Back to the ‘80s: Projections for living standards and inequality in the UK

The UK economy has, in many respects, performed well recently. Last week it was revealed that GDP grew by 2 per cent in 2016, above the OECD average, and higher than forecasters expected when the country voted to leave the European Union. Employment is at a record high and average wages, although still 4 per cent below their pre-crisis peak, have been growing at a rate of around 2 per cent a year in real terms. Yet dark clouds are forming on the horizon, particularly for those on low and middle incomes.

Our annual audit of Living Standards across the UK, which uses the macroeconomic forecasts of the independent Office for Budget Responsibility as well as expected tax and benefit rates, shows that growth in typical household incomes will slow sharply in the next few years.

Indeed, the strong income growth of the past few years has likely already ended. Very low inflation – driven by oil price falls – and rising employment could not have been expected to last forever, and inflation has picked up quickly since the EU referendum vote cut the value of Sterling. Looking at the next four years as a whole we project cumulative growth in average working-age incomes of only 1.7 per cent (or 0.4 per cent a year). This is the result of forecasts of above-target inflation, poor wage growth, no employment growth, and tightening fiscal policy.

But even more worrying is how this meagre growth is likely to be shared. While incomes are projected to stagnate for those in the middle, they are expected to rise (albeit weakly) for those at the top and fall significantly for those at the bottom – as shown in the figure below. The poorest quarter of working-age households are projected to be around 5-15 per cent worse off in 2020-21 than this year. In contrast, the highest income quarter would rise by 4-5 per cent.

The result is the worst period of household income growth for the poorest half of households since records began in the mid-1960s. The skewed growth would also represent the largest increase in inequality since the premiership of Margaret Thatcher, and would take inequality (measured here after housing costs) to new heights. This is illustrated below for three common inequality measures, with the most dramatic rise being in terms of the ratio of household income of the 90^th percentile compared to the 10^th, reflecting the extremely large fall in income at the bottom.

The large inequality increases of the 1980s – which until now have never really been repeated in the UK – can also clearly be seen. However, that was a period when incomes generally rose across the distribution – and significantly faster at the top. The current period is therefore unprecedented in combining weak overall growth with rising inequality and falling incomes at the bottom. To put it another way the next few years could be like the 1980s but without the feel-good factor.

Notes: The 80/20 ratio is the income of a household richer than eight out of ten households divided by that of one richer than only two in ten households; the 90/10 ratio is similarly constructed; and the Palma ratio is the income share of the top 10 per cent divided by the income share of the bottom 40 per cent.

So why does this projection look so bad and what can be done to change it?

The UK’s anaemic wage growth is linked to poor productivity growth, which has dogged the UK for a decade now. The OECD has drawn attention to the low levels of infrastructure spending in the UK and a lack of investment in human capital. Greater public and corporate investment could help spur greater productivity growth. Reducing the cost of housing could make a big difference too. Current mortgagors are benefiting from continued low borrowing costs but we can’t rely on record low interest rates forever.

There is also scope to continue the remarkable employment growth of recent years. Despite the record high, many parts of the country and many groups still have much lower labour market engagement. Our research suggests that addressing such disparities could put around 2 million more people in work by 2020-21.

But, beyond the rate of growth, how that growth is shared is in many ways a simple policy choice. The dismal projection for poorer working-age households (and those with children especially) is in large part due to welfare cuts of over £12 billion inherited by the new PM. These include a freeze in almost all working-age benefits until 2020, despite rising and higher-than-expected inflation; cuts to the generosity of in-work support; and large reductions in support for new families with more than two children. At the other end of the spectrum, the government is introducing tax cuts that will predominantly benefit middle to higher income households. While the government is seeking to bring down its fiscal deficit, how this burden falls – and what level of inequality it wants to see in this country – is entirely its own choice.