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

Adam Corlett, Economic Analyst and Stephen Clarke, Research and Policy Analyst, Resolution Foundation

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 90th percentile compared to the 10th, 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.

Useful links

OECD work on inequality

OECD work on the United kingdom

How the changing shape of the UK workforce has started to drag down wages

Click to download the report
Click to download the report

Today’s post is by Laura Gardiner, Senior Research and Policy Analyst at the Resolution Foundation

It’s clichéd to say that the most certainty you can take from any economist’s prediction is that it will be mistaken, but many got their forecasts for 2014 horribly wrong. At the beginning of this year, commentators were fairly united in hailing the ‘year of the pay rise’, with most expecting the UK’s enduring real wage squeeze to finally turn the corner, and some predicting that pay would bounce back quite rapidly over the course of the year. Two thirds of the way through 2014 this has not come to pass and the outlook has been repeatedly downgraded. For example the Bank of England now doesn’t expect a return to real wage growth until the middle of next year. Looking back, many of us are left wondering why we were all far too optimistic.

In answering this question some have pointed to the fact that the official data looks worse than other pay surveys, with pay settlements, for example, running at or above inflation during 2014. A major difference between the official Average Weekly Earnings (AWE) series and other surveys is that AWE, as well as capturing year-on-year changes in employees’ pay, will be affected by changes in the overall shape of the workforce. Do such ‘compositional’ factors shed light on what’s been happening to pay of late?

New analysis by the Resolution Foundation comprehensively assesses the impact of the changing make-up of the workforce on wages since the mid-2000s. It looks across a number of job and employee characteristics, including sector, occupation, age, sex, qualification level and job tenure, in order to understand how much of pay growth is down to pay changes within groups, and how much is compositional – owing to a shift in the proportion of employees across groups. For example, as others have highlighted previously, recent increases in employment in lower-paid sectors and continued contraction in the finance industry are likely to have dragged down on average pay growth across all employees.

While changes in the industrial mix look to be putting downward pressure on average pay, other factors, such as strong full-time employment growth in the last 12 months, are likely to be pulling in the opposite direction. To disentangle the pushes and pulls our analysis looks at all factors together, controlling for the overlap between each, to understand the overall direction in which compositional changes are driving wages and the relative importance of different job and employee characteristics to this. The overall compositional effect is shown in the red bars in the the following chart.

nominal wages

We find that between 2006 and 2013 the compositional effect was always positive, acting as a boost to pay growth. This is to be expected due to long-run shifts in the workforce such as rising qualification levels – a compositional boost to pay could be regarded as a normal state of affairs. It’s sobering to think that, had it not been for these changes, Britain’s already huge pay squeeze would have been a third deeper.

However, recent months mark a departure from this trend, with the overall compositional effect turning negative for the first time in the period we’ve looked at. This is due to negative effects from factors including occupations, age and job tenure outweighing the positive impact of rising hours and qualification levels, as the chart below shows.

compositional effects

Some of these drag effects are probably part of a good news story – the entry and re-entry of younger and less experienced workers reflecting rapid employment growth and falling youth unemployment this year. With the UK’s employment rate having returned to its pre-recession peak these effects are likely to fall out next year – we may be observing the temporary ‘growing pains’ of recovery. By contrast, the drag effect of the shift towards lower-paid occupations – the largest single compositional factor affecting pay growth – is more worrying as it could represent a longer-term change in the labour market.

To return to our opening question, this analysis does suggest that compositional factors help explain why pay growth in 2014 has looked quite so bad. We find that without the reversal in compositional effects between 2013 and 2014, real pay in the first half of 2014 would have grown by a very modest 0.1%, rather than the 0.8% fall we’ve experienced. So there may be reasons to give those economists who called 2014 wrongly a break this time round, although 0.1% real growth hardly represents a boom.

This analysis shows the important role that the changing make-up of the workforce plays in our understanding of average pay growth, for which reason we’ll be keeping a close eye on these trends as more data becomes available. But it mustn’t hide the fact that a generalised and dramatic slowdown in pay growth within sectors and different groups of workers has been by far the biggest factor explaining falling UK wages since the financial crisis (shown by the decreasing size of the grey bars on the first chart). Ultimately, prospects for ending the pay squeeze rest on a return to productivity growth and the willingness of employers to ensure that workers obtain a fair share of these gains.

Useful links

OECD Employment Outlook 2014 – Key findings for the United Kingdom

Entrepreneurs – stuck on the starting blocks?

Innovation is sometimes thought of solely in terms of new inventions. But, as the OECD’s Andrew Wyckoff explains, it’s much more than that – Apple’s iPod was innovative, not because it contained much in the way of new technology but because of clever design and shrewd marketing.

That sort of innovation can drive economic growth. As the OECD’s Innovation Strategy demonstrates, there are real obstacles to overcome in many countries first.