Why the welfare uprating bill is bad economics

Much of the reaction to the chancellor’s decision to uprate most working age benefits and tax credits by just 1 per cent per annum for three years has focussed on questions of distribution. As the Resolution Foundation analysis demonstrated 60 per cent of this £3.7bn cut will fall on working households, something very far from the rhetoric of the chancellor.

But, questions of fairness aside, what will be the economic impact of this cut?  We can answer this question with two fairly simple economic concepts.

The first is the fiscal multiplier. Simply put, the fiscal multiplier is a measure of how changes in fiscal policy (spending and taxation) impact on the wider economy. If we imagine £10bn of spending cuts and the multiplier is assumed as 1, then GDP will be reduced by £10bn. If the multiplier if 0.5, then £10bn of spending cuts will reduce GDP by only £5bn and, alternatively, if the multiplier is 1.5 then £10bn of spending cuts will reduce GDP be by £15bn.

The second concept is marginal propensity to consume (MPC). The MPC tells us how much of a pound of additional income will be spent on consumption (with the remainder being saved). Generally the lower a person’s income the higher the MPC – this is hardly rocket science, it stands to reason that the less money someone has the more likely they are spend it – whilst better off might save any additional cash, the worst off are already struggling to make ends meet and so are more likely to increase their spending if their income rises.

The fact that those in receipt of working age benefits and tax credits (that the chancellor is cutting in real terms over three years) have lower incomes means that they have a higher MPC. This means that the fiscal multiplier associated with cuts to social security spending are higher than many other types of cuts.

In other words, cuts that take money away from the worst off in society are likely to be more damaging to the wider economy and growth.

The government have argued that by raising the personal allowance (the bit of earnings which is free from income tax) they are ‘putting money back in people’s pockets’. But raising the personal allowance is a very poorly targeted way of getting money into the economy. The biggest beneficiaries are household’s higher up the income scale with dual incomes – and households higher up the income scale have a lower MPC.

This one reason why the Office for Budget Responsibility’s own estimates of the multiplier scored changes personal tax at 0.3 whilst changes in welfare were given a multiplier of 0.6. Even if the real terms cuts to working age benefits and tax credits were fully offset by an increase in the personal allowance (and they won’t be) this would still be damaging to growth – it would be a redistribution away from those more likely to spend and towards those more likely to save.

It very clear that the highest fiscal multipliers are to be found on capital spending and social security spending. The government’s focus on cutting these two areas might seem like good politics (roads don’t have a vote and the chancellor seems to think, perhaps incorrectly, that there is no limit to the public’s willingness to slash the welfare bill) but it is very bad economics.