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The coalition's £11bn stealth cut: switching from RPI to CPI

A technical quirk will allow the government to skim small amounts each year from lower income households.

What's the biggest cut George Osborne has made as Chancellor? Scroll through the Budget Red Book and the answer may surprise you. There's the removal of child benefit from higher rate taxpayers, clocking in at £2.5bn by the end of the parliament, and there's the time limiting of incapacity benefit which will save, eventually, around £1.2bn. But the biggest cut of all makes both moves look like minnows. It's the switch from the Retail Prices Index (RPI) to the Consumer Prices Index (CPI) as the measure used to calculate tax credits, benefits and public service pensions. It will save a colossal £11bn a year by 2015-16 -- and you won't be alone if you know nothing about it.

The switch to CPI is the biggest single stealth move by a chancellor in recent memory. And with the money coming mostly from the budgets of lower income households, it's beholden on us to give it a little more attention. The decision was made in Osborne's first budget as Chancellor in June 2010 and it was effective from April this year, at which point the indexing of all benefits, tax credits and public service pensions switched from the higher RPI measure of inflation (currently at 5.2 percent) to the lower CPI (currently at 4.5).

Although the annual differences in the two measures are small -- on average, the CPI has been around 0.7 percentage points lower than the RPI in the past decade -- they quickly get big over time. Cumulatively, prices under the RPI have risen 53.6 per cent since 1996 and by 35.6 per cent on the CPI. Those are dramatic differences in public spending, and they feed through directly into household budgets. If, for example, you're a working parent who received £500 a month in tax credits in 2010, then under the old system, your payments would rise to around £720 by 2020; under the new rules they'll rise to around £625. Have no doubt that a direct cut in benefits of the same level would have aroused considerably more ire.

To date, what little argument there's been over this issue has come down to technical details about the way the two measures of inflation are calculated. Put simply, there are two main differences. First, the CPI covers a smaller basket of goods than the RPI, excluding, for example, mortgage interest payments, Council Tax, vehicle excise duty and TV licenses. Second, each measure is calculated using a different mathematical formula. Now, as you might suspect, this quickly gets horribly complicated (for the masochists there's a full explanation here). But the important point is that, because of this difference in methods, the RPI would be (currently) around one percentage point higher than the CPI even if it covered the same set of goods. That, say some, means that the RPI overstates inflation.

No doubt the stats geeks among us could stay up all night debating such things. But amidst all the back and forth over "RPI versus CPI", there remains an awkward truth for the CPI gang: the reason the CPI is a poor measure of the cost of living is that was never intended to be one. It was invented by statisticians as a macroeconomic tool, not least for use by central banks, that would give a comparable measure of price-changes across different countries. In fact, the reason the CPI excludes certain important costs related to housing (unlike the RPI) is not that they're unimportant, but that European countries couldn't agree on a comparable way of measuring them.

For anyone who's still with me, it should be clear why this has proved such an effective stealth cut. It's complex, it's slow and it's technical. But in this fog of confusion, something critical is at stake. The impact of changes to indexing rules may not be immediate, but it is profound. As Britain's pensioners discovered to their cost in the 1990s, after Margaret Thatcher broke the earnings-link of the state pension, the result of slower annual increases in income reveals itself only slowly; it takes the form of a strange and uncomfortable sense, growing over time, that you're falling behind.

Of course, ultimately this is a decision made in the pursuit of fiscal sustainability. As the Chancellor is fond of saying, in times like these there are tough decisions to be made. But the truth is this £11bn stealth cut is not tough -- it's easy. It means skimming small amounts each year from the budgets of lower income households, in the hope you'll be out the door before they notice. Had the CPI not existed, the Chancellor would have found himself making these decisions up front, and having to justify them, instead of hiding behind a fortuitous statistical quirk.

If there's a lesson in history here for the Chancellor, it's perhaps to take care. Thatcher's decision on pensions is well remembered, and not fondly. And if Osborne is a fan of retro movies, he might do well to the heed the lessons of that 1990s classic, Office Space. In the film, three humdrum office workers come up with a plan to make billions by skimming a fraction of a cent from every transaction at a major US bank. Within hours the money floods in. But then they take too much and start to panic -- and rightly so. If there's one thing that's dangerous about stealth cuts it's the anger of those who find out.

James Plunkett leads the Resolution Foundation's Commission on Living standards.