How to tackle the UK cost of living crisis – four economists have their say

Inflation in the UK, already at a 40-year high, could top 13% in October, according to Bank of England forecasts. While wages have not kept pace with inflation, much of the expected pressure on households and businesses comes from rising energy costs.

A rise in wholesale energy prices has resulted in retail charges for businesses and households. While the government sets a price cap to protect consumers from sharp price hikes, it increases in line with market prices. This could see average household bills increase by more than £650 in January 2023 to the equivalent of £4,266 for the year.

Political leaders from all major British parties have presented proposals to alleviate the cost of living crisis this winter. We asked four economists to discuss the proposals so far and outline the measures they think could help ease some of the pressure on UK households and businesses this year.

Price controls and winter rationing

Alan Shipman, Lecturer in Economics, Open University

If left to the market, energy costs will soon be rising so fast that price controls may be the new prime minister’s only option this winter. A tighter price cap than what regulator Ofgem expects would be one way to avoid a spike in winter bills that multiplies fuel poverty.

That would work in a similar way to former Prime Minister Gordon Brown’s proposal. The government would negotiate new pricing agreements with utilities after assessing their profit margins and operating costs.

A lower price cap could send some smaller providers into the abyss, forcing the government to bail them out or take them over. This was before the recent spike in wholesale prices.

In fact, Ofgem has admitted that the requirements for new entrants with riskier business models were too lax ahead of a 2019 market review. Therefore, price controls would also help separate the viable operators from those who need to close Bulb Energy or turn it into effective public ownership.

A tighter price cap would also reduce the amount of gas that distributors and power generators can profitably buy on the wholesale markets. This could create shortages if the remaining supply is not rationed. EU countries are already preparing to limit industrial gas use during winter peaks, expecting Russia to shut down its pipelines as temperatures drop.

The prospect of fuel-efficiency shutdowns has sparked protests, particularly in Germany, where energy-intensive steel and chemical makers are negotiating exemptions. But a recession due to silent factories is likely to be shorter and less socially damaging than the one that follows, when the number of fuel-poor households exceeds 8 million this winter if prices are left unchecked.

Prioritize the energy transition

Adi Imsirovic, Senior Research Fellow, Oxford Institute for Energy Studies and University of Surrey

A coherent policy to reduce the projected explosion in heating bills this winter must also ensure energy security while still facilitating the transition to cleaner heat and power sources. None of the major politicians in the UK are currently pursuing such a policy.

The current government policy of capping prices and lower VAT payments encourages consumption and supports rich households that use more energy. Fossil fuel subsidies also discourage energy companies from investing in low-carbon sources. Getting rid of around £10.5 billion a year in fossil fuel subsidies could instead make targeted cash payments to vulnerable households.

Of the two Conservative Party leadership contenders’ proposals, Rishi Sunak’s targeted aid to poor households is a better cost-wise option than Liz Truss’ tax cuts. But his proposal for a further reduction in the VAT on energy would subsidize fossil fuels by encouraging consumption, thus failing to meet environmental criteria.

Labour’s proposed expansion of windfall taxes is arbitrary – why not tax Google, Meta, law firms or any of the many other companies that have recently announced significant gains? Taxing domestic producers like Centrica or EDF could deter investment in cleaner fuels like gas or nuclear here in the UK.

Labour’s recent price freeze proposal is also a policy of choice for the Liberal Democrats. A price freeze would be the worst option for climate change.

It would prolong dependence on fossil fuels by supporting demand that would continue to benefit Russian production and subsidizing wealthy households, which use and waste the most energy. Finally, price freezes can also lead to bottlenecks if suppliers cannot buy energy on the wholesale markets at or below the frozen price.

Target the weakest

Morten Ravn, Professor of Economics, University College London

In current conditions of rising living costs and monetary contraction (when the Bank of England hikes interest rates to cool the economy), it’s tempting for a government to provide a fiscal stimulus — tax cuts or spending increases — to soften the blow to the economy. The dilemma is that such a stimulus could make the inflation problem worse by encouraging people and businesses to spend.

Therefore, targeted measures would be most helpful at this time. High inflation and the slowdown in the economy due to higher interest rates tend to hit lower-income households harder.

Such households’ consumption baskets tend to contain more price-sensitive goods (energy, fuels and raw materials) and are more likely to be affected by the income squeeze. Policies targeted at this group could help the economy weather the crisis by protecting the most vulnerable.

Against this background, a reform of the Bank of England as proposed by Liz Truss would not be desirable. The Bank of England’s most pressing task right now is to protect its reputation for being able to offer low and stable inflation, and this requires protecting its current status.

Both Sunak and Truss have expressed a desire to reduce taxes. Truss’ plan to do so soon would likely complicate the Bank of England’s job by forcing it to raise interest rates higher and faster.

Sunak’s desire to make a tax cut later could exacerbate the slowdown in the economy in the meantime, as it would effectively imply a high tax rate today compared to the future, encouraging people to defer spending now. However, since neither Truss nor Sunak have clarified how their tax reform is to be financed, it is very difficult to further assess the consequences.

Overall, any of the current plans lack a commitment to rapid implementation to protect the most vulnerable groups in society in the very challenging economic situation we are currently experiencing.

Choose to invest and grow

Shampa Roy-Mukherjee, Associate Professor of Economics, University of East London

The Tory leadership race has used the country’s poor economy and cost of living crisis as a political pawn. Both candidates have proposed economic policies they believe would appeal to the Conservative Party’s 160,000 members, who are mostly wealthy white British males with an average age of 57.

Much of the debate in the Tory leadership contest has focused on tax policy. The competition’s front runner, Liz Truss, claims her tax cuts will lead to economic growth and avoid the recession recently forecast by the Bank of England.

However, unless the economy shows significant and sustained growth, these tax cuts could result in further reductions in spending on public services and wages, and increased public borrowing. They could also increase inflation by encouraging people and businesses to spend more unless offset by higher interest rates set by the Bank of England.

The other contender, Rishi Sunak, has proposed cutting taxes once inflation is under control by reducing income tax by 3p by 2029 (on top of the 1p cut promised in April). But his plan is sparsely detailed and would only benefit people who work. Furthermore, unless these cuts are backed by strong economic growth leading to higher tax revenues, the economic fallout could be the same as Truss’ proposed tax cuts.

Neither candidate has proposed supply-side policies that prioritize innovation, growth and domestic investment. These could include regulatory reforms, labor market flexibility, upskilling of the workforce and openness to trade.

Such measures would boost growth and help fight inflation by increasing competitiveness, efficiency, productivity and ultimately real wages – all of which have been negatively impacted by Brexit and the COVID pandemic. If supply-side problems are not addressed, this could lead to a further decline in productivity and real wages over the next decade.