Should the government compensate consumers for cost of living shocks?

 

Governments around the world are cutting taxes on petrol or fuel, including in Germany, Italy, Spain and Canada. The UK government has come under pressure to do the same, which is hardly surprising as the crisis may leave the typical British household £500 worse off. But the problem with this approach should be pretty obvious. Prices are rising because there is a reduction in the amount of oil and gas being produced. Prices therefore need to rise to discourage the demand for oil and gas to avoid physical shortages. If governments take measures to subsidise prices by taxing fuel less, then demand is discouraged less and prices will need to rise further, or there will be rationing.

Each individual government is tempted to cut taxes on fuel, because if they alone did so then their consumers would benefit, and other countries would only suffer a small increase in global prices. But if all countries do the same the policy is self-defeating: prices simply rise further to offset the government subsidy. If many states cut taxes on fuel, consumers in the remaining countries face significantly higher prices as the global price tries to match demand to supply, or there is rationing.

In principle a much better way of protecting consumers from the impact of higher energy prices is to let those prices rise, and compensate consumers for some of their loss in real income by transferring cash to them. Consumers still have an incentive to economise on energy, but the hit to their real income is reduced. As I argued during the previous energy price hike, this approach seems natural if the excess profits of energy producers and electricity distributors [1] can be taxed, effectively transferring from the small number of winners to the many losers of the price hike.

However I suspect most economists would ask why the government needs to cushion the impact of higher energy and food prices for those who can afford those higher prices. Most would agree that it makes sense for the government to protect those who would suffer real hardship as a result of higher prices, but why go beyond that? If we abstract from issues of supporting aggregate demand, any government subsidy today has to be paid for by raising taxes or borrowing, and why should the government do either to shield consumers from higher prices?

That is my own instinctive position on government subsidies in response to a hike in energy and food prices. Yes, the government should protect those most in need, but otherwise it should not provide any compensation, and the government certainly shouldn’t cut fuel taxes. I think that is the right position if the government could direct help perfectly to those who need it. The problem arises because the government cannot easily do that.

As this instructive study from Levell, O’Connell and Smith at the IFS notes, those most affected by energy price hikes are not just those on low incomes. Indeed the correlation between hardship following an energy price increase and low incomes is pretty low. That makes the government’s normal benefits system a poor vehicle for supplying assistance to those who need it following an energy price hike.

So one justification for the government providing compensation for everyone is that you can be sure of getting help to those that really need it. The problem, of course, is that you are providing help to many more who don’t need it, and so the compensation is very expensive. This is what the last UK government under Sunak did during the previous energy price hike, and it cost a great deal of money. A better alternative is to attempt to use what data the government has to proxy household needs, but did the government put any resources into trying to do that after the last energy price hike?

Of course the most effective way of getting help to those who need it is to directly subsidise the price of fuel. As we have already noted, that has obvious costs (what economists call efficiency costs) in terms of preventing consumers switching away from using energy. The IFS study noted above finds those efficiency costs to be large, partly because they also find that consumers do manage to economise quite a lot on energy use when prices rise. But despite this, they still find that optimal policy involves some degree of direct price subsidy from the government, and of course how much that subsidy should be depends on how effectively the government can target those who really need help by other means.

All this implies that, in the absence of an effective way of targeting those most in need after an energy price hike, there is an economic case for both income compensation and even some energy price subsidy. Yet I suspect that while this matters for economists it has rather less influence on politicians. They will want to provide help for consumers in an attempt to show the government is on their side in trying to reduce the cost of living, and therefore encourage voters to let them remain in office after the next election.

What will matter much more for politicians than any economic analysis is the finding that the cost of living crisis of 2022-24 was associated with an unprecedented failure of incumbent governments to retain power in democratic elections. High prices were caused by the recovery from the pandemic and the Ukraine war, yet it is governments who seem to have been punished by the electorate. The message this sends to governments today is if you want to hold on to power you need to do everything you can to shield consumers from the impact of higher energy and food costs.

Should economics matter more in shaping policy, and provide a more effective bulwark against politicians acting in their own interests? I’ve talked about this many times before. In a media environment where political journalists rather than subject specialists cover these issues, and political journalists rank political contacts and relatively unimportant scandals over expertise and the major issues, expertise and policy analysis will always take second place. Economics is not unusual in this regard, as we saw with medical advice during the pandemic. It is why Brexit happened, and therefore why living standards are now so stagnant in the UK.

Were not fiscal rules meant to stop governments handing out money to make their reelection more likely? Fiscal rules can do this for permanent tax giveaways or spending increases, but in this case, as with the previous energy price hike and with the pandemic, we are talking about temporary fiscal handouts. Our fiscal rules focus on medium term deficits (or the change in debt), and so will not stop fiscal giveaways that increase the deficit for just one or two years.

Could fiscal rules be changed to be more short term? I suspect the frustration with the impact on public debt of government largess during the pandemic and the subsequent energy price hike led some to advise the new Chancellor to shorten the horizon for the main fiscal rule from five to three years, advice she unfortunately took. The problem is that fiscal rules that apply over the short term are bad fiscal rules, because they will either do considerable harm or be quickly abandoned.

Attempts to target deficits in the short term, or target the level of debt even in the medium term, leads to inappropriate and harmful volatility in taxation or spending decisions as the government responds to every externally driven shock to the public finances. The most obvious example is a fiscal rule to balance the budget each year, which will mean spending cuts or tax rises during recessions and the opposite during booms.

A better possibility is to give independent fiscal institutions more authority to critique government decisions, but as we should know (but some still pretend otherwise) the OBR has no such power. [2] An independent fiscal institution that can give policy advice is effectively a counterweight to the failure of the media to take expertise seriously. In its absence, politicians are going to come under great pressure to cut fuel taxes and compensate all consumers by too much, and they are likely to succumb to that pressure.

[1] Electricity distributors may make excess profits if prices are based on marginal costs, which typically reflect gas prices, while average costs rise much less because of renewable sources of energy. The government is looking to modify that link. Normally higher profits from higher prices encourages additional investment to increase future production, but because of climate change we don’t want additional investment in oil and gas production.

[2] The OBR can comment on how changes in energy prices impact the economy, but not on what the policy response should be, as a true fiscal watchdog would.

Orbán, Trump and the International Right Wing Populist Movement

 

If you doubted that right wing populism is an international movement, then the turnout of support for Victor Orbán and his party Fidesz before Sunday’s election should have put you right. It wasn’t just visits from US Vice President Vance and Secretary of State Rubio, plus supportive messages from Trump himself. [1] Every leader of the main right wing populist parties in Europe offered Orbán support, alongside Netanyahu from Israel and of course Putin from Russia.

The scale of Orbán’s defeat, with his opponent Péter Magyar,winning a super majority of seats allowing him to undo constitutional changes enacted by Orbán, is impressive when set against past Orbán victories and the extent of election rigging in favour of Fidesz. But the main two reasons that Magyar won were fairly inevitable after a prolonged period of right wing populist government: economic stagnation and widespread government corruption. I noted here how severe economic decline is typical after a period of right wing populist government, and corruption is also standard in any highly autocratic state.

The durability problem with right-wing populist governments is not their popularity, but that these governments meet unpopularity with measures that degrade and possibly eliminate the democratic process. Sunday’s election result is a reminder that there are limits to what an almost entirely pro-government media can do, and the scale of Orbán’s defeat may have also deterred him from trying to ignore the result by claiming it had been stolen as a result of EU interference. [2] Orbán might have been able to get away with such a tactic if the result had been close and he still had large areas of support, but after such a large defeat popular resistance to such a tactic could have been too great for Orbán to risk.

The scale of Orbán’s defeat may also be a result of where that defeat came from. Sunday’s victor, Péter Magyar, was a member of Orbán’s party, Fidesz, until just two years ago. He is a right wing conservative, but broke with Orbán and Fidesz over the issue of corruption. In those two years Magyar worked tirelessly in visiting rural areas that had traditionally been Fidesz strongholds, and this may help explain the scale of his victory. Social conservatives who might have still hesitated to vote for a more liberal opposition leader were prepared to vote for Magyar. (A lesson perhaps for centre right parties elsewhere including the UK: you defeat right wing populism by fighting it rather than becoming it.)

The task ahead for Magyar is still immense, and it will take time to get rid of all the Orbán loyalists that have become entrenched after sixteen years of his rule. But the benefits for those outside Hungary are likely to be more immediate. Magyar has pledged to stop Hungary being the odd one out in the EU, which means no longer doing Putin’s bidding and trying to block European aid to Ukraine.

The desire of right wing populists around the world to support Orbán is also an indication of the key role that Hungary played in the international right wing populist network, both as an example of the kind of regime that this movement hoped to spread to other countries, and as a direct provider of cash for events and propaganda. However here the impact of Orbán’s fall should not be overestimated. In the UK, for example, few of those voting for Reform will even be aware of Orbán, and there will still be plenty of money around to support right wing populism in the UK and elsewhere.

This external support for Orbán doesn’t seem to have done him any good in Sunday’s election, and may well have been harmful. In particular Orbán’s increasing links with Russia and hostility to the EU (to the extent that his ministers acted as Russian spies within the EU) are unlikely to have been popular. But support from Trump could also have backfired.

I have argued for some time that a silver lining to Trump’s second term may be the damage he does to right wing populism outside the US. There are three reasons for this. First, right wing populists typically inflict severe damage to their own economy, to their voter’s health and so on. Because events in the US are often well publicised in other countries, voters can see this damage. As domestic right wing populists often cannot help themselves in praising or emulating Trump, then Trump’s failures in the US will reflect badly on right wing populists at home.

The second reason is that Trump, among the set of right wing populist leaders, is particularly incompetent. Not, I should say immediately, incompetent at keeping his political base happy, but simply in terms of decision making. In part this may simply be because of his mental health, but it also comes from his personality. A third reason is that some of those bad decisions directly impact voters overseas. Tariffs used to be the main example but now the consequences of Trump’s Iran war dominate. Trump’s unpopularity overseas is only likely to grow.

Unfortunately this third reason means that Trump’s impact on the success of right wing populism may be double edged. His increasing unpopularity caused by the evident harm he is doing will reduce the support for right wing populists, both in government and in opposition outside the United States. Even Farage, who in the past has been a very vocal and indeed loyal fan of Trump, recently said “I happen to know him, but that’s by the by”. Just as right wing populists outside the US begin to distance themselves from Trump, they will also begin to realise that what works for the MAGA base does not necessarily work elsewhere.

However Trump’s actions could actually add to the support of right wing populist parties outside the US if those parties are not in government. In particular Trump’s Iran war is leading to lasting increases in the price of energy and food, similar in scale to the increases seen after the end of the pandemic. We know that the latter was associated with a period where incumbent governments fell around the world, perhaps because many voters blamed those governments for the hit to their prosperity. In that respect Trump’s actions could provide a boost to right wing populists in the years to come.

For this reason alone Orbán’s defeat should not be seen as a turning of the tide against right wing populism. I argued here that ever since advocating extreme socially conservative views has become normalised, there will always be at least a third of the electorate that will be attracted by parties that make immigration and overt nationalism their main issues. Hard economic times, and in particular cuts to public services, will boost that number, as many voters begin to believe that immigrants are responsible for their stagnant real wages and their difficulty in accessing public services. [3] These are the circumstances that offer right wing populist opposition parties the chance to gain power, and in Trump’s case and perhaps in Orbán’s case to regain power.

[1] This is an interesting connection I was unaware of between the Republican party and Orbán’s election victory in 2010.

[2] Pusuing that possibility may be one reason for the variety of fake polls suggesting Orbán would win.

[3] This is the reason why it is so important to keep repeating the truth that immigrants tend to pay more in taxes than they take out in terms of using public services, because that discussion is a counterweight to populist narratives about immigration putting extra strain on public services.

Taxation as Insurance, Welfare and Entitlements

 

A rather abstract discussion which leads to a very specific conclusion about the merger of income tax and employee national insurance contributions

Paul Krugman has described the Federal US government as a gigantic insurance company with an army. Can the same thing be said of public spending in most European countries, including the UK? Broadly yes, with one big caveat and some smaller caveats. Indeed, where countries have an army for defensive purposes alone (unlike the US at present) even the army can be regarded as a form of insurance. Spending on law and order can equally be regarded as a kind of collective insurance against being harmed or robbed by others.

The biggest item of departmental spending in the UK is on health. This is a classic form of insurance, where we pay taxes but receive health care that is by and large free when we need it. Much of welfare spending is a form of insurance. The biggest item of welfare spending in the UK is the state pension, which is a type of insurance policy where you receive an annuity on retirement, which in effect insures you against the financial cost of a long life. Disability benefit can be seen as insurance against becoming disabled, unemployment benefit as insurance against becoming unemployed, and universal credit as insurance against low earnings.

In some of these cases, and particularly the last, seeing spending as insurance only works for everyone if it is insurance you might take out behind a veil of ignorance before life begins. A medical consultant is unlikely to want to take out insurance against low pay, as would an unborn child who knew their parents were billionaires. For that reason I’m using insurance in a Rawlsian, social liberal sense. Perhaps, as a result, we could describe much of state spending as a form of social insurance.

The major caveat is that a significant part of public spending is on education. (Of course the same is true in the US: Krugman was referring to Federal spending, and education is funded at the state level.) If we add child benefit, we could say that a significant part of public spending is for types of child support [1]. The smaller caveats include spending on transport, housing, overseas aid etc.

Of course a lot of this insurance individual citizens could provide for themselves using the private sector. We could provide for our health by taking out private insurance, but since Arrow’s seminal work economists have recognised the problems with personal health insurance, and the United States is a good example of why a private health system can be very inefficient. We can also buy our own pensions, but one large advantage of a state pension is that it avoids the risk of stock markets or interest rates being low when your pension matures. [2]

Putting the caveats to one side, taxation can therefore be seen as a form of insurance payment. Indeed one of our main taxes has the word insurance in it. In particular, taxes are a significant part of insurance against old age. This is important, because it means that during the middle part of people’s lives, and much of their voting lives, they will be paying taxes that considerably exceed the benefit they receive in terms of public services. Indeed in this respect taxes and benefits are like individual income and consumption: we earn (pay tax) more than we consume (use public services) in middle life and vice versa in early and late life. (This is also why the claim that immigrants on average put a strain on public services is just wrong.)

The insurance provided by the state is a little different from insurance provided by a company in terms of both contributions and benefits. State insurance is unlike most private insurance because benefit entitlements can be changed at any time. In addition, in theory many of the benefits paid out by the government, including benefiting from the NHS, do not require any contributions whatsoever. In practice we all make a contribution by paying tax, and everyone beyond a certain age pays taxes the moment we buy anything that isn’t zero rated for VAT. The idea that those paying income tax should have a greater voice in spending decisions makes no sense for this reason alone, and because few would want to argue that billionaires should have the right to much more political influence than anyone else.

Some state benefits require a degree of contribution. The state pension, for example, requires a minimum period of contribution to receive it, and how much you receive depends on how long you have been either earning or receiving child benefit. But how much you receive does not depend on how much money you contributed. What is less often noted is that the same is true for unemployment benefits, where you need to have been paying contributions in previous years. These requirements sometimes lead people to think that their contributions fund their pension, but this is false. Pensions today are paid for by those paying tax today.

Periodically I come across people who think that state pensions should not be classed as a welfare payment by the government because it is something they are entitled to by contributing employee national insurance payments (see this, for example). This is an illusion, because whatever requirements the government may make to receive a pension are pretty arbitrary. It is really a reaction to much of the media describing state benefits as ‘handouts’. Seeing these benefits as a type of insurance is much more realistic.

However there is a sense in which people are entitled to all state benefits. Paying taxes when younger is part of a social contract that involves the understanding that you will receive various forms of insurance, usually but not always later in life. Insurance against ill-health (a free NHS), insurance allowing you to live a long life without financial hardship (a state pension), as well as insurance against unemployment, having a low wage job/poverty and so on.

If we see taxes in general as largely a form of insurance policy, and welfare benefits as a form of insurance payout, then the argument for workers paying national insurance contributions alongside income tax is diminished. Having two separate taxes on income leads to all kinds of distortions that make little sense, and for this reason many economists have long argued that the two taxes should be merged. [3]

The reason this sensible idea has not been adopted by most Chancellors is simple. It would mean that pensioners would pay more tax and workers would pay less. Pensioners tend to vote more often than workers, particularly younger workers. [4] In particular, given the current system pensioners would argue that such a merger would be unfair, because why should they contribute to their pensions once they start receiving those pensions?

However that argument could be turned around, suggesting that linking particular taxes to particular benefits is a bad idea. It is a bad idea because those paying for private education could argue they shouldn’t pay the taxes that go to fund state education, and those paying for private medical insurance shouldn’t pay so much for the NHS and so on. Arguing that state pensions are a return on earlier national insurance contributiions views taxes as just like personal insurance, where we pay taxes just for what we personally get back in return. Instead taxes can be seen, as I show above, as a form of social insurance, where society collectively insures all of its members. If that is the case, relating a particular tax to particular benefits makes little sense. 

[1] Could state spending on children be seen as a form of insurance against the cost of having kids? The reason I don’t think this works is the state doesn’t support a proportion of the cost of having kids, but instead funds all the cost of educating kids. A major reason it does this is because education has clear economic benefits for society. This is perhaps why the OECD sometimes distinguishes between public spending that is military (defence), economic (education) and social (much of the rest)

[2] Retire when the stock market is booming and your pension will be that much better than someone who has contributed exactly the same but retired when the stock market was bust. Defined benefit personal pensions avoid this problem, but are now increasingly rare outside the public sector. In addition annuity rates can vary widely depending on the level of long term interest rates at the time the annuity is taken out.

[3] In my post three weeks ago I questioned the wisdom on political economy grounds of economists, including the IFS, arguing for abolishing zero-rating of VAT, so I’m happy to support them on this particular issue. (Here is the IFS putting the case for merger.) The case for merging employers’ NI contributions as well as employees' is more complex, in part because in the short to medium term the incidence of this tax is only to a small extent on wages (see here and here).

[4] To avoid this an income tax and employees national insurance merger could be combined with a one-off uprating of pensions, perhaps combined with getting rid of the triple lock for future pension increases.