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.