Improving UK Living Standards

Why is the recovery of living standards so slow?

There are two reasons. First, the bottom 50 per cent of the income distribution suffered a disproportionately large hit to their living standards. Since 2019-20, their disposable income has contracted by between seven and 20 per cent. In concrete terms, this means that the poorest 10 per cent of households have an income shortfall of some £4,600 on average. To be clear, this is not income lost but rather the amount in disposable income that would have accrued to households in the absence of the cumulative shocks of Covid and the spike in inflation. For the lowest decile the disposable income is £15,500 instead of £20,000. For the second decile, with disposable incomes of some £28,600, the shortfall is some £3,300. For the third decile, with disposable incomes of about £31,200, the shortfall is £3,100 and for the fourth decile, with disposable incomes of around £37,500, the shortfall is £1,800.

By contrast, the living standards of people in the top half of the income distribution have recovered much faster and returned to pre-Covid levels. For example, households in the fifth income decile (earning about £45,600) are better off by some £750 and those in the sixth income decile (earning around £53,800) are better off by about £600. As we have seen consistently throughout the cost-of-living crisis, the brunt of the impact has fallen on bottom half of the income distribution and that is where help should have been targeted much more than it was.

The second reason is that a faster recovery is being hampered by a combination of factors, including the slowdown in real wage growth, higher price levels for energy, housing and food as well as low economic growth, flatlining productivity and insufficient investment. Without a significant boost to public and business investment, it is hard to see how the new trend rate of growth of one per cent per year will pick up. Sustained real wage growth, which is the key driver of higher living standards, will also require a higher productivity performance, not to mention a better provision of public services and the rebuilding of the country’s social infrastructure. To achieve sustained improvements in living standards in the medium to long run, we need investments in green and globally tradeable activities and the corresponding skills. In the short run, progressive and targeted welfare policy is essential.

How has recent policy affected living standards?

Recent policy has been largely myopic and often regressive. The two per cent reduction in the main rate of employee National Insurance Contributions (NICs) that came into effect in January 2024 will cost the Exchequer some £100 per household per year, totalling about £10 billion by 2027-28. However, because of the freeze in income tax thresholds, the net impact will be regressive, reducing average disposable incomes for the bottom half of the population while raising average disposable incomes for the top half.

However, what has worked for households in the lower income deciles are two recent policy changes. One is the increase in the National Living Wage and the National Minimum Wage by almost 10 per cent last April and 10 per cent again in April 2024, which is a significant boost to people on very low incomes. The other is monetary policy tightening. We compared the actual path of interest rate rises to 5.25 per cent with a counterfactual scenario of rates rising only to 3.5 per cent. With looser monetary policy, we see that households in the bottom half of the distribution would have suffered more, by about 10 per cent of their disposable incomes over 2023-25. This would cut against lower debt costs that households would have faced. But since some households are saving and investing, this impact is much more moderate.

Which alternative policies should be adopted?

In the run-up to the Budget on 6 March 2024, there is much speculation about tax cuts. NIESR has been clear that if the Chancellor chooses to reduce taxes, it would be economically unwise to abolish inheritance tax or cut income tax. Both policies are fiscally wasteful, but also privilege people on higher incomes and thus have a regressive impact. What would help lower-income households much more would be the following three policies.

First, raise the threshold at which income tax is first due and the thresholds for the various bands, so that people keep more of their hard-earned money.

Second, help local authorities in distress and at threat of issuing section 114 notices (i.e. declaring bankruptcy) because otherwise they will have to reduce the provision of basic public services on which some of the poorest people depend the most, such as help for homelessness, social care and home-to-school transport for pupils with special needs. Besides a larger cash injection than the £600 million recently announced by the Secretary of State for Levelling Up, Housing and Communities Michael Gove, there is an overwhelming case to reform the Council Tax system – either by replacing it with a land value tax or by revaluing the bands. The current system is not fit for purpose: council-tax bills for households in the bottom income decile England represent about 10 per cent of earnings whereas for the wealthiest 10 per cent it is about two per cent.

Third, the country needs a credible commitment to maintain public investment at four per cent of GDP per year beyond the next general election, without the drastic cuts to public spending which will occur if the next government sticks rigidly to the fiscal rules. Consistently higher public investment in carefully selected areas and property funded public services will crowd in private investments as well. But this requires a reform of the fiscal framework, with a focus on the objectives of stronger growth and higher well-being and the commensurate use of instruments such as budget deficit and public debt. That could be either a change of rules (e.g. five-year rolling target for public debt or a 10-year target) or the incorporation of other elements, such as one fiscal event per year and a state of the economy address with an outline of the UK economy at national, regional and household level, against which progress is to be measured. Instead of booterism or declinism, we need an injection of realism and long-term commitment in economic policy-making.