27.04.2022

REASONABLE MEASURES IN CASE OF HIGH INFLATION

The analysis is from the weekly bulletin of the Institute for Market Economics (IME)

In March, the annual rate of change in prices reached 12.4%. Compared to March 2021, the increase in food prices was by 17.4%, and in fuels and transport in general - by 26.7%. For the month compared to February, the growth was 2.2%, with food prices rising by an average of 3.3% and transport - by 7.9%. Eurostat gives a similar picture in all EU economies - the average growth of the harmonized index of consumer prices per year is 7.8%, for the euro area is 7.4%; the growth of prices for March alone is 2.4%, which is even slightly higher than reported for Bulgaria.

In our country this is the highest inflation since 2008, when we had similar international dynamics of sharply rising fuels and basic agricultural products. In fact, the achieved prices of crude oil and wheat then remain unattainable at the moment. Then in the whole period from August 2007 to October 2008 the annual growth of prices exceeded 10% and reached a maximum value of 15% in May 2008. From the beginning of the global financial crisis until a few months ago, annual inflation in Bulgaria was above 5% in just two months in the spring of 2011 - then also after rising fuel prices.

Naturally, politicians have lost the reflex to propose and discuss economic policies in conditions of relatively high inflation. This applies both to budget planning and to household income and the tax environment. Whether for this reason, or because of the heterogeneous nature of the coalition, only "expectation" for a future package of measures is currently accumulating. It is also unclear how it fits into the stated intention of the government to update the budget in the middle of the year. However, all this does not prevent individual parties and politicians from publicly presenting their ideas for economic and/or social measures in support.

Whatever is done must be based on facts, opportunities and take into account the laws and principles that govern trade and human behavior. In the first place, each measure or package of measures is taken for a specific purpose. If we simplify the political task, it is either a matter of fighting inflation in search of instruments to lower prices (or at least not to rise more), or to alleviate its effects on businesses and households.

What does it mean to fight inflation and is there such an option at all? In a price shock driven by external factors, the possibilities for impact are limited. The decisions of the major central banks on monetary policy are not - and never have been - within the control of the Bulgarian government. To the extent that we can have an academic debate on the effect of quantitative easing and low interest rates, this is ultimately a factor beyond our control. The same is largely (not entirely) the case for fuel prices, electricity and some agricultural commodities - we cannot change the structure of the European energy market, nor can we change our dependence on Gazprom and the behavior of the monopolist; even less depends on us on how long Russia's war with Ukraine will last.

For many politicians, however, it seems to be a symbolic victory, a testament to the heroism of providing citizens with something "cheap" - from electricity and diesel, to oil, bread and, until recently, cucumbers. Can this happen? The price ceiling leads to a deficit, or if we want there to be no shortage - to the need for a direct subsidy for the trader and the manufacturer. Beyond the enormous administrative difficulty of imposing a fixed price on an otherwise free, complex and competitive market, possible subsidies will create extremely dangerous incentives. For buyers and sellers, price will cease to play its informational role, on the contrary - whoever consumes the most of an otherwise increasingly expensive resource will be rewarded the most with taxpayers' money.

Changing indirect taxes will have minimal effect, while the fiscal cost will be high. Reducing excise duties on fuels can undoubtedly lead to lower retail prices, but this decision must be taken collectively within the EU. There are generally two options for influencing prices through a change in value added tax. On the one hand, there may be a lowering of the standard rate. However, we must be aware - each reduction point will mean BGN 800 million less revenue in the budget, which must be compensated either by other taxes or cut costs. Even if we accept - and this is far from the reality - that the whole reduction will go to consumers, with such an expensive measure we support both the needy and the rich, lowering the price of cheese and potatoes, and luxury houses, cars or designer clothes.

If we talk about a general reduction of the tax burden and redistribution through the state, this is undoubtedly a desirable change; however, the potential for controlling inflation seems minimal. The idea of ​​differentiated rates has been discussed many times and the arguments against it remain valid. Purely politically, it is very difficult to give up one branch if such a discount has already been given to another. But even in terms of the immediate effect, the expected results are far from guaranteed - in other countries the consumer manages to receive between ¼ and 1/3 of the tax reduction (for example in Romania and Slovakia, where similar steps have been taken in the recent past). Bulgaria also has its own experience - in the 1990s bread and milk were released and we remember how the market worked and how much consumers benefited from this measure. In other words - we help the margin of the trader and the manufacturer and very little - the end user. This, incidentally, happened after the introduction of a reduced rate for restaurants in 2020 and is even openly acknowledged by the industry itself - prices are not reduced.

This approach faces other problems. Politicians talk with clichés - the strongest and most sustainable in the history of the transition is that of "bread". What exactly is "bread" no one wants to define, even from the industry hesitantly open the word that it may not be practical for all pasta, but only for a particular type. Let's put aside the administrative-control chaos that will accompany the categorization of the various "breads"; however, this will generally be the case for other products if there is a proposal to apply a reduced VAT rate to food groups. Even in the most optimistic market scenario, in which the consumer takes the full tax reduction of 20 to 9 percent, an "average Bulgarian" will receive about 34 stotinki per month because of cheaper oil and approximately 74 stotinki per month from cheaper bread. Clichés help with headlines and front pages, but they don't solve real problems.

Of course, there are also domestic sources of inflation on which policy can have some effect. Housing prices, for example, are highly dependent on the credit expansion of commercial banks, which can be affected. We also have controlled prices, for example in healthcare, education, and in the context of the debate - let's not forget that households are not on the free electricity market and for them the price has not changed since July 2021. Other changes in the business environment may alleviate the costs of small businesses - for example, a higher VAT registration threshold - and have an anti-inflationary effect in the medium term.

In this context, another note is important - the discourse of imported/domestic products is misleading, if there is a distinction, it is between internationally traded goods and non-marketable goods and services. We have, for example, an oversupply of electricity, oil, wheat, metals, plastics and chemicals (the list goes on) – i.e. Bulgaria is a net exporter of these products - this does not mean that prices will be low. For this type of goods the prices are international or at least close - we have a regional, European and even global market. In this sense, whatever measures are proposed to facilitate, encourage or subsidize production, this will not lead to a fall in domestic prices.

That is why it seems reasonable for politicians to reformulate their goal - it is possible to maintain and increase the purchasing power of household income. This is a pragmatic but honest approach, based on the acceptance of the inevitable manifestations of external factors on a small and extremely open economy like ours. How can such a package of measures be structured?

There are several categories of citizens whose incomes depend entirely or to some extent on government regulations. There has been a lot of talk about pensions since the election campaign and we will not stop here, but by July 1 it seems almost certain that there will be an increase - at least to integrate the supplement of BGN 60 in the basic pension, and probably even more . The weak coverage of the monthly social assistance system - there is a proposal to change the law in the direction of expanding the scope and amount of support, but only for 2023 - requires some temporary solution for direct support to the poorest households, which are the most severely affected by higher prices of basic products.

As the new government has also avoided or at least postponed the debate on an objective mechanism for setting the minimum wage, it will now have to adopt (another) ad hoc decision to increase it. With over 12% annual inflation, in fact, the increase to BGN 710 already seems to be lagging behind and purely arithmetically there will be an argument for an increase at least until the loss of purchasing power is compensated. As the very existence of a mandatory minimum wage set by the state contradicts free bargaining and economic principles, in this situation - high inflation and very low unemployment - a change in the nominal amount carries a limited risk of adverse developments in the labor market.

As early as the formation of the coalition, possible changes in public sector wages were generally postponed to the middle of the year. If the government keeps its commitment, analyzes should be made in individual sectors and administrations with proposals to increase efficiency and cost-effectiveness - and this should be the basis for increasing wages, but only after improving efficiency. There are some examples that seem to be in the right direction - for example, the increase in salaries for nurses and other nurses, which in fact is not even directly related to inflation, but is necessitated by structural problems in these professions. So the ministries have a very specific incentive to start changes - if we follow the promise, the change will allow for higher incomes.

Wages in the private sector have been growing steadily in recent years due to a number of long-term labor market factors and demographic trends. We continue to believe that a good solution - as we proposed in the alternative budget of the IME - is a significant reduction in the amount of insurance. This leaves income for workers and "rewards" employers who are out in the open and increase wages. This is a tax reduction that is aimed specifically at the economically active and stimulates growth. The argument for stimulating private investment through zero tax on reinvested earnings seems even stronger - and this year political turmoil and weak capacity will postpone much of the capital expenditures included in the budget, not to mention the delayed implementation of the Plan. for recovery and resilience. Such relief could at least partially offset the economic slowdown due to the effects of the war.

The policy to support income growth should and can happen without worsening the budget balance. On the one hand, higher-than-expected price increases increase budget revenues - directly through consumption taxes, and secondarily through higher nominal profits and incomes. Separately, state-owned energy companies will realize higher-than-expected profits, which may also be available to the fiscal authorities. Let's not forget that for a large part of the products with the fastest growth of prices on the global markets Bulgaria is a net exporter - ie we will have companies with improving financial results, which will also indirectly improve revenue collection.

Data on budget execution until March show an increase in tax and non-tax revenues by 12.2% - higher than planned for the year, which is a logical and expected consequence of inflation. On the other hand, as has been said, it is increasingly certain that capital expenditures will not be realized. The prudent policy is to distribute them transparently in June and in the vote in the parliament on the budget update, instead of making controversial (at least) tricks again in mid-December.

In other words, reasonable and well-targeted measures can be implemented to maintain and increase the purchasing power of households in a way that does not add an internal fiscal stimulus to inflation and does not increase the deficit.