Policy options to ease the cost of living crisis

What policy options are available to alleviate April’s living standards shock and how do they measure up in terms of cost, fairness and efficiency? Broadly the government has five measures it could take, and here we look at how they could be combined into an effective response.

One of the most prominent ideas in the debate, and part of Labour’s proposed package of measures announced at the weekend, is a cut in the 5% VAT on domestic fuel. Temporarily cutting VAT to zero would be worth about £90 per year to the typical household from April. Such a move would cost around £2½ billion for one year, and has a lot of political support on both the left and right.

A second idea is to remove the green levies on household bills and fund them instead via general taxation. Households currently pay “policy costs” for funding to support renewables and energy efficiency programmes, principally through their electricity bills. Moving these costs – around £185 per year for the average household – into general taxation would both cut energy bills, and help address the disincentive for consumers to switch their heating source from gas to electricity. The cost of such a measure would be around £5bn per year. But at some point, of course, taxes – the equivalent of around 1p on the basic rate of income tax - would have to rise to pay for these costs.

Cutting VAT or the green levies are both rather poorly-targeted measures, with rich and poor alike benefiting. Increasing an effective subsidy for fuel consumption by further reducing VAT in the middle of a climate crisis also seems to be a bad idea. So, what are the options for more targeted intervention to help households facing the worst of the living standards shock?

The Prime Minister has talked up the Warm Homes Discount, an energy-supplier-administered scheme currently giving around 2.2 million low-income qualifying households £140 per year, funded by other households’ bills. WHD is currently received by a ‘core group’ of the poorest pensioners plus a broader group that can be allocated by suppliers according to criteria they set out. Each supplier has a certain number of discounts to allocate, so some households can miss out even if they meet the criteria. WHD’s coverage of the most exposed low-income households is currently both limited and very patchy, to say the least.

In light of this, various proposals have been made to extend the scheme to more households in some way. One such option would be to offer additional government-funded support to anyone on means-tested benefits and with a household gross income below a fixed income of, say, £16,000. A £300 reformed WHD for the 4.5 million households that met these criteria would cost £1.4 billion if it were claimed by all households receiving these qualifying benefits. This would target spending very tightly on the least well off. But scaling WHD up to be a meaningful solution in this way would be bureaucratic and take-up rates would probably not be as high as for established benefits.

A better alternative might be to provide another temporary boost to Universal Credit, along with Pension Credit and the legacy benefits. Labour’s proposal to ‘expand the Warm Homes Discount’ is best thought of in this way, since all claimants of these benefits would be eligible for support. Spending the £2½ billion cost of the VAT cut on this mechanism instead would mean that some 8 million lower-income households would get around £300 more per year, cushioning much of the energy price shock.

A final option for the government is to limit the rise in the price cap and instead provide loans to suppliers, or stand behind commercial loans, to tide them over and recoup the money when – if - wholesale prices ease. Allowing suppliers to take commercial loans to cover the costs of taking on new customers from failed suppliers, under the ‘supplier of last resort’ (SoLR) provision, is already under consultation by Ofgem. For this to fly it would almost certainly require some level of Treasury guarantee, which for the chancellor would have the benefit of keeping the lending at arm’s length from the public finances. Loans to postpone SoLR costs, also part of Labour’s plan, would only ease the increase in the price cap by up to £90 per year. But this could be expanded to allow suppliers to set prices further below the formal cap, limiting the increase in bills to, say, 30% (compared to the anticipated 46% increase). This would spread the pain for households, but for the Treasury it comes with the inevitable risk that the wholesale prices remain high for some time, putting the taxpayer on the hook for losses.

The distributional impact of each of these options is shown in Figure 1. Unsurprisingly the VAT cut benefits everyone but does little to cushion the blow. The cash benefits option, by contrast, dramatically reduces the scale of the shock for households at the bottom end. Meanwhile loans arrangement would almost be sufficient to eliminate the overnight losses for many low-income households, although this would be pain deferred rather than avoided.

A package of measures?

A plausible package of measures to draw the sting would involve temporary targeted support to households on the lowest incomes combined with some form of loan support to spread payments into next year and beyond. Figure 2 shows the combined effect of loans to reduce the typical bill this year by £220 (allowing the cap to rise by ‘only’ 30%), with each of three fiscal options:

• a VAT cut;

• an expanded WHD offering £300 to 4.5 million households; and

• a £300 boost to cash benefits covering 8 million people.

We also show the distributional effect of Labour’s proposals: loans to cover Supplier of Last Resort (SOLR) costs, which would reduce typical bills by £94 this year, removing VAT on domestic fuel, and £400 boost to cash benefits.

This suggests that Labour’s package of measures is the best-targeted of those shown here. It does most to help workless households and low-income working families with children, who are the prime beneficiaries of the proposal for a £400 boost to household incomes for those receiving means-tested benefits (Figure 3). However, that targeting comes at a higher public cost of around £6bn than options that rely more on spreading the bill via loans to suppliers.

For the Treasury, at least, a cheaper alternative would be the combination of larger loans, a slightly smaller boost to cash benefits, and no VAT cut, with a total exchequer cost of around £2.5bn. This alternative would have a similar impact for lower-income households in April.

If the government wants to eliminate the worst of the living standards shock to the poorer half of households, something along these lines looks inevitable.