Poorer Households Face the Worst of the Living Standards Shock

UK Policy Income and Inequality

Poorer Households Face the Worst of the Living Standards Shock

Commentary
Posted on: 25th January 2022
By Multiple Authors
James Browne
Head of Work, Income and Inequality Analysis
Christina Palmou
Senior Economist

Last week’s inflation figures showed that the cost of living is rising faster than expected, piling further pressure on household incomes. Earlier this month, we examined how households are going to be hit by the big rise energy bills expected in April, alongside other changes. But as the December inflation reading made clear, the prices of other goods and services are already rising well above the Bank of England’s 2% inflation target, and another 20% increase in energy bills is expected in October too. How high will inflation rise overall over the coming year, and how will its impact differ across income levels?

Combining Cornwall Insights’ forecast for energy bills with inflation forecasts from Oxford Economics for other goods and services, we estimate that headline inflation will average 5.5% over the 2022–23 financial year, essentially remaining at its current high level. Prices will thus increase much more quickly than both earnings (forecast by the OBR to increase by 4%) and state pensions and other cash benefits, which will be uprated by 3.1% in April in line with last September’s CPI inflation rate.

So far, the pattern of price rises has affected households at all income levels roughly equally, broadly speaking. Accounting for the prices of different goods and services rising by different amounts[1] and differing budget shares for these across income levels, average effective inflation levels for the ten income decile groups were not significantly different in December. Although the poor have been most affected by rising energy bills, they are less affected by rising prices for transport, restaurants and household goods and services. However, this is set to change: soaring energy prices will particularly affect poorer household for whom energy bills represent a larger share of their budgets. The lowest-income households will face an effective inflation rate of more than 7% in the next financial year compared to less than 5% for the richest three income deciles.

Figure 1: Inflation set to rise for poorer households

Source: TBI calculations using Oxford Economics and Cornwall Insights forecasts.

Where will this leave real household incomes? It’s important to remember that as well as facing rising prices, households can expect their cash incomes to increase, even if they do not keep up with inflation. The OBR forecasts average earnings growth of 4% in 2022–23, and state pensions and most cash benefits will be uprated in line with September’s CPI figure of 3.1%.

The combination of all these factors plus higher National Insurance Contribution (NICs) rates from April will lead to an average 3% fall in real household disposable incomes in 2022–23 compared to their level in 2021–22. Again though, the higher inflation rate faced by poorer households means that they will see a larger income fall: the poorest tenth of households will feel 4% poorer than they did last year, a huge income squeeze by any measure. By contrast, even though richer households will be more affected by April’s NICs rise, households with above-average incomes will see their spending power fall by only around 2½%. These are big falls in real incomes that have historically only been seen during deep recessions such as those of the early 1980s and the 2008 Global Financial Crisis.

Figure 2: Poorer households set to see biggest hit to real income levels

Note: Figures in real terms, adjusted by income decile-specific CPI inflation based on Oxford Economics and Cornwall Insights forecasts and data from the 2019–20 Living Costs and Food Survey.

Source: TBI calculations using UKMOD version 2.5.1 run on uprated data from 2018–19 Family Resources Survey. UKMOD is maintained, developed and managed by the Centre for Microsimulation and Policy Analysis at the Institute for Social and Economic Research (ISER), University of Essex. The results and their interpretation are the sole responsibility of TBI.

This analysis doesn’t account for all changes to household incomes that may occur next year. In particular, although we allow for average earnings levels to change, we don’t make any changes to hours worked. If households could increase their earnings, either by getting a pay rise, switching jobs or working additional hours, this could offset some of the additional costs. Focusing just on those households with someone in work,[1] these households would on average households need to increase their earnings by more than 8% to offset increasing prices, more than double the expected level of average earnings growth. And again, lower-income households would have to do significantly more: they would need increase their earnings by 11% on average to offset the higher cost of living. This is partly because of the higher inflation rate they face, but also because they are more likely to face withdrawal of benefits at steep rates if they increase their earnings - notwithstanding the recent reduction in the Universal Credit taper rate - and so have to increase their earnings by more to achieve the same rise in net income.

Figure 3: Lower-income working households have to increase earnings by more to offset higher costs

Note: Chart shows how much households with someone in work would have to increase their total earnings on average to offset the reduction in income shown in Figure 2, taking into account the average marginal effective tax rate and average earnings level for each group.

Source: TBI calculations using UKMOD version 2.5.1 run on uprated data from the 2018–19 Family Resources Survey. UKMOD is maintained, developed and managed by the Centre for Microsimulation and Policy Analysis at the Institute for Social and Economic Research (ISER), University of Essex. The results and their interpretation are the sole responsibility of TBI.

What could the government do about this? First, they could seek to limit the impact on the poorest households by uprating benefits in line with the inflation rate they experience. As the IFS has argued, this could involve as a first step using a more up-to-date inflation figure given that advances in administrative systems allow for changes in benefit rates with less notice. For example, using the December rather than the September CPI inflation figure would make a big difference in April – benefits would rise by 5.4% rather than 3.1%.

But this would not fully solve the problem caused by the shock to energy prices expected in April, let alone if growing geopolitical tensions over Ukraine cause wholesale gas prices to spike further. As we argued earlier this month, some combination of loans to energy suppliers to smooth the impact on energy bills and more targeted support to poorer households through a benefit increase or an expanded Warm Homes Discount looks inevitable.

[1] Oxford Economics produces separate forecasts for food, road fuels, domestic energy and ‘core’ inflation (i.e. everything else).

[2] Note that this is a minority of households for the bottom three income decile groups, and less than a quarter of households in the poorest decile.

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