Welfare reforms have increased household vulnerability to external shocks

Thanks to the large cuts to working-age benefits and tax credits made as part of the UK government’s austerity programme, the tax and benefit system is now less effective at protecting households from adverse shocks to their income. That is the central finding of research by Professor Mike Brewer and colleagues presented at the Royal Economic Society's annual conference at the University of Warwick in April 2019.

Their study finds that between 2010 and 2016, income from social security benefits (such as child benefits, the state pension, housing benefit and jobseekers allowance) and tax credits (such as the child and working tax credits) became a less important part of household income. The share of household income that comes from social security and tax credits fell from 29% to 27%.

In addition, payments of these social security benefits and tax credits became less strongly related to changes in households’ own income. This means that the ability of the welfare system to stabilise incomes has fallen since 2009, during which time austerity has meant large cuts to working-age benefits and tax credits. At the same time, the large rise in the income tax personal allowance means that the tax system now does less to dampen fluctuations in household income than it used to.

Despite this, volatility in overall household incomes has fallen since 2010, on average, thanks to a large fall in the volatility of household earnings and in private pensions. Even though there has been a rise in temporary and insecure forms of employment, such as zero hours contracts and forced self-employment, the researchers find that, on average, UK households had more stable finances in 2016 than in 2010.

Volatility or instability in incomes is usually thought of as undesirable, as it suggests that households are facing large amounts of risk or insecurity in their financial circumstances. Previous research has shown an association between high levels of income instability and depression, poor health of adults and children, food insecurity, an inability to make mortgage repayments, reduced educational achievement of children, and problem behaviour in adolescents and children.

A crucial role of the tax system and of social security benefits and tax credits in the UK is to protect households from income instability or shocks to their income or family circumstances (such as redundancy or divorce). It does this by providing support to households with a low income, paid for in part by levying taxes on those with higher incomes. As well as redistributing from the rich to the poor, this also helps to stabilise incomes for households whose circumstances vary over time.

The new study finds that social security cash benefits and income-dependent refundable tax credits reduce the volatility of household private income by about a quarter for those of working age, and by about 40% for those aged 60 or over. Income tax and national insurance also reduce volatility – by dampening large increases in income – but overall the impact on household income volatility is very small indeed.

This means that the benefit and tax credit system is much more important both for redistributing income and protecting households against uncertainty than the tax system.

The period studied in this research – from 2009 to 2016 – includes most of the strongest economic downturn in the post-war era – the Great Recession of 2008 to 2012 – as well as the subsequent economic recovery (from 2012 to 2016).

The Great Recession was atypical in that the fall in output has been passed through to lower earnings rather than to lower employment: when the recession ended in 2011-12, the employment rate was just two percentage points lower than its pre-recession peak, but median earnings were 8% lower.

During this period, the UK has also seen a rise in temporary forms of employment (including zero hours contracts) and self-employment. Despite this, the research finds that, on average, household earnings had become more stable by 2016 than they were in 2010. This is mostly because households were less likely to see large falls in their earnings due to unemployment as the economy moved out of recession.