Expert View: It isn't the middle class that feels the fuel-bill chill

Higher prices encourage improvements in energy efficiency
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Inflation has been in the news lately, mainly because of the massive rise in household energy prices, up nearly 30 per cent over the year. This has provoked the claim that "middle class" inflation - large houses to heat, large cars requiring a lot of petrol to run - could be as high as 10 per cent.

The claim is wrong. The hike in energy prices actually bears disproportionately on the less well-off because energy accounts for a much larger part of their spending.

The costs of maintaining large middle-class homes and cars are matched by equally large incomes.

The Office for National Statistics' Family Expenditure Survey tells us that 6 per cent of the spending of the poorest fifth of households is on electricity and gas, compared with only 2 per cent for the richest fifth. And while it is true that nearly 5 per cent of the spending of the better off is on road fuel, against just 2 per cent for the poorest fifth, petrol prices have only gone up by 7.5 per cent in the year to August. So the 30 per cent rise in household energy is a much greater burden on the poor than is the 7.5 per cent increase in road fuel on the better off.

What does the hike in domestic fuel costs imply for the inflation rate faced by the poor?

Official inflation is an average of the price increases in all the items we regularly buy, weighted according to the amount we spend on them. If we spent all our money on electricity and gas, our inflation rate would be 30 per cent. If we spent only half (and the other half on items whose price hadn't changed), our inflation rate would be 15 per cent. In reality, energy costs account for just over 3 per cent of total spending for the average household, so that 30 per cent increase has contributed 0.9 per cent to the rate of inflation. But the fuel increase adds 1.8 per cent to the price inflation experienced by the poor.

This is much less dramatic than the alleged 10 per cent "middle class" inflation. But an additional percentage point on the overall inflation rate is actually a big deal. In a typical year, real living standards grow by 2.5 per cent as household incomes grow that much faster than prices. The massive hike in fuel prices last year could have wiped out more than a third of that increase for the average household, and two-thirds of the real increase in living standards for the poor (assuming their incomes grew at the same rate).

Dramatic fuel price increases last made headlines when VAT was controversially imposed on domestic energy by the Conservative government in the 1993 Budget. The move was intended to put up household fuel prices, in two steps, by the full 17.5 per cent VAT rate. That increase would, according to Treasury figures, have raised £2.3bn a year in extra revenue, making households worse off by that amount (as it is, then chancellor Norman Lamont introduced the first rate, of 8 per cent, but Labour halted any further increase).

Yet that 30 per cent rise in domestic fuel over the past year has a much larger impact on households, reducing their real disposable income by 0.9 per cent, or around £7.2bn. Had it been a Budget measure, it would have been very significant (right up there with the 2002 rise in national insurance contributions) and very unpopular.

These days we are net importers of oil and gas, so fuel price increases are a new burden on the UK economy.

But there is a silver lining: energy costs have become a new kind of global economic stabiliser. When the world economy starts to overheat, energy prices rise and cool off demand, which is one reason why UK consumer spending was weak last year. This happens automatically, without any need for (unpopular) government intervention.

Moreover, higher fuel prices encourage much-needed improvements in energy efficiency and associated reductions in carbon emissions, again without the need for the government of the day to act.

Bill Robinson is director of economics at Pricewaterhouse-Coopers