On welfare cuts and automatic stabilisers

Cuts to welfare spending seem to be in the headlines daily nowadays. Every time a bad bit of economic news is announced (which is often), the prospect of yet more welfare cuts seems to raise its ugly head. Just this week, following the terrible Q4 growth figures, there was a story in the Independent about certain ministers who are pushing for further cuts to welfare.

There are a number of issues around welfare which are regularly discussed. These include ‘fairness’ and ‘making work pay’. A lot has been written on both sides of the arguments on this, so I’m going to focus on the likely economic impact of welfare cuts.

Now a key argument on welfare cuts is that the deficit needs to come down and everyone needs to contribute (we’re all in this together remember). Putting aside the fact that I don’t think we should try to reduce the deficit at the expense of jobs or living standards, I want to look at whether the claim that welfare cuts help reduce the deficit stand up to scrutiny.

A lot of people would say that the purpose of working-age welfare benefits is to provide a subsistence level of income for those who are either unable to find work, or unable to work altogether due to ill health or disability. While that’s true, welfare payments also serve a very important macroeconomic function. They act as an ‘automatic stabiliser’.

What are automatic stabilisers? From Wikipedia:

“In macroeconomics, automatic stabilizers describes how modern government budget policies, particularly income taxes and welfare spending, act to dampen fluctuations in real GDP.”

In other words, in a boom, the government collects more taxes and pays out less in benefits which helps put the brakes on to prevent the economy from overheating. Conversely, in a slump (like the one we’re in now), less tax is collected and welfare payments soar as people lose their jobs and businesses make less sales. This acts to prevent the economy going into free-fall. The stronger the automatic stabilisers, the shallower are the slumps and the quicker are the recoveries.

In response to criticism of his economic policies, George Osborne has claimed his plan is flexible because he has “been prepared to let the automatic stabilisers operate..”. I’m not sure what he means by that. What would not letting them operate look like? I suppose you could stop paying benefits to new claimants, or make people pay the same rate of tax even when their incomes fall, but no sane person would advocate that. So in Osborne’s world, ‘flexibility’ seems to mean not taking complete leave of your senses.

In any case, the Government are not letting the automatic stabilisers operate, they are trying to weaken them all the time. Bedroom taxes, Atos reassessments, cuts to council tax benefits, these all weaken the automatic stabilisers. What does this mean? It means that income will be taken out of the pockets of the poorest (who by the way spend most of their income), who then spend less in local businesses. These businesses then make less sales, leading to the government collecting less in tax, while the businesses might decide they don’t longer need as many staff, or even go bust.

Spending is a circuit. It goes round and round the system, not stopping after its first use. The government thinks by cutting the amount it pays benefit claimants by x pounds, it will save x pounds. It’s easy to see the flaw in this logic though. If you give someone £100 less in benefits, that’s £100 less going into the economy. Someone else has lost £100 in income (unless that person’s taxes are cut by the same amount, but the Government are not proposing to cut taxes). The actual saving for the Government will not be £100, but a figure much much smaller. It could even be negative if the cuts further depress employment. The welfare bill could actually go up.

This, in a nutshell then is why cutting spending by x pounds is only cutting the deficit by (-)y pounds. This confuses all sorts of people who are starting to claim austerity is not happening because the deficit is rising.

What the cuts to welfare also mean is that the next time there is a crisis, it will be much deeper, because our new, weakened automatic stabilisers are not strong enough to stop the slide and spark the recovery.

There’s actually a strong case for strengthening the automatic stabilisers. You could do this on the tax side by perhaps linking national insurance rates to the unemployment rate, or on the welfare side by guaranteeing jobs for those who are made redundant following an economic slump.

Cutting welfare in a slump is a very dumb thing to try to do. It won’t work and will make things worse. They will be disastrous on an individual level for many families bearing the brunt of these cuts. With jobs not being created in sufficient number (no matter what the Government tries to say), there’s no possible way the cuts can act as an ‘incentive to work’, and as we’ve just seen, in macroeconomic terms, weakening automatic stabilisers in a slump is an awful idea. Dumb, dumb, dumb.

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10 thoughts on “On welfare cuts and automatic stabilisers

  1. Hi Alex

    I totally accept the point you are making but I would argue that the benefit cuts have very little to do with deficit reduction. Instead, it seems more likely that the purpose of the benefit cuts is to immiserate the poor – a class of people despised by the current government and the prevailing ideology. Hence the narrative, of a “something for nothing” culture that Cameron and Osborne say they are trying to break.

    Further to your point about the automatic stabilisers, would not a multiplier effect operate such that £100 reduction in benefits takes a multiple of £100 out of circulation? So if the multiplier is 0.8 then consumption expenditure will fall by £400?

    1. I don’t rule out your theory about benefit cuts as a possible explanation, but in this post I’m trying to scrutinise one of the Government’s stated reasons for cuts, i.e. to contribute to deficit reduction. You are right that the multiplier effect could mean that cutting by £100 could take more than £100 out of circulation, but here I just try to show that when the Government says cutting by £x saves £x, this is rarely, if ever true.

      1. Hi Alex
        Just an addendum to my first comment.
        Assuming an average propensity to consume of 80% of income, then I should have said that a 100% reduction in benefits will reduce consumption expenditure by £500, not £400 as I originally said. Of course, the propensity figure has been pulled out of thin air. A more conservative estimate of 0.5 would reduce consumption expenditure by £200 for each £100 cut in government expenditure.So it seems clear that benefit cuts do not provide a reasoned pathway to growth and are much more likely to produce economic contraction.

        1. Bear in mind that propensity to consume is 1 – propensity to save. And it is saving that pays down debt.

          So not only do you reduce the income of the population, you also reduce their debt repayments and keep the interest flowing to the banks, etc.

  2. Good post. It’s the austerity death spiral such as we are seeing in the Eurozone. I too was puzzled by Osborne’s claim that he was allowing automatic stabilisers to work freely, because as far as I can see he is actually cutting them.

    I don’t think it’s quite correct to claim that the government isn’t cutting taxes. Raising the personal allowance is a tax cut, but it doesn’t benefit the very poorest – the people who either exist entirely on benefits or whose earned incomes are below the personal allowance limit. Those people are effectively experiencing tax RISES, since benefits are really a negative tax. As those people are also the ones who are most likely to spend any extra money they receive, cutting benefits for the very poorest makes no economic sense whatsoever.

    There is also the problem that cutting in-work benefits such as housing benefit increases the reliance on emergency provision – which is actually more expensive. And reducing people’s incomes increases hardship, which carries medical costs so increases pressure on the NHS. So even for people who are not the very poorest, cutting benefits can be a very short-sighted policy.

  3. ‘So in Osborne’s world, ‘flexibility’ seems to mean not taking complete leave of your senses’ is a wonderful sentence. In fact, Osborne should be raising benefits … because as Frances said that ‘negative tax’ would be the sort of ‘tax cut’ that would increase demand in the real economy. Great post!

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