Cut welfare while the sun is shining

Cut welfare while the sun is shining

Using the cover of rising employment and a steadily growing economy, the Chancellor, George Osborne, used his latest budget to make massive real terms cuts to working-age welfare payments. He froze all working age tax credits and benefits in cash terms, increased the speed at which tax credits are tapered away and reduced future support for larger families, sweetening the pill with an unprecedented government-directed hike in the national minimum wage for over 25 year-olds, which he called a “living wage premium” in a rhetorical flourish designed to wrong-foot the left.

He portrayed his budget as a “new contract with the country”: businesses would get lower corporation tax but needed to pay their workers more; welfare would be less generous but the return on work would be higher. Overall, state spending would reduce.

Labour and anti-poverty campaigners responded by identifying specific exceptions to his presumption that work would be made to pay more, highlighting particular types of families whose circumstances would leave them less well off. The Institute for Fiscal Studies said the benefits freeze would cost 13 million families an average of £260 per year. Living wage campaigners were quick to point out that while the Chancellor might have borrowed their language, his proposed wage rate was lower than theirs and he did not have their support. Commentators and economists highlighted the projections by the Office of Budget Responsibility (OBR) that the living wage premium would raise unemployment, reduce growth and itself lead to an estimated 60,000 job losses.

Compared to the final budget of the outgoing Coalition government, the Chancellor also eased the rate at which state spending is expected to fall, reducing the size of the anticipated budget surpluses in the second half of the parliament.  While the full detail of departmental spending will wait for the spending review later in the year, a commitment was made to significant extra resources for the Ministry of Defence and a real terms freeze for the NHS.

The Chancellor also clarified the terms of the new fiscal framework, requiring the stock of debt to fall each year as a proportion of GDP and the government to run a surplus when the economy grows at a rate of above 1 per cent.

£12bn of welfare cuts…

The much anticipated cuts to the welfare bill fell disproportionately on families of working age. A four year cash freeze on working-age benefits, tax credits and local housing allowances saves £4bn annually by 2020-21. Further reforms to tax credits and universal credit – faster phasing out of support, the limiting of the child element to two children, and removing the family element for new claims – saves a further £5.8bn annually by 2020-21.

A further £2bn is reduced from the housing benefit bill by a forced capping of social housing rents, which are typically covered by housing benefit, with the remaining savings coming mainly through aligning the “work ready” Employment and Support Allowance payments with Jobseekers Allowance. Overall, the welfare policy changes announced in this budget reduce government spending by £12bn annually in 2019-20, rising to £12.9bn the following year.

…but a hiking of the minimum wage and higher tax allowances

The Chancellor advertised his budget as being about “lower welfare, higher wages and lower tax”. Accordingly, the tax-free allowance was raised to £11,000 from next year, and then pledged to rise with the national minimum wage; the higher rate is pledged to rise to £43,000 as a step towards a higher tax rate of £50,000 as promised in the Conservative election manifesto.

But the big news was the decision to raise the minimum wage to £7.20 from next April for over 25s, a rise of 50p an hour from the rate of £6.70 that will come into force in October 2015. At a stroke, this tears up the near twenty-year consensus on the operation of the Low Pay Commission, designed to set a rate for the minimum wage based on economic evidence of what is possible without jeopardising employment. The Low Pay Commission’s role, at least for the over 25s, is now confined to recommending the pace at which the newly branded ‘living wage premium’ can rise to its politically-directed target of £9 by 2020.

Indeed the Chancellor himself admits that 60,000 people could lose their jobs as a result of this rise in the minimum wage, a number he described as “fractional” and more than compensated for by the overall rise in employment.

By borrowing the language of the living wage campaign, long the darling of the left, ensuring that cuts to family support only apply to families with children as yet unborn, and simultaneously reducing the headline rate of corporation tax from 20 per cent now to 18 per cent in 2020, the government has created a complex overall position of winners and losers whose political impact is as yet unclear.

Public sector workers will also feel the heat as pay awards continue to be restricted to 1 per cent in cash terms for the next four years, with corresponding savings to the government through lower contributions to public sector workers’ pension pots.

The pace of public service cuts is softened….

The spending allocations to government departments will not be set out in detail until the spending review later this year. But this Budget increased substantially the available envelope of funds within which departments will receive their allocations as compared to March (albeit within a declining total): a further £83.3bn in total will be made available to departments over the current parliament compared to the previous allocation according to the OBR.

Within this the budget suggested that spending on the NHS would remain roughly constant in real terms, but the Stevens plan to reconfigure spending within this envelope would be implemented, and defence spending would rise to the NATO target of 2 per cent of GDP.

…contributing to lower surpluses.

The government still expects to be able to eliminate the deficit mid-way through this parliament and run a surplus of around 2 per cent of GDP by the end of the parliament, but the speed at which that will be achieved has slowed, as indicated by the shallower slope of the July 2015 forecast line in chart 1 below.

This is partly due to a revising up of the GDP forecast but also due to the slower rate of cuts to government departments. Overall spending on public services is now expected to fall by an average of 1.5 per cent a year in real terms over this Parliament, similar to the 1.6 per cent a year cuts over the last parliament.

Chart 1: Budget deficit forecasts (% of GDP, cyclically adjusted)

Source: OBR

In order to keep the headline projections on track, the government is relying on significant asset sales towards the end of the parliament, the details of which appear to have not been announced. For example, borrowing in 2018-19 and 2019-20 is expected to be higher in absolute terms by £20bn and £17bn respectively but the government expects this to be more than compensated for by privatisations, earmarked to raise 25bn and 31bn in the same years.

The overall tax take rises…

Although the headline corporation tax rate is projected to fall, and income tax allowances are rising, the net policy changes to taxation are to increase revenues by around £6.5bn annually by the end of the forecast period over and above increases to tax revenues that arise naturally from a growing economy.

These are driven primarily by:

  • a further clamp down on avoidance and compliance, presumed to bring in revenues of around £5bn annually towards the end of the parliament and resourced by an increase of around £265 annually to HMRC;
  • a significant shift in the tax system experienced by self-employed and owner-directors by the abolition of the dividend tax credit, replacing it with an annual dividend allowance (raising around £2bn annually);
  • a large rise in insurance premium tax (raising around £1.5bn annually);
  • the restriction of pensions tax relief for very high earners (£1bn); and,
  • other smaller measures such as a cut to the climate change levy, changes to vehicle excise duty and the ending of permanent non-dom status.

The complete list of spending and revenue raising measures with costings and associated OBR risk analysis is summarised on table A1 from page 185 of the OBR’s Economic and Fiscal Outlook.

…and debt levels are still projected to fall

The stock of government debt is still expected to have peaked in the financial year 2014-15 as anticipated in the March budget, but at a slightly higher level than was previously thought, before starting its descent in 2015-16 as chart 2 below shows.

This trajectory of falling debt will come under increased scrutiny in future years due to the introduction in this budget of a new fiscal rule that requires the stock of debt to keep falling as a proportion of the economy, regardless of the rate of economic growth. Only the second part of the new fiscal framework – the requirement to continue running a surplus – can be suspended if the economy is not in “normal” times, defined as GDP growth of less than 1 per cent.

That the government has introduced a “normal” test for austerity policies is a marked difference to the rhetoric of the previous emergency budget in 2010 that instead suggested it was important to cut even when economic growth was slow, in order to “rebalance”. The economic historians will note that Keynes has won the day.

Chart 2: Public sector net debt forecasts (% of GDP)

Source: OBR

Growth remains strong and stable….

The Office of National Statistics now believes that economic growth in 2014 was 3 per cent, as originally expected at the time of the 2014 Autumn Statement, higher than the previous estimate of 2.6 per cent, and is then expected to stabilise in the medium term at an annual growth rate of 2.4 per cent from 2017, as chart 3 below shows.

Overall this is a slightly higher forecast than in March, due to a slight widening in the OBR’s estimate of the output gap: the amount of spare capacity in the economy. With government spending weak and a persisting trade deficit, growth is driven primarily by increasing confidence among consumers and businesses.

Chart 3: GDP growth forecasts

Source: OBR

…with inflation low…

Assumptions around the expected pace of inflation, which were revised down significantly at the March budget due to low oil prices and a high currency that pushes down import prices, have fallen a little further as chart 4 below shows.

This represents the net effect of a large number of offsetting factors, including policy changes in this budget such as reduced social housing rents (downward pressure on the price index) and the increase to the minimum wage (upward pressure as costs are passed through by retailers).

Taken together, the OBR expects inflation to return to the Bank of England 2 per cent target a little later than previously anticipated, but also makes the point that since most of the factors affecting the inflation forecast in the short term come from external factors rather than the level of demand in the economy, they are unlikely to change the Bank of England’s overall monetary policy stance: interest rate (and gilt yield) expectations have risen slightly since March although the market does still not expect base rates to start rising until the second quarter of 2016.

Chart 4: Inflation forecasts

Source: OBR

…and employment rising.

The benign set of economic indicators is completed by the employment picture which shows that the number of people in work in the economy has been revised upwards yet again. This is driven by population growth and increases in the number of economically active older workers, offset by tightening labour market conditions and some job losses as a result of a sharp raising of the minimum wage.

The OBR expects the unemployment rate to fall to a low of 5.1% in 2016, before stabilising at a long-term rate of 5.4% as the effects of the changes to the minimum wage have their full impact towards the end of the parliament. Average wages meanwhile are expected to start rising strongly from 2016 and will remain significantly above inflation for the forecast period.

Chart 5: Employment forecasts.


It is inconceivable that the Chancellor could have found the political space to introduce this budget if the economy was not already strongly growing. Growth and employment forecasts look secure but were that to change, a budget that cut state support for working-age people in an environment where rising unemployment was causing pain would be harder to justify.

Similarly, a slower-growing economy or faster rises to interest rates would alter the arithmetic balance between the size of the economy and the cost of debt repayments in a way that could throw the government’s books out of balance.

A faster-than expected rise in CPI inflation will also make the freezing in cash terms of working-age benefits feel harsher to recipients.

In the next few months, the main developments to watch out for are:

  • the spending review that will allocate the ever-reducing government expenditure between departments. Expect significant reform in the NHS, and further reconfiguration of local authorities.
  • the conclusion of the Labour leadership race in mid-September that will settle the political dividing lines around this budget and beyond.

Looking into 2016, the increase in the minimum wage will have a disproportionate effect on retailers, hospitality and care sectors, particularly outside London. Expect some consolidation in these sectors, as well as rising prices for consumers, and difficulties for younger low paid workers on the minimum wage when they reach the age of 25. The effects in the care sector could have a fiscal impact as many of the costs are paid not by the recipients of care, but by the government, either directly or indirectly.

In the banking sector, the shift from a bank levy, paid by the larger banks, to a corporation tax surcharge on the entire sector may make it harder for new entrants to compete with existing retail banks, in line with the government’s stated objectives.

The reaction of potential future students to the offsetting changes of first, the replacing of maintenance grants with loans and, second, the lifting of the cap on student places is uncertain. The data so far suggests that student numbers will probably rise despite the need to borrow more, but some cohorts may decide it isn’t worth it.

The change to the tax treatment of small business owner-directors, making it less attractive to take profits as dividends rather than wages may shift a change in behaviour that has a positive effect on income tax receipts, as well as leading to some grumbling amongst a traditional Conservative base of small business owners and growing numbers of self-employed traders.

In the longer term, a new green paper on the future of pensions could herald a policy shift away from pension tax credits to more self-managed ISA-type tax-free savings products designed to grow a nest egg for older age. Combined with policies announced in previous budgets that scrap the requirement to purchase an annuity on retirement, this may represent a significant rethinking of the role of the state to prepare people for later life.

Towards the end of this parliament, the government is expecting significant income from asset sales. Some of this will come from the continuing return of banking assets to the private sector, but there may also be large new privatisation programmes.

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