Will inflation go up when prices rise? Free Press Journal 23rd July 2022

 

Clearly the government is looking at tweaking the structure to garner more revenue as the economy is not behaving the way it was expected. The logical question is whether this will work

One of the bolder decisions taken by the government was to increase the GST rates on several goods and services. This was taken at a time when inflation was high at around 7% with surprises coming in every day, the latest being the rupee touching the 80 mark against the dollar.

The justification for the imposition of these rates was manifold. First several goods were kept out of the ambit to begin with, that needed to be corrected. This is logical considering a review was taken after five years. Second, producers were indulging in beating the system through the unorganised sector route through labelling concessions. This led to leakages which needed correction. Third, the government has realised that the automatic buoyancy taken for granted in 2017 did not work out. Hence a review of rates was essential. The ultimate justification was that the average rate now being charged was lower than the pre-GST regime and hence this was only a part of the tax structure as even at the time of imposition of this tax, it was made clear that the rate had to converge. Therefore it was a well thought-out strategy and we can expect more such changes until the convergence takes place.

Hence clearly the government is looking at tweaking the structure to garner more revenue as the economy is not behaving the way it was expected. The logical question is whether this will work. The answer is that it is ambivalent. On one side, increasing the price of packaged atta or taking a hospital bed of above Rs 5000 a day does mean paying more. Hence it will be hard to dodge this tax. The unorganised sector selling smaller quantities, as well as organised sector selling dairy products, will witness higher prices.

Two things can happen. First consumers will shift to unpackaged products if the burden is high. Second producers may stop labelling products, by packing products in packaging material without printing. Even today one can buy a sandal soap of established brands without the cost of the brand, as tax rates are lower. This cannot be ruled out. The same holds for hospital beds which can be priced at Rs 4999 to avoid the tax, just as has been done by hotels to come into a lower tax bracket. The other escape route is the selling of products through the ‘loose’ mode where there is no identification trail.

The other side of the story is interesting. The CPI index may of move much as all commodity prices are based on quotations received which are largely the organised sector, the ratio will be 70-80% and unorganised at 20-30%. Therefore the amount may not be very high statistically as the majority was being taxes already at this rate.

The timing however is curious. On one hand the duty on fuel products has been reduced. On the other LPG prices have gone up. It is hard to guess whether the aim is to protect the common man or not as LPG is consumed by the middle class while petrol supposedly by the rich. Using the same rationale, the present tax of 5% could be affecting the middle class more than the rich. With inflation likely to be above 7% in the next few months the decision could have been kept on hold.

By not deferring this decision inflationary expectations will turn adverse. Also considering the central bank is working hard to control inflation by hiking rates the sentiment change will add to the worries. This will mean that the RBI has to weight this in while taking a call on interest rates which are bound to rise on this score.

This also comes at a time when the rupee is falling. This affects the prices of all imported goods as the exchange rate has moved around 7% in the last 6 months. While it is true that global commodity prices have eased the depreciation neutralises this impact, the final effect will vary across goods. But to the extent prices increases it will increase input costs and make producers consider another round of increase in prices. If chemicals become expensive so will the price of toothpaste and shaving cream. Companies have already started passing on higher input costs and may choose to go in for another round once it starts to pinch their profit margins.

Hence we have to be prepared for higher prices though the inflation rate per se may change marginally. More importantly it will affect all consumers with the middle class probably bearing the brunt. Also given the direction that the GST Council has taken there will be the tendency for more of such hikes to be invoked over the next few years until the equilibrium is attained. Quite clearly the argument given earlier that the tax burden and hence prices would come down will not play out as the economy has not quite behaved the way it was expected. Looking ahead, economic growth is expected to move upwards quite gradually. Even the 7% growth this year will be marginally higher than the pre-pandemic times and hence faster acceleration may be required.