|Date:||21 March 2016|
|Authors:||Andrew Hood and Paul Johnson|
|Publisher:||Institute for Fiscal Studies|
There has been a lot of dispute in recent days over the extent to which “we have all been in this together” or government tax and benefit reforms have been “fair”. There are obviously many different ways of assessing this. In this observation we draw on recent IFS work to provide some assessment of what has happened to living standards across the distribution and what has been the direct effect on incomes of tax and benefit policy.
In broad terms income inequality is lower than before the recession as increasing levels of employment have helped those towards the bottom of the income distribution and falling real wages have hit those in work, including higher earners. We would expect that equalisation to unwind as further benefit cuts bite and earnings start to rise, such that inequality at the end of the decade is likely to be similar to inequality at the start.
The direct effect of government tax and benefit policy, on the other hand, has been to take money from those working age benefit recipients towards the bottom of the income distribution. That reflects in part some unpicking, but by no means a complete unpicking, of the very big increases in tax credits introduced by the last Labour government. Those in the middle and upper parts of the income distribution – including most pensioners and people on average earnings and above – have been remarkably well protected from tax and benefit changes on average. Meanwhile the very highest earners - those on over £100,000 a year - have seen significant tax increases.
Chart 1 illustrates the pattern of overall changes in living standards. The solid line shows that there has been a considerable equalisation of the income distribution in the years since the recession, with incomes rising for those towards the bottom of the distribution and falling for those towards the top. This reflects a combination of rising employment, falling earnings and some increases in benefit income (between 2007–08 and 2009–10). On some measures, inequality is now at a 25 year low.
The lighter dotted line shows our projections of what will happen to incomes over the next five years. This line slopes in the other direction. The lack of real income growth at the bottom reflects further benefit cuts, while the better performance further up is dependent on real earnings rising as expected by the OBR. Finally the darker dotted line shows our projections for the period as a whole (which also of course depends on earnings rising as projected from now). It suggests that we should expect much of the recent fall in inequality to be undone over the next five years, resulting in a similar change in incomes for rich and poor over the whole period since the recession. Some evidence, perhaps, that we are all in it together.
The numbers in chart 1 are for the population as a whole. But in fact things look rather different for different age groups. Chart 2 shows our projections for what has happened to the median household incomes of three different age groups – those aged 22-30, 31-59 and 60+. There are big differences here. The median incomes of the over 60s are about 10% higher now than they were pre-crisis. Those of working age still have incomes below pre-crisis levels, with the youngest suffering most, albeit with something of a recent bounce back. The strong income performance among the over 60s results from the fact that pensioners were the least affected by falling real earnings, pensioner benefits were mostly protected, and some of the poorest, oldest pensioners have died and been replaced by a generation with higher state and private pension entitlements.
The extent to which changes in the overall economy can be attributed to government policy is an open question. It is difficult to say whether employment levels have risen so much because of what this government has done right, or earnings levels fallen because of government mistakes. However, changes to the tax and benefit system are clearly the result of policy decisions – albeit decisions taken in a context of an unsustainable budget deficit and falling inequality. Chart 3 shows the percentage gain or loss in income resulting from tax and benefit changes for each income decile from May 2010 to April 2015 split between pensioners, working age people with children and those without children. Chart 4 shows the same thing for the period from May 2015 to April 2019, including announcements in last week’s Budget.
Source: Hood and Elming (2016)
Focussing on the first period four strong conclusions can be drawn. First, tax and benefit changes had little effect on pensioners and much bigger effects on those of working age, especially those with children. Second, they have resulted in significant losses for those of working age in the bottom half of the income distribution. That is not surprising as a result of various cuts to working age benefits have taken effect. Third, those from the middle of the distribution most of the way up (most people on average earnings and above, certainly up to £50,000 or so a year) saw very small changes in income, on average, as a direct result of tax and benefit policy. Given the scale of the overall austerity measures implemented this group were remarkably well protected from tax and benefit changes. For this group the increase in the personal allowance and falls in petrol duty largely offset the effects of the big increase in VAT and some benefit cuts on average. Remember, though, that the protection of this group does have to be seen in the context of falling real wages which have hit their living standards. Finally the top decile, and in particular those on the very highest incomes, earning more than £100,000 a year, faced some significant tax increases. Indeed, if measures introduced in the final months of the last Labour government were included too, the average loss in the top decile would rise to 6.5% of income, making them the biggest losers over the period.
The long-run impact of planned changes over the course of this parliament follows a similar pattern, for a similar set of reasons. Again, pensioners are protected while poorer working age households are hit hard, especially those with children. This is the result of the continued protection of pensioner benefits (including maintaining the ‘triple lock’ on the basic state pension) while making further deep cuts to working-age benefit spending. Again, households in the upper half of the income distribution (but below the very top) are likely to see little direct impact of tax and benefit changes on their incomes on average, as some benefits cuts and small tax rises are offset by further increases in the income tax personal allowance, and the raising of the higher rate threshold.
So the income distribution has narrowed, but tax and benefit changes planned for this parliament will likely help take it back to something like pre-recession levels. Two final points.
First, “fairness” encompasses much more than just the shape of the income distribution or the effects of taxes and benefits on it. The sources and distribution of wealth, changes in public service spending and much else besides matters. Within the narrow remit of tax and benefit policy we have shown before how one of the most important effects of the shift to universal credit (if it ever happens) will be to strengthen work incentives for some of those who currently gain the least from moving into work or earning more. That is an important element of fairness. At the other end of the income distribution there must also be limits on the amount of tax it is “fair” to ask a higher earner to pay. People will differ over where those limits are.
Second, the pattern of effects from tax and benefit changes over this parliament results directly from three policy choices: £12 billion of working age welfare cuts; the protection of pensioner benefits; and increases in the income tax personal allowance and higher rate thresholds. Not only were these policies in the Conservative manifesto last year, they were front and centre. Neither the fact of their implementation nor their distributional consequences should be a surprise.