibility – in ways that could ultimately rebound on families. The Chancellor cannot afford to make that mistake. He must navigate a path between providing support for those who need it most while also repairing our creaking public finances.

Ruth Curtice is Chief Executive of the Resolution Foundation. You can find her on Substack and on BlueSky. James Smith is Chief Economst at the Foundation, and you can find him on BlueSky.

This article was originally published on the Foundation’s Substack.