Income distribution in times of austerity: why the cuts are likely to widen the gap

Nicola Pensiero.
Yesterday, the House of Commons passed a bill that will cut £12bn in welfare programmes. Chancellor George Osborne argues that the government has no choice but to continue reducing the budget deficit. When announcing the plan, he pointed to the unfolding Greek crisis to reinforce his idea that a country has to be in control of its own borrowing or the “borrowing takes control of the country”. The plan is expected to move Britain “from a low-wage, high-tax, high-welfare economy to the higher wage, lower tax, lower welfare country we intend to create”. Despite the proclaimed intentions, a likely consequence of these planned cuts is an increased polarisation of household incomes, as my recent research shows.
I have been using IMF data on government measures intended to reduce the budget deficit in 17 OECD (Organisation for Economic Cooperation and Development) countries including the UK in the period 1978-2009 to explore the distributional consequences of austerity measures. The results show that spending-based fiscal adjustments increase inequality in (disposable) household income significantly*. (A spending cut of 1% of GDP is related to 0.5% increase of the Gini coefficient, a measure of inequality for which a value of 0 reflects a perfectly egalitarian income distribution, and a value of 1 equals perfect inequality.) Two IMF studies (PDF) show that another effect of fiscal consolidation is higher unemployment and that part of the effect of fiscal consolidation on income inequality runs through higher unemployment.
Poverty levels and inequality between household incomes in the UK are already among the highest among developed economies, and the planned welfare programme cuts are likely to exacerbate the economic divide. Cuts to social security will particularly hit young people and working families. Working-age benefits are frozen for four years, and they are already below subsistence levels. Tax credits will be limited to the first two children. Housing benefit will be withdrawn from those aged between 18 and 21, while tax credits and universal credit will be targeted at people on lower wages by reducing the level at which they are withdrawn. Worse-off students will be forced to take even more loans as student grants will be replaced by loans from 2016-17.
As George Monbiot argues, there is clearly a blaming attitude to the poor underpinning these measures. The message that the government is sending to the poor is that if you are unemployed, you have poor job seeking attitudes, and those attitudes should not be encouraged by cash transfers. If you are young, you will not be productive unless forced to be so. If you are young, you have strong family bonds you can rely on in hard times. Part of the reason the low paid and poor have children is to claim more benefits. If benefits are cut and those changes introduced, there won’t be any disruptive consequences; those willing to seek work will find it and those who do not have not tried hard enough or have been too selective. At the same time, a higher national minimum wage will be introduced from next April at a rate of £7.20 an hour for people over the age of 25. However, this will not compensate poorer working families for lost tax credits, the Institute for Fiscal Studies concluded (PDF). In fact, tax credits and minimum wage target different groups: “tax credits support those with low annual family incomes”, while “minimum wages support those with low hourly wages, many of whom have higher family incomes”. Hence they are not substitutes.
Reducing the generosity of social benefits has been accompanied since the 1980s by the deregulation of the labour market in further widening the gap between highly and low paid and between wealthy and poor families. The UK stands out as one the countries with the lowest level of labour market regulation. Since the 1980s the UK and other OECD countries have started to abandon job protection. I have introduced in my analysis a composite index of labour market regulation from The Economic Freedom of the World Index (EFI), including hiring regulations and minimum wage, hours’ regulations and mandated cost of worker dismissal, and centralised collective bargaining. The results show that lowering labour market regulation exacerbates income inequality and that the UK together with the other English-speaking countries has record levels of low regulation.
Fiscal adjustments and low job protection are helping to widen the divide between better-off and worse-off families and the macroeconomic notions supporting those policies are driven more by hysteria than by logic and evidence. Fears over government solvency and sovereign debt crises are unfounded and the attempt to point towards the Greek crisis as a lurking outcome is misleading. A good introduction to these issues is this blog by Bill Mitchell, Professor in Economics and Director of the Centre of Full Employment and Equity (CofFEE), at the University of Newcastle, NSW, Australia.
In synthesis, fiscal deficits are scary because it is assumed, using the household spending analogy, that government saving (i.e. budget surpluses) adds to national saving which can be used to fund future public expenditure. This view is erroneous. A sovereign government in the currency meaning of the term (unlike Greece!) does not need to save in the currency that it issues. As a matter of national accounting, a government budget deficit adds net financial resources to the private sector (households and firms) and a budget surplus has the opposite effect. Public surpluses do not create a reserve of money that can be spent later, and governments simply spend by crediting accounts in the banking system. Finally, the fact that the government is not technically or financially constrained in spending does not imply that it can spend in an unlimited fashion without consequences. The constraints pertain to the real economy (for example, rising inflation) not to the capacity of borrowing money.
This blog first appeared on http://www.llakes.ac.uk/blog/income-distribution-times-austerity