Should we have a one-off cost of living payment?

Written by Andre Ugalde - Winchester College

Advantages

Raising living standards

A one-off cost of living payment can provide immediate financial relief to low-income households by temporarily raising their disposable income. Households can spend the money to meet essential needs such as food, utilities and rent, which will improve their living standards.

Figure 1 - (iStock/The Independent)

Assuming they act rationally, households are likely to spend the money incrementally to support ongoing living costs, which cannot be paid for in one instalment.

Is it a safer option?

While this transfer payment can support low-income households, it also mitigates the risk of creating an unemployment tramp. If the payment were to be recurring, some households would find that the opportunity cost of working is not substantial enough to justify employment over living solely on these transfer payments.

Consequently, the financial incentives to work weaken due to the combined impact of the welfare benefits and work-related expenses such as commuting costs. This was seen in the UK, where the economic inactivity rate in 2022 was 22% (Economic inactivity, 2023).

Conversely, a one-off payment provides immediate support without the perception of continuous income, thus not discouraging employment.

Growth and reinvestment

Issuing a one-off cost of living payment will increase economic growth. Low-income households will have a high marginal propensity to consume, meaning that they will likely spend a substantial portion of any additional income they receive. For example, a similar cost of living payment of £326 in July 2022 resulted in an increase of spending by approximately £130 the next month. (Lump-sum cost of living payments poorly designed to alleviate deprivation, 2023) 

As consumption is a component of aggregate demand, increased spending shifts aggregate demand from AD1 to AD2. The multiplier effect amplifies this impact, causing further increases in real output (pushing AD2 to AD3) due to secondary spending cycles.  

As economic growth rises, the government will receive more tax returns, which can act as a hypothecated tax to fund green energy initiatives like wind farms. This can deglobalize our energy supply, improve self-sufficiency, and reduce costs as green technology becomes more commonplace and affordable, as seen in the chart below.

Figure 3 - International Renewable Energy Agency (IRENA), Renewable Power Generation Costs in 2021, July 2022

Disadvantages

Can we be trusted to spend responsibly?

Before implementing a one-off cost of living payment, the government should carefully consider individuals’ spending behaviours. Thaler’s concept of Mental Accounting suggests that Windfall payments, such as unexpected bonuses, are more likely to be spent on discretionary items because people view this money as a bonus rather than part of their regular income.(Thaler, 1985) This illustrates how people treat money from different sources as distinct and separate funds, misunderstanding its fungibility (that all money is the same regardless of its source).

Hence, recipients may use a one-off cost of living payment for non-essential goods instead of necessities. Moreover, the IFS reported that lump-sum cost of living payments led to a spending pitfalls, stating, “large one-off payments, rather than smaller regular payments, are less useful for long-term budgeting”. (Lump-sum cost of living payments poorly designed to alleviate deprivation, 2023) Thus, a one-off payment may not improve households’ financial situations as intended.

Demand-pull inflation

While a one-off cost of living payment is intended to alleviate the cost of living crisis, it may worsen it. Research indicates that lump sum transfer payments cause consumption spikes. (Lump-sum cost of living payments poorly designed to alleviate deprivation, 2023) Since approximately 60% of aggregate demand is composed of consumption (GDP and me, 2016), this will push aggregate demand outwards substantially, creating demand-pull inflation. This not only negates the benefits of the transfer payment but can significantly worsen living standards. As this demand-pull inflation sets into the economy, prices rise while consumers, having spent their lump sum payment, find their purchasing power diminished.

Without continuous transfer payments, their ability to pay for basic necessities and goods is even further reduced. This is a form of government failure, where the costs of their intervention has resulted in a net welfare loss due to the law of unintended consequences. However, recent data may suggest that purchasing power may not erode as much as expected.

Figure 5 - (BBC News, 2024)

Figure 5 illustrates that wages are currently rising faster than prices: there is a higher derived demand for labour due to firms needing to produce more goods. In this way, purchasing power may not erode significantly even in the face of potential demand-pull inflation.

Equivalence

Assuming households act rationally and have sufficient information, Ricardian equivalence states that expansionary fiscal policy may not be effective in stimulating aggregate demand. A transfer payment is likely to be financed by national debt, which is repaid by raising taxes. Forward looking households may save the payment if they foresee that it will be funded by future tax hikes. This is illustrated in figure 6, where an increase in transfer payments in the short term will lead to a fall in long term disposable income as taxes will inevitably increase.

Figure 6

Aggregate demand may not increase as much as expected if people save they payment instead of spending it, reducing the fiscal policy’s effectiveness. However, not all households will choose to save due to bounded rationality and incomplete information: they may not anticipate future tax increases. The transfer payment is principally aimed at low-income households, who are likely to spend it immediately to support their living costs because they have a high marginal propensity to consume. Therefore, it may be unrealistic to assume many households will save the payment.

Verdict

While a one-off cost of living payment may offer benefits and ease of administration, it has some fatal flaws. To maximise citizen welfare, a hybrid welfare scheme could be more effective. Staggering payments over 12 months could prevent demand-side spikes and avoid long-term employment disincentives. Moreover, targeting payments to those in need rather than distributing them universally would be significantly more cost-effective and equitable.

Sources:

BBC News (2011) ‘UK inflation rate: How quickly are prices rising?’, 14 January. Available at: https://www.bbc.com/news/business-12196322 Economic inactivity (2023). Available at: https://www.ethnicity-facts-figures.service.gov.uk/work-pay-and-benefits/unemployment-and-economic-inactivity/economic-inactivity/latest/ GDP and me (no date). Available at: https://www.ons.gov.uk/visualisations/dvc396/index.html Labour market overview, UK - Office for National Statistics (no date). Available at: https://www.ons.gov.uk/employmentandlabourmarket/peopleinwork/employmentandemployeetypes/bulletins/ uklabourmarket/august2023 Lump-sum cost of living payments poorly designed to alleviate deprivation (2023) Institute for Fiscal Studies. Available at: https://ifs.org.uk/news/lump-sum-cost-living-payments-poorly-designed-alleviate-deprivation Thaler, R. (1985) ‘Mental Accounting and Consumer Choice’, Marketing Science, 4(3), pp. 199–214.