After the recession, the real pain begins

Published on Public Finances and the Economy

Fuel price protests rattled Blair. The 10p tax row dogged Brown. Is David Cameron ready for the storm that his huge raid on our personal finances is about to unleash?

Economic narratives take shape like stalactites: the drip, drip of daily headlines deposits its wisdom and, before you know it, there’s a solid consensus. For the recent recession, that consensus runs something like this: things were much worse than expected in the financial system but far better than predicted in the real economy – particularly in terms of the fallout in unemployment and home repossessions.

Now, the thinking goes, we are on a tentative path to recovery but we need to watch the growth figures carefully. Some still predict a double dip; most do not. But the key framing questions for 2011 are broadly accepted – will growth pick up, and can a resurgent private sector create jobs as fast as they are being destroyed in the public sector? Will the gamble pay off?

Behind that account, however, lies another story. It is one that is increasingly at odds with the impression given by headline GDP numbers and, critically, with the coalition’s “on the mend” narrative. It focuses not on GDP, or the headline figures, but on the living standards of a swath of our working population on low to middle incomes. It is a story not of riding high in the boom years and then falling, only to bounce back quickly and thrive in the years ahead, but one of prolonged squeeze – a tale of growth without gain.

Today, the hard reality for working families is this: Britain is in the midst of the biggest squeeze on living standards since the 1970s. The typical working household is now poorer in real terms than it was a year ago. In 2011, it will get poorer still. Even as growth resumes and the nadir of the financial crisis fades into memory, millions of families are living through a prolonged, personal recession.

Coupled with the continued anxiety about job losses, this helps explain why economic optimism about the year ahead has plummeted by 25 percentage points in the past year from a net positive of 3 per cent to -22 per cent. It is why the challenge for party leaders in 2011 is not just to win the argument on cuts, but also to close the growing chasm between the abstract talk of recovery and the bleak outlook facing families.

Mind the gap

Part of the explanation for the present gap between economic rhetoric and reality is simple: there is a long-standing metropolitan refusal to accept where the real “middle” is in Britain. The uncomfortable truth is that a far larger proportion of the British population is far more financially exposed than either the political establishment or the media want to believe.

A third of the working-age population lives in households on below-average incomes (see the box at the bottom of the page for definitions) yet earns too much to be eligible for most benefits. This group enters 2011 as worried about falling wages as it is about job losses.

Our first graphic (see below) shows just how poorly the prevailing economic narrative describes the plight of this group. Among those who stayed in full-time work, real wages rose in 2008/2009 as growth fell. Now – although the government’s message is that the worst is over – that trend has reversed.

Over the past year, real wages fell by a wallet-squeezing 5 per cent. According to government figures, this crunch is expected to continue until 2013, by which time, in real terms, the average low-to-middle-income family will be roughly £700 poorer per year than it was in 2009. The same projections suggest that many working families may be no better off come the 2015 election – after five years of resurgent “growth” – than they were when the coalition took office.

All this is before cuts to benefits or tax increases. And if interest rates spike, it could be much worse – no empty concern, given that inflation is projected to surpass its official target for the whole of 2011, bolstering the view of monetary hawks such as Andrew Sentance at the Bank of England, who has voted consistently for rate rises over recent months. In the year to come, the nightmarish scenario of anaemic growth, rising unemployment and climbing interest rates is a very real possibility.

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Storm warning

To appreciate the political storm that is likely to develop, just add to this volatile context the coalition’s spending plans for the coming year.

It is widely understood that there will be sweeping cuts to public services and aspects of the welfare state, such as housing benefit. But, even now, very few people realise the scale of the “hit” facing working families on modest incomes – a direct consequence of the scale and pace of the consolidation, combined with the strategic decision to protect all universal benefits for those over 60 and not ask more of the better-off. Measure after measure in 2011 will increase the running costs of raising a family – or reduce people’s ability to meet them.

Crucially, much of this pain will be experienced not just as service cuts but as price rises – ensuring that the government takes much of the blame, whether deserved or not, for wider increases in the cost of living. The hikes have already started, with families feeling the pain of a VAT rise this month that will increase the typical annual shopping bill by upwards of £200 – more than double that, for some families. Rail fares are increasing by 6 per cent on average and season tickets for commuters are going up by hundreds of pounds.

At a time of record petrol prices, fuel duty has risen once more and will go up again in April. Price rises for key local services, from out-of-school clubs – up 12 per cent last year – to care for the elderly, will outstrip inflation. When tempers flare over this, the coalition will want to argue that, on the big choices for taxes and benefits, it is on the side of Britain’s hard-pressed families. That will prove a hard sell. In under three months’ time, the Chancellor’s planned cuts to tax credits – totalling an eye-watering £6bn by 2014 – will turn from an abstract threat into a direct hit on millions of bank accounts. Most of these changes are too stealthy to grab headlines, but the scale of some of the losses will penetrate the fog of media indifference.

Take the cut in support for childcare: about half a million working mothers on low to middle incomes will lose almost £500 a year on average, with the hardest hit losing a staggering £1,300. Ministerial platitudes about “improving work incentives” will only rub salt in the wound. The axing of schemes such as the Education Maintenance Allowance, which paid up to £30 a week to 16-to-18-year-olds from low- and modest-income families to enable them to attend school or college, comes on top of all this.

Add on its impact – a loss of about £1,000 a year for half a million families with a combined household income of less than £21,000 – and the sheer number of large-scale losers starts to become clear.

The coalition’s flagship policy in these debates will be the £1,000 increase in the amount that can be earned before paying tax, which will benefit low-to-middle-income earners by roughly £170 a year. In normal times, this would be a significant gain, but in the context of 2011, it is not even enough to offset the rise in VAT, let alone the far larger tax credit cuts.

To make matters worse, in order to help ensure that only basic-rate taxpayers benefit from this, the maximum taxable income that can be earned before the 40p tax rate kicks in will be reduced from £37,400 to £35,000. The result? About 700,000 people currently on the 20p tax rate are likely to be shunted into the 40p tax band. If so, not only will their marginal tax rate double, they will also become unsuspecting victims of the planned removal of child benefit for higher-rate taxpayers. A family with two children on £42,000 will be worse off by £1,750 a year – fanning the smouldering embers of the child benefit row.

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Perils and prizes

It all implies that 2011 is going to be a perilous year. There can be little doubt there will be a major living-standards flashpoint. As Labour learned to its cost in office, even small changes in personal finances can trigger furious reactions. Recall that it was the fuel protests, above any other domestic issue, that most rocked the Blair government – and they occurred against the sunny backdrop of rising wages, low inflation and growing public spending. Even the 10p tax debacle that so wounded the Brown government involved losses much, much smaller than those about to be inflicted on many families (see above).

So, how is the political class in Westminster likely to respond? Just as Labour had to rethink its “double dip” critique of the government last autumn when the facts began to suggest otherwise, so the coalition would be wise to revise its cheery line about being “on the mend”.

But the challenge for party leaders runs far deeper. Whisper it quietly, but something of a convenient consensus has emerged between Labour and the coalition about the cause of the squeeze on living standards.

With all sides tending to focus blame on the cuts, Labour can stay in its comfort zone of railing against Tory-led spending plans, while the coalition can stay in its own, lambasting Labour’s economic record. Both sets of supporters feel vindicated and the media are happy to stay on familiar ground.

Labour is right to say that some of the choices over cuts will hit certain groups hard – in some cases, very hard – just as the coalition is correct to say that some of the cuts would have happened whoever was in power. But the truth, unfortunately, is much less comfortable: this isn’t just about cuts. The roots of this problem lie in neither downturns nor deficits. The struggle of people on low to middle incomes to meet the running costs of modern life is not new, just newly exposed. For the past seven years, real wages have been near stagnant for all but the affluent, with living standards for low-to-middle-income earners being propped up by rising tax credits and easy consumer debt – both now in reverse.

The deeper cause of this longer-term wage squeeze is a point of contention and woefully underexamined. Some argue that, in advanced economies, routine middle-income jobs are being made redundant by technology, while those above and below them – in knowledge-intensive and low-skilled service roles – remain relatively immune. Pointing to the US experience, they say that the great postwar tide that created a new middle class is now receding. Others highlight the declining share of national income going to workers in the form of wages, as they increasingly lose out to profits.

In a sense, it is no surprise that the big parties are yet to embrace these issues; they are hugely unsettling for both left and right. They raise foundational questions about the nature of British capitalism that can’t be answered only by spending more or less. Yet both sides will fail if they reach for knee-jerk solutions; we will neither tax nor deregulate our way to creating more decently paid jobs.

For Labour and the broader centre left, that means there is a lot of hard thinking to do in 2011 – above all, grappling with the realisation that a mere reliance on a redistributive welfare system and a nod towards investment in skills will not answer the living-standards conundrum of the decade ahead. To his credit, Ed Miliband has signalled that he appreciates this. As for the government, an eye-catching tax cut, in the form of a further large increase in personal allowances, will hold obvious appeal in the second half of this parliament. In political terms, it promises a double dividend – uniting every shade of the coalition, from darkest blue to pinkest yellow, while also making life hard for Labour. But the smarter members of the government know that such a move would represent an electoral balm rather than a full economic cure.

Both the prize and the risks are there for all to see. Just look to the US for an example of how declining standards of living can ignite politics. Today in Britain, this is still virgin territory.

To leaders who can show that they have answers – that they know what must be done to return living standards to an upward path – that ground lies open. Whoever ends 2011 occupying this terrain will be in pole position to win in 2015.

Gavin Kelly is chief executive of the Resolution Foundation and was deputy chief of staff at 10 Downing Street from 2007-2010

Why those in the middle are feeling the squeeze most

Roughly 11 million adults in the UK live in households on low to middle incomes – too rich to rely significantly on state support but too poor to escape a constant struggle with living costs. They work in a wide range of sectors.

As they are neither the poorest nor the more affluent, media attention rarely focuses on them. Defining the group is not simple: because it costs more to run a household with more members, the boundaries vary according to size of household.

For example, to be at the upper end of the group – the national “middle” income – a single, working-age adult requires an income of £20,000, while a couple with no children require a total income of £30,000. For a couple with three children, this rises to £48,500.

These levels of income are not commonly associated with a life of scarcity. As such, aside from tax credits, these households qualify for little financial support from the state. Yet many in this group are highly exposed. More than half of low-to-middle-income earners have less than a month’s income in savings. Two-thirds are not saving for a pension. Half struggle to keep up with day-to-day bills.

Two-thirds of homeowners in the group are on fixed-rate mortgages, and so they have not reaped the gains of low interest rates. As one difficult year passes into another, many will be pushed still closer to the edge.