What does the furlough extension mean for the UK economy?

The economics of furlough

Furlough is a term few of us were aware of until the coronavirus lockdown, but it has become a lifeline for many people and businesses.

Now the government has extended the scheme until the end of October 2020, what does the extension mean for the UK economy?

On Tuesday (12 May), Chancellor of the Exchequer Rishi Sunak announced the extension of the furlough scheme.

Basic economics argues that increases in unemployment during a crisis event, such as the COVID-19 pandemic, pose a significant concern to policymakers.

At the same time, lay-offs could slow down any expected and potential economic recovery, since rehiring and training workers may be substantially costly for firms. This is particularly true for workers who have acquired job specific skills. In their case, it may be beneficial for firms not to let them go.

However, as firms face on-going weak demand for their products or services, they may not have the financial means to keep paying these workers, particularly in the presence of credit constraints, which are often exacerbated during a crisis.

In the case of the COVID-19 pandemic, due to the disruption of major supply chains, and the weakening of aggregate demand through individuals’ lower consumption cash flows, there has been the case for UK government intervention through furlough wage subsidies. The hope is it could potentially limit lay-offs and speed up economic recovery by eliminating search and training costs, especially over the post-COVID19 era.

Providing a consumption boost

As always happens with economic events, there is a bright and a relatively dark side. On the bright side, the good news is that many people keep their jobs, while the scheme provides a continuous boost to consumption cash flows and, therefore, to aggregate demand, thus sustaining national income and employment levels.

It is known that rising unemployment threatens to severely put a brake on the economy. More specifically, such a case not only threatens to have negative spillovers at one time, but also to push the economy into a vicious cycle of lower expenses, lower consumption and investment, higher unemployment and so on, putting permanent detrimental effects on any expectations of recovery. Such outcomes are expected to result in productive capital being foregone, while the long-term productivity of the economy is pushed further downwards.

The taxation context

On the dark side, while these positive challenges should be seriously considered and cannot be overlooked, they need to be glanced within the context of tax policies. In other words, the state expenses to support such a furlough scheme, in combination with the deferring of the majority of income tax payments and the declared tax holidays for business in various sectors in the economy, are expected to incur a substantial increase to budget deficits, with further repercussions for public debt levels.

Certain studies put the cost of these tax losses at up to £50 billion, an equivalent of virtually 4% of annual gross domestic product (GDP). This is expected to more than double government borrowing for the current fiscal year, which if not soon reversed, could have detrimental effects on international borrowing conditions, borrowing interest rates, inflation and on the course of the pound in the medium run.

Asymmetrical effect

An additional risk associated with such supportive schemes is that the programmes could potentially affect firms across sectors asymmetrically. The government will need to monitor which types of workers subsidised firms keep versus those they let go. That is, subsidised firms may have kept the workers with the most specialised and relevant skills in greater proportion than firms in ineligible industries.

Overall, the furlough wage subsidy programme could effectively tackle unemployment amidst the COVID-19 crisis. We only hope that it will eventually help to preserve job specific skills by easing firms’ liquidity constraints, as growth is expected to pick up after the pandemic crisis.