Will the welfare cap fit?

This morning the Office for Budget Responsibility (OBR) published its first Welfare Trends Report. At the request of the Chancellor George Osborne this is to be a new annual report looking at the trends in, and drivers of, spending on benefits. This important frequent review of spending on the individual components of the social security and tax credit budget is a welcome addition to the OBR’s remit. Sensibly, rather than just covering spending covered by the new welfare cap, the OBR has chosen to cover the total cost of social security and tax credits, including state pensions.

Today’s welfare trends report sets out revisions made to forecast spending on different benefits over different forecast vintages. Between March 2011 and March 2014 forecast spending in 2015–16 on housing benefit has been revised up by £2.5 billion (11%, as shown in Chart 4.4), as both the expected number of renters and the level of rents relative to earnings exceeded the OBR’s forecast. Over the same period forecast spending on incapacity benefits in 2015–16 has been revised up by £3.5 billion (34%, as shown in Chart 4.5) as the numbers expected to be receiving these benefits has increased, claimants of incapacity benefit have been transferred to employment and support allowance (ESA) slightly more slowly than anticipated, and a greater proportion of those transferred have been deemed to eligible for ESA (and for the more generous rates of ESA).

In future revisions of this type might lead to policy action being required if a breach in the Chancellor’s new welfare cap is to be avoided. The cap applies to “welfare in scope” spending: that is the total cost of social security and tax credits, excluding spending on the state pension, jobseeker’s allowance (JSA) and housing benefit for those receiving JSA. In the March 2014 Budget the Chancellor set this cap at the same level as the OBR’s forecast for spending on welfare in scope for the years from 2015–16 through to 2018–19. This means that in 2015–16 the cap is set at £119.5 billion (out of total social security and tax credit spending of £218.8 billion) rising to £126.7 billion in 2018–19.

Further details of the possible rationale behind the cap, and the way it operates, can be found in Chapter 2 of the February 2014 IFS Green Budget. Broadly, the way that the cap operates is that in every Autumn Statement the OBR will assess compliance with the cap. It will be deemed to be breached if policy action has caused forecast spending to exceed the cap, or if forecasting changes have caused forecast spending to exceed the cap by more than 2%. If breached, the intention is that the Chancellor will either take policy action to bring spending back within the cap or will obtain Parliamentary approval to increase the cap. Evidence from recent years (specifically Budget 2012) shows that forecast spending on welfare in scope can be revised up by more than 2% and therefore this 2% margin for error is not so large as to make the cap irrelevant (see slide 26 here)

The logic behind the 2% buffer is that it allows a tighter cap to apply to increases in welfare spending brought about by policy changes without the risk of relatively small fluctuations in forecast spending frequently leading to breaches of the cap. In some cases defining what counts as a policy change might not be straightforward. A newly announced increase in a benefit rate is a policy change, while a higher than expected birth rate that pushes up child benefit spending is a forecasting change. But what about an operational decision to delay or slow the rollout of a reform expected to reduce spending? The OBR’s judgements over such factors in future could make the difference between the cap being met and the cap being breached: but at least these judgments will be made by the OBR and not by the Chancellor.

The OBR also identify the likely causes of any breach of the welfare cap in future years. One such risk is higher-than-expected September CPI inflation, which would lead to higher spending on most benefits within the cap. Roughly speaking, a permanent 1% increase in the price level from September 2015 would boost forecast welfare in scope spending by 1% and at a stroke use up half of the 2% buffer. However if the Conservatives form the next Government this risk to spending could be significantly reduced. The Chancellor pledged in his recent conference speech to freeze most working age benefits in 2016–17 and 2017–18, which would transfer the risk of higher-than-expected inflation from the welfare budget to the recipients of those benefits in those years. The other main risk described in the OBR’s report is operational risk. For example, the OBR’s forecasts are now based on the (already delayed) transition from disability living allowance (DLA) to personal independence payments (PIP) reducing claimant numbers by one quarter and spending by £2.8 billion in 2017–18 (or by 17% of what it would have been). Finally, there will inevitably be other forecasting errors – largely due to things that could not be anticipated. Such errors could also lead to forecast welfare spending being increased (or reduced), potentially making the difference between the cap being met and the cap being breached.

Today’s OBR report is welcome. And the welfare cap could, in principle, help governments avoid undesirable increases in spending. But neither the welfare trends report nor the welfare cap are a guarantee of better policy making. If cuts are deemed to be the right response to higher projected welfare spending then those cuts should be well argued and well designed, rather than simply those that are the quickest or politically easiest to achieve.

IFS public finance observations are generously supported by the Economic and Social Research Council (ESRC).