In 2012, the UK passed the Welfare Reform Act – a piece of legislation aimed at reducing public spending. It included cuts to several welfare programs, like housing benefits, child benefits, or disability living allowance.
Supporters of the policy argued that it would help restore fiscal discipline and reduce dependency on social programs. Critics viewed it as placing a disproportionate burden on lower-income communities.
More than 10 years later, when public finances are under severe strain in many countries, researchers are using the reform as a laboratory to better understand the impact of welfare cuts. Among them are Jim Goldman, Assistant Professor of Finance at McGill University, and Manuel Adelino, Professor of Finance at Duke University.
In a working paper, they show that low-income households tend to bear a double burden when welfare transfers are cut. The economic mechanism behind this has implications well beyond this specific reform.
A feedback loop hiding in plain sight
The first impact of the cuts is direct and straightforward: a household that depends on government support loses income when that support is removed. But Adelino and Goldman’s key insight is what happens next.
“Low-income households have a high marginal propensity to consume,” said Goldman.
They tend to spend a high share of their income, and they mostly do this locally: in grocery stores, cafés, retail stores, or for everyday services. When their benefits are cut, they adjust by reducing that spending. And because households whose benefits are cut are also disproportionately employed in the local businesses where their spending happens – food and accommodation, retail trade, and similar sectors – the negative demand shock quickly becomes an employment shock for the same group of people.
“The data clearly show that, after the reform, businesses dependent on local demand don’t do as well in regions where benefit cuts are deeper,” said Goldman.
This overlap between where low-income households spend and where they work drives the segmented nature of the feedback loop. Higher-income households, who are more likely to work in finance, information, or other sectors less sensitive to local demand, are largely unaffected. The negative employment outcomes in affected areas concentrate among financially fragile individuals more likely to be affected by the benefit cuts in the first place.
The balance sheet consequences
The effects don’t stop at income and employment. Adelino and Goldman trace the impact through to household consumption and household finances, and the picture there is equally striking.
“We see outstanding balances of credit card debt increasing and also account overdrafts,” said Goldman.
Faced with a loss of income and, in harder-hit areas, a lower likelihood of employment, low-income households reduce consumption and increasingly turn to unsecured debt. The reform is associated with a significant decline in consumption expenditures, and a rise in credit card balances and bank account overdrafts among financially fragile households. At the same time, access to formal loans falls – meaning the cheaper channels for obtaining credit become less available.
This deterioration in household balance sheets represents a less visible but lasting consequence of the cuts. New analyses suggest that personal bankruptcies increase in geographic areas most affected by benefit cuts. This doesn’t show up in employment statistics but can shape the financial fragility of affected households long after the initial shock.
These findings don’t look at the benefit side of the program and are by no means the final word on the mechanics of welfare reform, said Goldman. But by tracing each link in the chain – from benefit loss, to reduced local spending, reduced employment likelihood, and balance sheet stress – they do offer insight into how welfare cuts affect different regions, businesses, and households. Understanding these effects might help governments design austerity measures that better anticipate how costs are distributed.
“When designing needed public spending reduction programs, you want to think about how you can smooth out the effect of the shock,” said Goldman.
Read Goldman and Adelino’s working paper: “Segmented Multipliers: Evidence from Welfare Cuts.”
This article was written by Eric Dicaire, Managing Editor, McGill Delve.
