Decomposing Income Changes in the UK in the 2000s

Household disposable income can be regarded as a function of several attributes: individual and household characteristics, the returns to these characteristics (e.g. in terms of wages) and the tax-benefit system. Between 2001 and 2011 in the UK, there have been various changes to these attributes. For example, in regard to earnings we have seen a decline in real full-time weekly earnings between 2007 and 2013 and narrowing of the gender gap for median full-time weekly earnings (ONS, 2014). There has been a large increase in the proportion of tertiary students, part-time male workers and ethnic minority groups (author’s calculations in the Family Resources Survey). When it comes to fiscal policies, examples of the changes in the period are the real increase in the National Minimum Wage, the reforms to Child and Working Tax Credits, and the increase in the top marginal tax rate. All these changes have resulted in stable income inequality level and a small decline in relative poverty (DWP, 2013).

In recent years, there has been growing literature on income decomposition that has tried to disentangle the effects of different factors on poverty and inequality. It has paid particular focus on the UK and on the effect of tax-benefit policy changes vs other things (see e.g. Bargain & Callan, 2010; Bargain, 2012; Brewer & Wren-Lewis, 2012; Paulus et al., 2014). The evidence suggests that the direct effect of policy changes has been to reduce poverty and inequality, while 'other' things lead to the opposite results. What is the effect of 'other things' a result of, remains to be addressed.

There is also a large body of literature that focuses on changes in wages and employment in the UK (see e.g. Dolton et al., 2010; Lindley & Machin, 2013; Gregg et al., 2014). However, this literature does not address how changes in wages and employment translate into changes in the entire household disposable income. The automatic stabilisation effect of the tax-benefit system has not yet been fully quantified.

This paper tries to address the gaps in the literature. To our knowledge, it is the first one to decompose changes in the entire distribution of household disposable income in the UK in 2001-11 due to fiscal policy changes (policy effects), benefit take-up (take-up effect), changes in population characteristics and the returns to these characteristics (non-policy effect). It also isolates the automatic stabilisation effect of the tax-benefit system. The paper builds on the existing decomposition literature and combines the use of microsimulation techniques (see Bargain & Callan, 2010) and parametric and non-parametric methods (see Bourguignon et al., 2008). We decompose the pre-recession (2001-07) and recession (2007-11) periods separately.

Our results are consistent with the existing evidence showing that policy effects in the UK have reduced the level of income inequality while non-policy effects have increased it. Non-policy effects explain a significant share of the changes in household disposable income. For example, in both periods higher education expansion has lead to income increases for the richest decile groups and so, to increased income inequality. Internal migration (moving out of London) has lead to significant income increases, but these have been almost entirely off set by the negative income effects from emigration. Finally, the increased level of inequality due to the non-policy effects would have been even higher if it was not for the automatic stabilisation effect of the tax-benefit system. We highlight the role of the tax-benefit system in reducing income inequality, which may be bigger than previously thought in the literature.