Should Governments Protect Citizens From External Shocks To Living Standards?

By Simon Wren-Lewis, November 26, 2024

Simon Wren-Lewis is Emeritus Professor of Economics and Fellow of Merton College, University of Oxford. He was one of the seven members of the UK Labour Party’s 2015-2016 Economic Advisory Committee.

One of the themes in post-US election analysis, including my own, has been the shock to real income caused by recent commodity prices increases (energy and food). The idea is that less engaged voters (low information voters) blame the government rather than Russia or the pandemic for these shocks, which is why the last few years has been a disaster at the polls for incumbents.

In that analysis I wrote:

Economies can get hit by negative external shocks, and these are likely to happen increasingly often because of climate change, foolish populists or dictators and so on. No government has the power to stop all these events impacting negatively on their citizens.

When it comes to external price shocks of the kind experienced after the pandemic, the second sentence needs much more justification, as many governments did attempt to shelter voters from some of the worst energy price increases. Furthermore some suggested at the time, and continue to suggest, that governments should have done more along these lines. Indeed I wrote in favour of using windfall taxes on energy producers to pay for consumer support here.

It is helpful to make some distinctions about who is gaining when commodity prices rise, and who is losing. Gains could be going to the profits of companies that can be taxed by the government (e.g. domestic energy producers), or the incomes of individual domestic producers of these commodities (e.g. farmers). Alternatively these gains could be going to firms or individuals outside the country and so cannot be taxed by the government.

I discussed the case of where the gainers can be taxed in detail in my post on an energy windfall tax, so I will just summarise the main points here. First, if the price increases are caused by some global supply shortage (caused by wars or whatever), higher prices are doing the job of equating supply and demand. Any transfers have to ensure that they don’t significantly undo the incentive for consumers and firms to economise on the scarce commodity, and for producers to expand supply. On the latter, oil and gas is something of a special case, because we don’t want producers to increase the supply of those commodities due to climate change.

For most countries the gainers are overseas and cannot be taxed. The impact on consumers can still be cushioned by their governments, but what item in the government’s budget identity should change to match this handout? Raising taxes would be straightforward, but there is a danger of simply replacing one cause of discontent (lower real incomes due to higher commodity prices) with another (lower incomes due to higher taxes).

Alternatively handouts to consumers could be paid for by increasing the stock of government debt or reserves held by banks. This cannot be done if the price shock is permanent, and often governments do not know if price shocks will be permanent or temporary, but support can be given on the assumption it is temporary and then phased out if the shock is more persistent than originally thought. To the extent that deficit funding is just deferred taxes [1] people end up paying for the handouts at some point, but because less engaged voters normally don’t see deficits in that way (or believe they or those they care about won’t pay the higher future taxes) this form of financing will be more popular than using immediate tax increases. Whether the macroeconomic situation justifies deficit financing of handouts (a fiscal stimulus) is another matter, but that is likely to be very context specific, so is difficult to discuss in general terms.

I know it seems increasingly pointless these days, but let me first ask whether shielding consumers from some of the impact of a global price shock is optimal in any macroeconomic sense. Suppose deficit financing of any handouts essentially involves delaying rather than avoiding payment by consumers (i.e. they avoid some costs today, but pay more in higher taxes in years to come.) Here I think we need to distinguish between different types of consumers.

If the government partially compensates consumers for a price shock, but consumers eventually end up paying for the handout through higher taxes, the government is essentially smoothing the impact of the shock on consumer incomes over time. Most consumers have sufficient savings to do this themselves, and don’t need the government to do it for them, so government action here is pointless but fairly harmless.

However a significant minority of poorer consumers do not have the ability to smooth the impact of the shock on their incomes, and would find it difficult, impossible or just too expensive to borrow to do so. For this group the state can usefully act as an income/consumption smoother.

There is also a redistributive case for supporting poorer consumers after a commodity price shock. If the commodities are either energy or food, these are necessities, and higher prices will increase absolute and relative poverty. [2] That suggests there is an economic case for giving handouts to poorer households after an increase in the price of commodities that are necessities, paid for by higher taxes on the more prosperous, either at the time of the price shock (politically unpopular) or later (through deficit financing).

Returning to politics, would handouts following a commodity price increase focused on poorer households have a significant political impact in shielding the government from the unpopularity of higher prices? The obvious problem is this would leave large numbers of less engaged but reasonably well off voters unhappy with the government. Indeed for many, handouts for poorer households might increase their displeasure. As I noted here, socially conservative voters are radicalised to the right in bad times because of concern about the ‘undeserving poor’.

This makes it very tempting for governments to extend compensation to all or most consumers, provided they can get around or ignore any fiscal rules that limit deficit financing. Yet even in this case it may have a limited effect in political terms. Handouts after prices have increased to compensate consumers for lost income leave the shock of paying higher prices in place, and for less engaged voters it may be this that really counts. (In the US case, where real wage growth has been strong recently, the idea is that people think the government is responsible for higher prices but they are individually responsible for getting higher wages.)

This problem could be avoided if subsidies were in a form that prevented the prices paid by consumers rising in the first place, but doing this ends the incentive for consumers to substitute away from the expensive commodity. If all governments did this then prices would just rise further in order to clear the market.

So the payoff for a government that attempts to cushion the impact of a commodity price shock on consumers by spreading its cost over time is uncertain. Which in one sense we already would have suspected, because while many governments did provide support after energy prices rose, we know that among those that were up for election recently, none has survived.

Footnotes

[1] Whether deficit funding has to be just delaying tax increases is a minefield issue I have discussed many times, and don't want to reopen here. For any country that tries to stabilise its debt to GDP ratio over the medium term it will be deferred taxes (or reduced government spending).

[2] Compare two annual post-tax household incomes: £30,000 and £100,000. Suppose spending on food and energy is £10,000 and £20,000 respectively. That leaves £20,000 and £80,000 to spend on other things, so the poorer household has a quarter of the amount of the richer household remaining. After a price shock of 50%, that ratio becomes £15000:£70000, so the poorer household has just over a fifth of the amoount of the richer household to spend on other things.

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