ExplainSpeaking: Why India’s government is wrong to claim inflation hits the rich harder than the poor

Dear readers,

Last week, India’s Ministry of Finance said that “Inflation in India has less impact on low-income strata than on high-income groups”. In other words, the poor in India have been less affected by the price hike than the rich.

The claim, published in the April Monthly Economic Review (MER), which is published by the Department of Economic Affairs of the Union Ministry of Finance, also claimed that inflation in India was as it ” reinforced the favorable redistribution of income from the top to the bottom and from the middle-income group. In other words, high inflation not only did not hurt the poor as much as the rich, but it also became a means of reduce the inequalities between the rich and the poor in the country.

Is it true?

The short answer is: It is wrong.

The long answer is more illuminating, but before explaining how the Department of Finance got it wrong, here’s a detailed look at how it arrived at those conclusions.

How did the government come to this conclusion?

On page 13, the MER has an information box titled “Assessment of Overall Inflation in Different Expenditure Groups”. The relevant MER downloadable by clicking here. In this box, the government rightly argues that inflation based on the consumer price index affects consumers and households “in a manner consistent with their spending patterns and shares”. In other words, while the overall price level may have increased by, say, 10%, this affects different people differently depending on what they consume most and where they spend their money. It is therefore possible to imagine that if the overall price level has increased mainly due to a sharp increase in food prices (vegetables, fruits, etc.), then the household which devotes 90% of all its monthly income to food will be more affected than a household that devotes only 30% of its income to food.

As explained in an article last weekheadline inflation is generally divided into three subgroups:

1> Food and drink

2> Fuel and light

3> Basic Elements (all remaining elements)

The MER does the same. As explained in last week’s article, headline or headline retail inflation is driven by varying levels of inflation within these categories.

To understand the impact of inflation on the population, the government has divided the general population into three categories based on expenditure data from the 68th round of the National Sample Survey (NSS) on household consumption expenditure, 2011-12:

1> Top 20% (or richest)

2> The Middle 60% (the middle class)

3> The bottom 20% (the poor)

He then differentiated this population into rural and urban areas in order to fully understand which specific segment of the Indian population suffered the most due to high inflation – was it the rural poor or the urban rich or the rural middle class, etc. .

This set of pie charts shows the distribution of expenses among different types of people.

Pie charts: distribution of spending among different types of people

As can be seen, there are striking differences. For example, while the rural poor spend more than 60% of their total expenditure on food, the urban rich spend less than 33% on food and beverages. These distributional differences are important because a spike in food inflation will create higher effective inflation for the rural poor than for the urban rich.

Based on these differences in expenditure as well as the prevailing inflation in these products, the government has arrived at the following (see all the graphics below) actual inflation rates for each population group for the two years – 2020-21 (or FY21 – the year Covid first hit India) and 2021-22 (or FY22 – the year India’s economy has begun to recover)

Charts: actual inflation rates for each population group for the years 2020-21 and 2021-22.

A few things stand out:

1> Inflation rates experienced by almost all classes of people (except the rural wealthy) were higher in FY21 than in FY22. This is consistent with the fact that inflation overall CPI fell from 6.2% in FY21 to 5.5% in FY22.

2> In addition, in urban areas, the greatest reduction in the rate of inflation (from 6.8% in FY21 to 5.7% in FY22) is observed among the poor and middle group. The wealthy also faced a reduction, but the quantum was lower – just 80 basis points – from 6.5% to 5.7%.

3> Similarly, in rural India as well, the greatest reduction in the rate of inflation was seen among the poor. In fact, the rural wealthy saw their inflation rate increase slightly between FY21 and FY22.

Using the last two observations, Finance Ministry officials concluded: “Therefore, it can be inferred from the above analysis that the decline in inflation has reinforced the favorable redistribution of income from the top down and middle income group”.

Why is this the wrong conclusion to draw?

To understand this, one must review what inflation is and how it takes place.

The inflation rate for a year is the rate at which the price level increases relative to the prices of the previous year.

Imagine that, to begin with, the general price level is Rs 100.

Then suppose that the inflation rate in the first year is 10% and 8% in the second year.

What do you think the price level will be at the end of the first and second years?

It will be Rs 110 at the end of the first year and Rs 118.8 at the end of the second year. The latest Rs 0.8 is crucial as prices rose by 8% to Rs 110 (not Rs 100).

In other words, high inflation in year 1 continues to play a role in driving up prices in year 2.

Assuming prices were Rs 100 at the start of FY21 and applying the effective inflation rates faced by the rich and poor in urban and rural areas, we get the following price levels (see table 1).

If prices were 100 rupees at the start of FY21, here are the price levels at the end of FY22 after applying effective inflation rates.

And it is clear that at the end of the financial year 22, it is the urban poor who are the most affected by inflation in India.

Is there any corroborating evidence to suggest that the urban poor were worse off?

It turns out there is. A similar exercise was carried out by CRISIL Research based on the same data from the 68th cycle of the National Sample Survey (NSS) on household consumption expenditure, 2011-12.

Table 2 below confirms the results.

Table 2: The urban poor bore the maximum burden of inflation after the pandemic.

The CRISIL research note said: “Mapping these spending patterns with current inflation trends reveals that the urban poor bore the maximum burden of inflation post-pandemic.”

Are the poor always worse off because of inflation? If so, then why?

On one level, it is quite bizarre for the Treasury to claim that the high inflation of the past two years has hurt the rich more than the poor. It is even more disconcerting to conclude that high inflation has reduced existing inequalities in the Indian economy.

Not only is this incorrect, as noted above, but it also flies in the face of a large body of academic literature which has repeatedly shown that the poor end up suffering the most when inflation rises.

For example, a 2001 article titled “Inflation and the Poor” by William Easterly (then with the World Bank) and Stanley Fischer (then with the IMF) – published in the Journal of Money, Credit , and Banking – tried to test the claim that “inflation is the cruellest tax of all” because it hurts the poor relatively more than the rich.

“The essential argument a priori is that the rich are better able to protect themselves or benefit from the effects of inflation than the poor”, affirm the two pillars in the article. For example, the poor often keep most of their money in the form of cash – and inflation robs money of its purchasing power – while the wealthy have the ability and opportunity to store their wealth in financial instruments (for example, stock markets or real estate) that cancel out the effect of inflation. Similarly, the poor often save much less than the rich and as such have relatively less room to maneuver to deal with spikes in inflation. Then there is the issue of compensation. The poor are generally dependent on wages – which often do not keep up with the rate of inflation when prices rise sharply and suddenly.

Easterly and Fischer empirically established the effect of inflation on the poor. They did it in two ways.

First, they relied on the results of a global survey of 31,869 people in 38 countries, which asked whether individuals thought inflation was an important national issue. This provided an indirect way to address the question of whether inflation is more of a problem for the poor than for the rich.

Second, they assessed the effects of inflation on direct measures of inequality and poverty in various cross-country and cross-sectional samples.

Here is what they concluded: “Our evidence supports the view that inflation is considered more of a problem by the poor than by the non-poor, and that inflation appears to reduce the relative income of the poor. It thus adds to a growing body of literature which generally, though not unanimously, tends to support the idea that inflation is a cruel tax.

Their article also referenced a 1996 study of India by Gaurav Datt and Martin Ravallion – titled “Why Have Some Indian States Done Better than Others in Reducing Rural Poverty?” – who found that observations with higher inflation rates also had higher poverty rates.

Share your views and questions at [email protected]

Stay safe,
Audit

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