financial services

Inflation and Taxes

tax-inflation

With news of retail inflation reaching a high of 3.58% in October as per data released by the Ministry of Statistics and Programme Implementation and wholesale inflation touching a 6-month peak of 3.59%, it behoves the intelligent individual to understand how tax and inflation relate to each other.

So, what is inflation, retail or wholesale?

Inflation, in economics, is the rate at which prices of certain typical goods rise as measured in percentage terms, over a base year. As a result, the ‘purchasing power’ of your money falls, or, in other words, you are able to buy less of your daily needs after an increase in inflation rates.

In India, inflation is measured by two separate rates known as the Wholesale Price Index (WPI) and the Consumer Price Index (CPI).
While the WPI indicates the rise in prices at the level of the wholesaler or distributor, the CPI indicates rise in prices at the level of the consumer.

How are they measured?

Both the inflation rates track changes in the price of a ‘representative basket of goods’. The WPI takes into consideration nearly 700 wholesale items which are grouped into Manufactured goods, Primary goods (food and drink etc.) and Fuel and Power (petrol, electricity in kilowatt-hours etc.). Each of these is assigned a more or less arbitrary ‘weight’ by the statistician. A weight is just a number between 0 and 1 that is multiplied by the price of that group to signify its importance. The sum of all weighted prices is then divided by the number of items and expressed as a percentage of the corresponding values in the ‘base’ year (2011-2012 according to current procedure).

The CPI, on the other hand, takes the weighted aggregate of about 260 items of common consumption. The base year used in the calculation of CPI is 2012 at the moment.

While CPI data is collected and calculated by the Ministry of Statistics and Programme Implementation every month, the WPI is managed and published by the Department of Economic Affairs, Ministry of Commerce and Industries periodically.

Relationship between Inflation and Tax

Inflation is bad from the point of view of the consumer because it leads to rise in living costs. On the other hand, the microeconomic correlation between supply and price dictates that producers will only produce more if prices were to rise. This is true because the other method of increasing revenue, increasing the consumer base, has limited scope, especially for Fast Moving Consumer Goods (FMCG). So, a little inflation is good for the economy as a whole.

Macroeconomic theory says that inflation is largely a result of “too much money chasing too few goods”. That is to say that when too many incomes rise and purchasing power increases, people tend to demand more of a good. An indirect effect of increased demand is that producing firms will respond to the incentive of increased revenue by maximising the price of their product. Hence, the rise in prices and resulting inflation.

Taxes, be they income tax rates, excise, octroy, GST, have an inflationary effect on the economy. Income tax, for example, increases the price of labour (measured in man-hours) and effectively reduces the number of people who are willing and able to obtain employment. It is another matter that supply of labour in developing economies such as India always remains above demand for it.

Hence, in theory, at least, reducing tax rates could reduce inflation. The discerning reader would notice that reducing taxes would also result in lower government revenue which it could have used to fund welfare and infrastructure projects. Moreover, in many situations, inflation would keep on increasing even if tax rates are reduced to zero. So this can’t be a long-term solution to runaway inflation.

So, what is the possible solution?

The present government has set an inflation target of under 4%. Hence, there is always concern when the rates near this self-appointed ceiling. Addressing the root cause of the rise in prices is answered by the statistics themselves.

Current CPI inflation has been influenced by rice in retail prices of vegetables after irregular rains. Prices of crude oil in the international market are also going up. Disruptive effects of demonetization and the GST have also taken their toll. It is the responsibility of the executive to take decisive measures to stem the trend.

This information is provided to you in the public interest courtesy of AllIndiaITR, a product of Corwhite Solutions Private Limited.

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