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The cost of living crisis: a pre-Budget briefing

The Institute for Fiscal Studies (IFS) has produced a pre-budget briefing about the cost of living crisis.

Executive summary

The recent surge in inflation, driven by spectacular increases in energy prices, has driven sharp falls in household living standards, huge government intervention to try to mitigate it, and serious policy headaches. As such it continues to be the backdrop behind many of the most pressing issues that will face Chancellor Hunt when he delivers his first Budget on 15 March. This short report analyses the latest outlook for inflation, how this varies across households and is impacted by the government’s interventions on consumer energy prices, and the resulting effects on real earnings and benefit levels.

Key findings

  • High inflation has hit lower-income households hardest, mostly because of the sharp increases in gas and electricity prices. As a share of total spending, the lowest-income households are almost three times as exposed to energy costs as the highest-income households.

  • The Energy Price Guarantee (EPG) is planned to rise from £2,500 to £3,000 per year for a typical household in April. In addition, the last instalment of the £400 reduction from energy bills is set to be paid in March.

  • On the other hand, the most recent forecasts suggest that consumer energy prices are set to fall below the EPG level from this summer. If this happens then the impact of raising the EPG level on energy bills will last only a few months – months in which the seasonal drop in energy use will considerably soften the budgetary impact for households. Nevertheless, taking financial years as a whole, in 2023–24 energy bills net of publicly funded discounts are on average expected to be about £380, or 20%, higher than in 2022–23; and about £1,083, or 88%, higher than in 2021–22.

  • Another key cost increase for some households, not incorporated in headline inflation measures, will be rises in mortgage rates. This will mostly affect better-off households: around one-half of the highest-income fifth, and one-third of the middle-income fifth, have a mortgage. Across all households with a mortgage, we estimate that an increase in mortgage rates from 2% (the typical 2021–22 rate) to 5.8% (in line with Bank Rate increases since 2021–22) would on average reduce incomes after mortgage payments by 7.5%. This rises to 10% for those aged under 45, who tend to have larger outstanding mortgages. Due to the prevalence of fixed-rate mortgages, this is a cost shock that will be rolled out gradually, but around 1.4 million households will come to the end of a fixed-rate deal during 2023. For those that do, the resulting impact on disposable incomes can, as the numbers above attest, be of a similar magnitude to the impact of inflation in all other (non-housing) items over the past year.

  • The cost of living crisis shows up starkly in real earnings levels. Perhaps surprisingly, real mean earnings had actually grown by 6–7% between December 2019 (just before the pandemic) and March 2022 – something of a pickup from the paltry 2–3% of the preceding 27 months. But the sharp increase in inflation after Russia’s invasion of Ukraine caused real earnings to plummet. Taking the three years since the beginning of the pandemic as a whole (December 2019 to December 2022), average real earnings have grown by just 1–2%. That lack of significant real earnings growth is seen across the earnings distribution.

  • Looking ahead, the Bank of England forecasts that average real earnings will fall in the coming financial year. The freezing of tax thresholds will further push down take-home pay. Median net-of-tax earnings are expected to be 2.5% lower in April 2023 than in April 2022, and 1.7% lower than in April 2019, before the pandemic.

  • Comparing the coming year (2023–24) with this one (2022–23), it is likely that we will see some pay compression, as the National Living Wage is set to rise slightly in real terms. Combined with the fact that benefits will likely be slightly higher in real terms in 2023–24 than in 2022–23 – after rising by 10% in April – this means that households on low wages will, on average, not see the substantial further falls in real incomes during 2023–24 that many higher-income households are likely to see.

  • However, for benefit recipients the bigger picture is that the April 2023 annual uprating of benefits will merely take them back to around the real level they were at a year earlier. It will not address the shortfall that opened up between September 2021 and April 2022 due to the deficient (lagged) way in which benefits are uprated. That ground will only be regained some time after inflation returns to the level it was at before Autumn 2021. Compared with their pre-pandemic (2019Q2) levels, real benefit rates were 7.6% lower in 2022Q2, and will be 6.2% lower in 2023Q2 and still 2.0% lower in 2024Q2. Astonishingly, it is not until April 2025 that benefit rates are set to recover the ground they lost over the autumn and winter of 2021 due to lags in uprating them with inflation.

  • The fact that benefits, despite being price-indexed, have not kept pace with inflation during this crisis is the backdrop behind the additional cost of living payments made available to benefit recipients during 2023–24 to try to plug the gap. Overall, these payments actually result in the government spending around £2 billion more on recipients of means-tested or disability benefits in 2023–24 than it would have needed to simply raise ordinary benefits in line with current inflation.

  • Childless families with no one in paid work and on universal credit and entitled to no other additions (e.g. health-related additions) tend to do especially well out of the crude, flat-rate arrangement. Because their ‘ordinary’ benefit entitlement is relatively low, those entitlements will only have had around £200 of their value eroded by inflation since 2019–20, yet they will receive the full £900 in cost of living payments in 2023–24. On the other hand, almost half of all families with three or more children on means-tested benefits would have been better off if the government had not introduced cost of living payments, but had instead just ensured that normal benefits kept pace with inflation. Having someone in receipt of a disability benefit, or having someone in paid work, are also characteristics that make benefit-receiving households less likely to have been adequately compensated for the lack of timely uprating by the flat-rate cost of living payments.

  • These crudely targeted cost of living payments also create ‘cliff edges’ in the system. Receipt of each of the three £300 instalments of the payment will be contingent on having been a universal credit recipient in a specific prior month. We estimate that, as a result, in each of the three relevant months there will be around 825,000 people who earn slightly more than is consistent with universal credit eligibility and who, as a result of missing out on the cost of living payment, end up with less income than other similar people who earn less. Equivalently, they could increase their own income were their earnings to be slightly lower.

Download the full report

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