Demand and supply: why the Budget fails on A-level economics

At first sight, the 2013 Budget seems to mean good news for prospective homebuyers and working parents. Under the new Help-to-Buy programme, the government will act as a guarantor for mortgages which are only backed by modest deposits. The programme will make it more attractive for lenders to offer mortgages of this type, as they will now be able to achieve the same rate of return at a lower risk. Effectively, what this programme does is shift the credit risk from lenders to taxpayers. At the same time, childcare costs of up to £6,000 will now become tax-deductible at the basic rate of income tax (20%). This is as if childcare costs were added to working parents’ Personal Allowance, or in other words, they can now pay childcare costs out of their gross income rather than their net income, saving up to £1,200 per year.

Both of these measures, though, share the same fundamental flaw: they are attempts to address supply-side problems through demand-side measures. They will therefore at best deliver a very poor bang for the buck, and at worst, they will do no more than push up prices without improving access.

A demand-side subsidy can make sense when a product is easily accessible to the vast majority, but out of reach for a small number of people. Most of us can afford a phone, for example. Yet a few of us cannot, and trying to address this problem through the supply side – making the provision of phone services more competitive – would not lead very far: that market is already fairly competitive, and even though there are surely some efficiency reserves left, they would not be enough to make the product available to those who have no or virtually no income of their own. This is why in this situation, a demand-side instruments like income support can make sense.

Yet the markets for childcare services and homes are fundamentally different. Childcare costs in the UK are among the highest in the world. In most of continental Europe, a similar proportion of children are enrolled in childcare services, but parents’ out-of-pocket payments are substantially lower, and only Denmark spends more on childcare subsidises. Some countries have high levels of private childcare spending, others have high levels of public childcare spending, but the UK is almost unique in combining high levels of both private and public spending with mediocre outcomes. There is nothing intrinsically expensive about childcare. Costs are pushed up by restrictive staff-to-children ratios, combined with expensive safety inspections and complex requirements about day-to-day details of service provision. And while, to be fair, the government is doing something on that front, this budget makes clear that their main approach is to whitewash the problem through higher levels of subsidies.

The mortgage subsidy scheme represents an even worse variant of the same basic flaw. The childcare measure is merely cost-ineffective, but it might at least make childcare a bit more affordable for some families. This is because the interventions in the childcare market do not make supply inelastic – they just make it unnecessarily expensive. (Graphically speaking: the problem is not that the supply curve is too steep, but that it is too high up.) In the housing sector, however, supply has become virtually static. In 1995, the UK was building 36 new homes per 10,000 inhabitants, a risibly low rate by international standards. Then came a twelve-year-long surge in house prices, which, in any half-way functioning market, should have led to a construction boom. Yet the completion rate of new dwellings actually fell for a while, before recovering to reach a – still risible – 38 homes per 10,000 inhabitants by 2007.

It’s not the demand side of the housing market that needs sorting out. And there is no need to spell out the implications of pushing up demand under conditions of fixed supply.

Childcare is inherently expensive, Kristian, because it is inherently labour-intensive. Regulations on ratios might make it more expensive but it is never going to be anything other than labour intensive. You are, however, correct about the bloated regulatory costs. To give one example: My wife works in an independent school in the 'Reception' year. Because "rising fives" are entitled to childcare vouchers that can be used for that year, the local council insists on 'moderating' the provision. This means pre-moderation inspections and post-moderation inspections and a whole raft of bureaucracy in-between. This is for a school department which has already been recently inspected as part of the whole school inspection regime - and rated as "outstanding" on every single criteria, without exception.
HJ, it's quite possible that I've initially overestimated the impact of these ratios. Still, I wonder what else explains the big differences in the international comparisons (see p. 92 in my book; I can't copy all the figures all in here). Can that all be due to inspections? Or is there something else?
Kris, ten years ago, my wife briefly thought about going into childcare at home when our kids were young. The list of forms to fill in, hurdles to jump, authorities with their own checklists (Ofsted, local authority, local health authority, fire brigade, CRB checks on all staff, GP test for illnesses, health and safety blah blah blah) was terrifying, what it boiled down to was six months of bureaucracy - the inspections all had to be in a certain order, one after another with weeks of gaps in between - and actually having paid staff on the payroll before she/we could even accept our first paying guest. I am sure it has got much worse by now. So there is a massive barrier to entry. Once you are open, you can charge as much as you like and the subsidies just push up the price (they cannot be competed away by new entrants). That said, an average one adult to four kids ratio seems OK to me, so if one worker is low paid £16,000 that's staff costs of £4,000 per child per year and you can add on 50% at least for overheads, rent, NICs and so on, so thats £6,000 per child = £120 per week for the most basic basic set up. As to Osbornes Brownian housing boom, this is like negative land value tax, it will makes things far far worse and just end up with bankers and large landowners getting even richer for doing even less. The answer might be reduce barriers to entry/increase supply, but that's just a pull. What the rent seekers really need is some low cost competition from council run nurseries that offer places for £80 a week (schools are free - why not nurseries) and loads of council housing where the council stubbornly charges £80 a week rent for whatever size a home and that will push prices down as well. A bit of unfair competition if you like.
Kris, no I don't think it's all down directly to the cost of inspections. However, as Mark Wadsworth points out above, childminding regulations/inspections have been hugely bureaucratised in the last decade or so, leading to a fall (of about half, I believe) in the number of people prepared to be childminders. Thus does not surprise me at all since they now have the whole EYFS curriculum imposed on them. My wife has to deal with this in her school and you just wouldn't believe what is involved (most of it to no good purpose). The point is that childminding was always the least expensive form of childcare so now people increasingly have to use more formal provision such as day nurseries. You then get into the costs of premises which, as you know, are highly inflated in this country. These things conspire to raise the cost. I do not doubt that lower ratios can sometimes be manageable but, frankly, if you ask anyone who actually has to do the job, there is limited scope.
Mark, HJ: Makes sense; too bad that that kind of stuff is hard to quantify.

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