Contribution Summary – ‘Inflation – The Most Iniquitous Tax’ article submitted by Ramneek Singh

towards admission to PhD Program in Finance

Mentor: Dr. Jaydeep Mukherjee (Professor of Economics, IIFT Delhi)

Authors and Primary Contribution:

Ramneek Singh

1. Responsible for coming up with the first draft of the article

2. Performed most of the analysis

Mukund Agarwal

1. Suggested changes to the first draft

2. Reworked on a portion of the Introduction

Avijit Narayan

1. Suggested changes to the first draft

2. Reworked on a portion of the Recommendations (Controlling Food Inflation)

Swati Verma

1. Suggested changes to the first draft

2. Reworked a portion of ‘Effect of Inflation in India’ Section

Please note that even though the above-mentioned sections were primarily drafted and researched
up on by Ramneek Singh, all authors have been equally involved and have thorough knowledge of
topics covered in the article.
Inflation: The Most
Iniquitous Tax
By –

Ramneek Singh
Avijit Narayan
Swati Verma
Mukund Agarwal
 INTRODUCTION

Milton Friedman once famously said “Inflation is taxation without legislation”. Even the
former PM of India, Dr. Manmohan Singh, in 2008 when asked about his policies to
curb inflation at the cost of development, stated that inflation is an iniquitous tax.

Rising inflation has been the cause of several uprisings around the world. From the
1918 rice riots in Japan and the 2007-2008 world food price crisis, to the ongoing
unrest in Venezuela, inflation has been at the heart of these events and people,
particularly those from the lower strata of the society, have been the flag bearers.
These and many similar events have led to the creation of two schools of thought.

The first school of thought, consisting of economists like Fischer and Modigilani
(1978); Laidler and Parkin (1975), believes that inflation is iniquitous in nature because
it is the poor who mostly bear the brunt of increased prices as a result of the lag in
wage increase with respect to inflation. Contrary to this, economists like Blinder and
Esaki (1978); Bach and Stephenson (1974) belonging to the second school of thought,
believe inflation redistributes income to the lower income quintiles through the debtor-
creditor channel, wherein poor debtors owe nominal debt to rich creditors.

This essay further tries to investigate the iniquitous nature of inflation and understand
how it affects the people around the world and in India. Additionally, it goes on to
recommend the steps needed to address this iniquity from India’s perspective.

WHAT DOES INFLATION DO?

Empirical data [1] suggests that inflation leads to redistribution of wealth in a way that
hurts the poor. Businessmen, land owning farmers become richer whereas middle
class salaried people, low-income labourers, fixed-income earners register a reduction
in their wealth. This widens the gap between poor and rich.

This relation between income inequality and inflation can be illustrated using Gini
coefficient [2]. During 1980’s, Brazil was going through severe inflation (Figure 1).
Mapping the Gini coefficient data of Brazil for those times, shows that income
inequality moved in tandem with inflation rate. Annual inflation rate rose from 107% in
1981 to 2700% in 1990 with Gini index increasing from 57.93 to 61.43. This shows that
1inflation can affect income distribution in a substantial way if it gets out of hand.
Similar trend has been observed in other countries like Mexico and Argentina.

Sources:
[1] Doepke; Schneider (2006). “Inflation and the Redistribution of Nominal Wealth”. Journal of Political Economy.
[2] World Bank Database. Gini coefficient ranges between 0 and 1, 0 showing perfect equality and 1 showing perfect inequality.
1
 Source: World Bank Database
Figure 1: Gini Coefficient & Inflation Rate Vs Time (Brazil)

Another indicator which points to the hindrance [3] in social progress that is caused by
inflation is the ‘Social Progress Indicator’ [4] which is a measure of a society’s ability to
meet its basic needs and provide its citizens the opportunity to enhance and sustain a
better quality of life and reach their full potential.

It has been observed that countries with a high social progress index (Figure 2) and
low inequity tend to have had prolonged periods of lower inflation rates and more
economic stability. As it turns out, these countries are the ones which are developed
and have a high per capita GDP.

Social Social
Progress Type Progress Score
High 70 - 100
Middle 40 - 70
Low < 40
Source: World Bank Database 2015 and Social Progress Index Report 2016
Figure 2: Social Progress Type Vs Average Inflation Range (Countries falling in that inflation range)

This implies that inflation’s ill-effects are not restricted to a stratum of society but it
affects the entire society. And it calls for a better understanding of inflation and its
causes.

INFLATION MEASUREMENT

To start understanding inflation, we must first understand how it’s measured. Inflation
is caused by a mismatch in demand and supply. In India, inflation is measured using
two metrics - the Consumer Price Index (CPI) & Wholesale Price Index (WPI), with
Sources:
[3] Urrutia, Miguel Cardenas, Mauricio (1995). “Macroeconomic Instability and Social Progress”. National Bureau of Economic Research.
[4] Social Progress Imperative Organization. It computes Social Progress Indicator for more than 120 countries.
2
reference to a base year. Since CPI focuses on changes in cost of living at consumer’s
end, it is used as the standard measure of inflation. The items in a CPI basket and the
weights assigned to them depend upon the consumption pattern of the people in the
country, and hence vary from country to country (see Table 1). For example: In
developing countries, the level of social progress is moderate/low (Figure 3) and
majority of the population has limited access to necessities. This translates into them
buying more into categories like food [5], thereby making their consumption basket
heavy on necessities.
Social Progress vs GDP Per Capita ($PPP)
100 Norway
90 New Zealand Canada
Social Progress Index

Latvia France United States

80 Costa Rica Kuwait
Brazil
70 China
Nepal
60
India
50
Afghanistan
40
30
20
- 10,000 20,000 30,000 40,000 50,000 60,000 70,000
GDP Per Capita ($PPP)
Source: World Bank Database 2015 and Social Progress Index Report 2016
Figure 3: Social Progress Index Vs GDP per Capita ($PPP)

Therefore, net inflation is not an independent variable but is a function of change in

prices of several items and is more influenced by the highly-weighted items.

Table 1: Weights assigned to different baskets in CPI-India and US

Rural - Urban - Combined Urban -
Item Item
Weight Weight - Weight Weight
Food and beverages 54.18 36.29 45.86 Food and beverages 14.901
Pan, tobacco and
3.26 1.36 2.38 Transportation 16.418
intoxicants
Clothing and footwear 7.36 5.57 6.53 Housing 41.448
Housing - 21.67 10.07 Medical Care 7.551
Fuel and light 7.94 5.58 6.84 Recreation 5.793
Miscellaneous 27.26 29.53 28.32 Apparel 3.437

Source: Data from Ministry of Statistics and Program Implementation Education and communication 7.087
(Base 2012) Other goods and services 3.365

Source: Data from US Bureau of Labour Statistics

(Base 1982-84)

In India, we see that inflation (Figure 4), CPI (Rural & Combined), closely follows the
food inflation index i.e. because it has been assigned the highest weight [6], thereby
making it the most influencing [7] variable in net inflation calculation.

Sources:
[5] Pons, Nathalie (2011). “Food and Prices in India: Impact of Rising Food Prices on Welfare”. Centre de Sciences Humaines (Delhi).
[6] “Rising food prices have a massive impact on emerging economies”. Business Insider. August 2015.
[7] Furceri, David et al (2015). “Global Food Prices and Domestic Inflation: Some Cross”. IMF Working Paper. WP/15/133.
3
 Groupwise Inflation - India (Urban)

10%

5%

0%
January 2014 November 2014 September 2015 July 2016
Clothing and footwear Food and beverages Fuel and light
Housing Miscellaneous Pan; tobacco; and intoxicants
Inflation

Groupwise Inflation - India (Rural)

10%

5%

0%
January 2014 November 2014 September 2015 July 2016
Food and beverages Pan, tobacco and intoxicants Clothing and footwear
Fuel and light Miscellaneous Inflation

Groupwise Inflation - India (Combined)

11%

6%

1%
January 2014 June 2014 November April 2015 September February 2016 July 2016
2014 2015
Clothing and footwear Food and beverages Fuel and light
Housing Miscellaneous Pan; tobacco; and intoxicants
Inflation
Source: Data from Ministry of Statistics and Program Implementation 2016
Figure 4: Change in Inflation (India) with Time

Whereas in the US, inflation seems to be following the Transportation Index’s [8] trend
(Figure 5). Thus, an increase in inflation in India may signify that Food and beverage
prices have increased whereas in US it might mean that Transportation prices
(implying fuel prices) have increased.

Groupwise Inflation - US (Urban)

0.07 0.15
0.05 0.05
0.03
-0.05
0.01
-0.01 -0.15
2000 Jan 2002 Jan 2004 Jan 2006 Jan 2008 Jan 2010 Jan 2012 Jan 2014 Jan 2016 Jan
-0.03 -0.25

Housing Food and Beverages Inflation Transportation (on secondary axis)

Source: US Bureau of Labour Statistics 2016

Figure 5: Change in Inflation (USA) with Time
Sources:
[8] Neely, Christopher J. (2015). “How much do oil prices affect inflation?”. Federal Reserve Bank of St. Louis - Economic Synopses.
4
Therefore, depending upon the distribution of items in the consumption basket, an
increase in inflation will affect different sections of society differently.

EFFECT OF INFLATION IN INDIA

The effect of inflation can only be analysed if we know what has been causing it. The
characteristic of recent inflation, in India, is such that it has been concentrated mainly
on food and energy (fuel) [9]. These two items (primarily food) form a high portion of
the consumption basket of the poor (Figure 6) than of the rich and thus, lower income
households tended to experience the ill-effects of inflation harder than the higher
income groups over the last decade.

LOWEST CONSUMPTION(~74%) LOW INCOME HOUSEHOLDS(~22%)

Transport, 4% Transport, 7%
Others, Others,
9% Energy, 10%
Housing, 9%
6%
Food and
Beverages, Food and
Housing,
53% Beverages,
20%
35%

HIGH INCOME HOUSEHOLDS(~1%) MIDDLE INCOME HOUSEHOLDS(~3%)

Transport, Food and Transport, 8%

20% Beverages, 12%
Others, 12%

Food and
Others, Beverages
15% , 21%

Housing,
39% Housing, 34%

Source: Data from World Bank – Consumption 2010

Figure 6: Consumption pattern of households from various income groups

As per the tenets of taxation [10], the high-income groups (HIG), who have more
disposable income and savings than the low-income groups (LIG), should be taxed
more, however inflation erodes the purchasing power of the LIG more. A higher price,
for HIG, might just translate into them buying a lower quality of the same good.
Whereas for LIG, who consume a higher share of their income, the increase in prices
of necessities, like food, causes a steeper decline in savings and real income, and
with increase in price, the only option left is to stop buying the good altogether.

Sources:
[9] “Who suffers from inflation?”. The Economist. June 2011.
[10] Kabinga, Musonda (2016). “Principles of Taxation”. Tax Justice and Poverty Organization. Paper 5.
5
To illustrate this, let’s assume that Effect of Inflation on Rich (HIG) and Poor (LIG)
there’s an economy where many
Price after inflation
goods have a price lesser than 0.005 Price before Inflation
Poor's Reserve Price

f(x)
average (log-normal). In case of Rich's Reserve Price

inflation, the LIG with a lower

reserve price (70) than the HIG 0
0 100 200 300 400 500 600
(210), will see several goods going Source: Based on self-generated data
x
Figure 7: Effect of price shift due to inflation on HIG and LIG
beyond that threshold thus making the previously affordable goods unaffordable.
Whereas the HIG will still be able to afford a considerable number of goods.

What further adds to the plight of the poor is the fact that they are still not financially
included. In fact, there are as many as 9 states and UTs having a below average or
low level of financial inclusion, and they have the following CRISIL Inclusix Score (it
denotes the level of branch penetration, deposit penetration and credit penetration as
a single score).
Table 2: States having the lowest CRISIL Inclusix Score
CRISIL Inclusix CRISIL Level of
State Population Level of Financial Inclusion
Score Inclusix Financial
Bihar 30.2 10,40,99,452 BELOW AVERAGE Score Inclusion
Rajasthan 39.4 6,85,48,437 BELOW AVERAGE >55 HIGH
Jharkhand 39.4 3,29,88,134 BELOW AVERAGE Between
Assam 39.6 3,12,05,576 BELOW AVERAGE 40.1 and ABOVE
Chhattisgarh 35.4 2,55,45,198 BELOW AVERAGE 55.0 AVERAGE
Meghalaya 36.4 29,66,889 BELOW AVERAGE Between
Manipur 21.6 25,70,390 LOW 25.0 and BELOW
Nagaland 28.9 19,78,502 BELOW AVERAGE 40.0 AVERAGE
Arunachal Pradesh 30.5 13,83,727 BELOW AVERAGE <25 LOW
Source: CRISIL Inclusix Volume 3
These 9 states account for ~23% of the total population which means that almost one
fourth of India’s population has no/limited access to financial services. Thus, more
people, especially the poor, are forced to hold their financial assets in the form of cash
rather than in interest-bearing assets (figure 8), which in turn exposes their savings to
inflation induced reduction in purchasing power.

50%

40%

30%

20%

10%

0%
Secondary
Insurance Bank Mutual Other Post office Cash
market Real estate
and pension deposits funds investments savings savings
investments
Allocation of Urban Household's savings 9% 19% 5% 3% 4% 30% 4% 26%
Allocation of Rural Household's savings 15% 31% 0% 0% 3% 0% 5% 45%

Source: National Council of Applied Economic Research Household Survey, 2011

Figure 8: Savings pattern for Urban and Rural households

6
At times of high inflation, with no means to fight it, the poor tend to be burdened more
than the rich. This is what makes inflation the most iniquitous tax.

HOW DO WE TACKLE THIS INIQUITY?

We’ve established that inflation becomes iniquitous primarily because of two reasons:

1. High Food Inflation

2. Lack of Financial Inclusiveness

Let us now look at how we can address these two issues.

A. Controlling Food Inflation

High food inflation is the main reason behind inflation’s iniquitous nature. ‘Food and
Beverages’ consumption basket primarily consists of 12 subgroups (Figure 9). The
weights given to the different subgroups determine the overall weight given to ‘Food
and beverages’ group in CPI basket. So, which subgroups drive food inflation?

12
10
8
6
4
2
0
Cereals Pulses Sugar and Non- Snacks,
Meat and Milk and Oils and Vegetable
and Egg Fruits and confectio Spices alcoholic sweets
fish products fats s
products products nery beverages etc.
Rural - Weight 12.35 4.38 0.49 7.72 4.21 2.88 7.46 2.95 1.7 3.11 1.37 5.56
Urban - Weight 6.59 2.73 0.36 5.33 2.81 2.9 4.41 1.73 0.97 1.79 1.13 5.54

Source: Data from Ministry of Statistics and Program Implementation (Base 2012)
Figure 9: Weights assigned to different subgroups in ‘Food and Beverages’

As per our analysis [11], 99.4% of ‘Food and beverage’ inflation (2013-16 period) could
be explained by inflation in ‘Vegetables’, ‘Oils and Fats’, ‘Fruits’ and ‘Eggs’ subgroups
with ‘Vegetables’ subgroup being most influential.

High ‘Vegetables’ inflation means that there is more demand for vegetables than what
is being currently supplied. There is less supply because Indian farmers don’t grow
enough vegetables [12]. There are two major reasons for this:

I. Lack of cold storage facilities: There is a dire need for cold chain warehousing
as only 25% of the total capacity is available for fruits, vegetables, processed
foods and pharmaceuticals.
II. No Minimum Support Price (MSP): Government takes measures to contain the
prices of goods basket that is most consumed by the lower stratum of the
Sources:
[11] Based on authors’ own analysis. Regression was conducted with ‘Food and beverage Group Inflation’ as Dependent Variable and
other ‘Sub Groups’ as independent variables. Results were obtained after proper residual analysis.
[12] “Why don’t Indian farmers grow more vegetables?”. IFMR Trust. January 2013.
7
 society, i.e. ‘Food and Beverages’, via providing ‘Minimum Support Price’
(MSP) to farmers. This increases supply thereby driving down the prices and
bringing relief to low income households. Further, to bridge the gap between
MSP and price at Public Distribution Shops, subsidies are provided. These
indirectly lead to inflation (general inflation, not food inflation). The increase in
general inflation at the expense of food inflation makes inflation less iniquitous,
benefitting 74% of the Indian households (Figure 6).

Recommendations:

Given the above two problems, some of the steps that the government could take are:

I. Provide support like low cost of funding for setting up cold chain infrastructure
facilities and subsidised power tariff.
II. At present, there is no MSP for Vegetables. Introduction of MSP will act as an
incentive for farmers to grow more vegetables and will lead to a decrease in
gap between demand and supply. Note that long run impact of MSP on food
inflation is not as over-bearing as generally perceived [13].
III. Rectifying supply-chain inefficiencies by allowing FDI in rural logistics, with a
single window for paperwork and clearances.

These are quick-fix measures, but, in the long run, agricultural productivity must be
stimulated via capital investments in rural infrastructure.

B. Financial Inclusiveness

Financial inclusion means delivery of financial services to the excluded sections

(mostly low -income groups) of the population with the provision of equal opportunities.
Financial inclusion will not only lead to a decrease in poverty but will also reduce
income inequality [14]. To make financial inclusion a reality, the GOI and RBI have
taken a few steps in the past which include Nationalization of Banks (1969, 1980),
Priority Sector Lending, Establishment of Regional Rural Banks (RRBs) (1975, 1976),
& Service area approach and Self-help group bank linkage programs (1989,1990).
However, success has been slow owing to lack of a strong network of financial
services, and financial instruments not suited to rural residents. This is where
payments banks come into play.

Sources:
[13] Sonna, Thangzason et al. (2014). “Analytics of food inflation in India.”. RBI Working Paper Series.
[14] Park, Cyn-Young (2015). “Financial Inclusion, Poverty, and Income inequality in Developing Asia”. ADB Economics Working Paper.
8
Payments banks [15] are specialized banks that reach and provide the last-mile
connectivity to rural areas, which regular banks cannot. Thus, entities like Indian Post,
Telecoms and Retail chains, which have more penetration in un/under banked areas,
have been given preference over other entities to launch payments banks.

Recommendations:

Though the current scenario for payments banks looks promising, going forward the
following recommendations must be considered to ensure their success (financial
inclusion):

I. Easing Regulations: At present, RBI has fixed the minimum capital requirement
for payments banks at 15%. This should be brought down further because the
payments banks work on wafer thin margins and it will be difficult for them to
have 15% of their assets locked.
II. Financial Literacy: Wealth creates wealth. Even a little saving can go a long
way if channelized correctly. Thus, payments banks should ensure that
everybody has equal access to financial information and services.
III. Access to Other Financial Instruments: Use payments banks as vehicle to
promote insurance services for crops, life and cattle etc., which will reduce the
risk premiums for commodities.

CONCLUSION

Inflation has indeed been the topic of much debate. Recent inflation, which is
characterized by increased food prices, hurts the poor more than the rich. While there
are intellectuals and scholars who argue against this iniquitous nature of inflation
saying that it also leads to growth (which it does), we would like to disagree with them.
That is because the poor shouldn’t be made to pay the price of progress. Inflation not
only leaves them poorer but it also leaves them struggling for necessities. Loss of
purchasing power is also skewed in favour of high income households as food forms
a smaller fraction of their expenditure.

Government has been trying to contain inflation by providing safety nets for the poor
like NREGA but it hasn’t been fully successful. RBI has also been trying to contain
inflation and has adopted an inflation-targeting monetary policy, and though it has
been successful at containing net inflation, food inflation still largely remains

Sources:
[15] Singh, Charan (2014). “Financial Inclusion in India: Select Issues”. IIMB WP.
9
untargeted and dependent on factors like weather. So, the two main factors – financial
insecurity and high food inflation – causing the iniquity, remain unaddressed.

To tackle this iniquity, agricultural productivity and financial inclusion of the un/under
banked segment must be promoted. Investment in agricultural infrastructure and
promotion of financial literacy via payments banks will go a long way in lifting people
out of poverty.

Inflation is a necessary evil and policies are meant to focus on the necessary
part (growth) and wipe-out the evil (iniquity).

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