A high inflation rate generally has negative effects on the economy and society by reducing the purchase power of income, discouraging saving, reducing investments, increasing production costs, but there are certain economic actors who benefit from high inflation rates.
Among these economic factors, the following stand out: governments, debtors, real assets owners and goods producers, shares investors as well as, under certain conditions, exporters.
However, if we look at the inflation rate increase episode started in 2022 and the price increase determining factors, the government is by far the biggest winner benefiting from the generalized increase of prices:
Of the RON 61 billion budget revenues increase in 2023, a total of RON 45 billion came from price increases alone.
1. The case of Energy: +RON 40 bln in 2022
Let’s take for example the case of energy – one of the important actors of inflation – and see what and how the state gained from the prices that put pressure on both industries and consumers:
In April 2022, the Romanian government introduced capping schemes through emergency ordinance for gas and electricity prices, valid until April 2023, both for domestic and non-domestic consumers. Then, in September, the government issued a new emergency ordinance extending compensation schemes until August 2023. However, these schemes were reduced.
But, along with price caps, the government also introduced additional taxes for companies in the energy field, taxes that apply to “the additional profit” determined by the energy price increase.
Moreover, as the energy price went up, the VAT rate applicable to these prices remained unchanged and generated additional revenues for the state budget since it was applied to a larger base.
Also, the state is a majority or a minority shareholder in the most important energy producers in Romania: Hidroelectrica, Nuclearelectrica, Romgaz, OMV Petrom. These companies registered record levels of profitability in 2022 and a large part of these profits were paid as dividends to shareholders, the government being the main beneficiary.
According to industry estimates, additional revenues to the state budget from the 3 sources of income (VAT, surcharge, dividends) reached over RON 40 billion. However, the price caps applied especially to individual consumers were borne from these funds. But these had lower value than revenues. Moreover, these compensations were paid by the government with delays in order to fit the cash budget deficit in the set target.
Thus, according to data concerning budget execution for 2022, compared with 2021, revenues from profit tax increased by 33%, other taxes on income, profit and capital gains increased by 17.3%, other taxes on goods and services increased by 250%.
However, in 2023, energy prices fell to values recorded prior to the war started by Russia in the Ukraine. Subsequently, state budget revenues from the energy sector decreased. Prices recorded decreases for methane gas, electricity and fuel. This resulted in lower returns from VAT, significantly lower profits of companies from the energy sector, translating into lower taxes on profit, significantly lower taxes on additional profit, as well as significantly lower dividends received by the government from companies in which it holds stakes.
Hence the government’s need for additional revenues and the taxation increase episode implicitly.
Given these circumstances, profit tax revenues increased by only 9.2%, other taxes on income, profit and capital gains went up 15%, other taxes on goods and services decreased by nearly 11%.
2. The case of VAT
VAT collection is another source of additional revenues for the state budget. Since VAT rate is applied to higher value, the state budget collects more from VAT when prices go up.
Since inflation reached 16.4% in 2022, this rate practically translated into an equivalent additional increase of VAT returns.
Practically, VAT returns tend to increase along with real economic growth when VAT remains unchanged, to which the inflation rate is added.
Consequently, according to budget execution in 2022, VAT returns increased by 18.6% in 2022 compared with 2021. Over 16% of this raise is exclusively due to the inflation rate increase.
However, in 2023 the rate of inflation was significantly reduced, to 6.6%. Subsequently, revenues from VAT increased by nearly 11%.
3. Taxation on wages: +20%
Income tax is another means of gaining from inflation for the government. The evolution of wages is influenced by the ratio between demand and supply on the labor market, the evolution of productivity as well as the inflation rate evolution.
If purchasing power was diminished in 2022, with salaries having an evolution slightly below the inflation rate, conversely, in 2023, this decrease in purchasing power was recovered and wages went up by more than double the inflation rate, given also a labor market with a shortage of personnel.
As a result, revenues from income tax increased accordingly: by approximately 20%, both in 2022 and 2023.
4. Real GDP (deflated) growth and state revenues nominal growth: in 2023, of the 61 bln increase in revenues, 45 bln came from inflation
On the whole, one way to calculate the impact of price increases on budget revenues is through the GDP deflator. It shows the evolution of prices for the entire economy and it represents a weighted average between consumer prices (inflation rate), prices for industrial producers (industrial production prices) and import and export prices. And as long as there are no changes in taxation or no improvement in collecting, budget revenues grow with the increase of the nominal GDP (that is, real GDP increase and the value of the deflator for that year).
As a consequence, total revenues went up 21% in 2022, while the deflator was 13.4%, and real GDP growth reached 4.7%. Therefore, the nominal growth of GDP was 18.1%. The difference up to 21% of the revenue increase came largely from the exceptional taxation of energy.
Thus, from the RON 80 billion increase in revenues, RON 51 billion can be attributed to price increase (including energy prices), while approximately RON 10 billion came from additional revenues from energy (surcharge, higher dividends).
In 2023, revenues went up 13.3%, given that real GDP rose by 2.1% and prices increased by (the deflator was) 9.8%. Therefore, nominal GDP increased by nearly 12%. Consequently, in 2023, of the RON 61 billion revenues increase, the impact of prices increase was RON 45 billion.
5. How the borrower gains from inflation. The biggest debtor is the state
Another category of beneficiaries of high inflation rates are debtors. And the state is the main debtor in the Romanian economy.
Debtors, such as governments and companies, can benefit from high inflation through the reduction of the real value (purchasing power) of their debt. In other words, high inflation makes the amount owed worth less in real terms, meaning borrowers can repay their debt with fewer resources.
Moreover, throughout this period, interest rates were strongly negative real, which actually reduces debtors’ borrowing costs.
For example, in the case of sovereign bonds issued by the Treasury, the coupon (interest rate) was, in 2022, half of the inflation rate at most. This means that a buyer of the government bonds with short maturity (1-2 years) obtains a negative real return on the investment.
Although the nominal interest received is positive, the purchasing power at the maturity of the bond (the nominal value of the bond plus the coupon) is lower than the initial amount invested in the bond. In behavioral finance, this situation is called “monetary illusion”. On the other hand, the debtor (issuer of the bond) gains, as purchasing power, the negative real yield of the bond, in the sense that they will repay a lower purchasing power than the one received.
Moreover, since public debt is a nominal value, it also relates to a nominal value (nominal GDP). Therefore, while public debts has increased at an accelerated rate, the nominal GDP also rose due to more accelerated inflation hikes.
This way, due to the high deflator (caused by high inflation and an even higher increase in industrial production prices), the public debt, calculated as a percentage of the GDP, remained relatively constant, at a value below 50% of the GDP.
6. The danger of toying with inflation
The governments’ approach to pay public debt through high inflation (which actually means the payment of the debt by consumers through higher prices) is a dangerous one which can degenerate into financial crisis.
When the inflation rate decreases and the government can no longer use inflation to “pay” the public debt, financial crises can occur.
One such example is the crisis of the peripheral countries of the Eurozone that followed the subprime crisis. All those countries had high inflation rates before joining the Eurozone and practically used inflation to support budget deficits and high public debts. Upon joining the Eurozone, they were no longer able to use (generate) inflation to manage the public debt and had serious problems in financing it.
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NOTE:
The current inflation episode has several overlapping causes that led to this evolution.
Among these, we note:
- The unprecedented printing of currency during the pandemic to avoid economic depression. The main central banks, globally relevant, more than doubled their balance. This unprecedented growth of the money supply has led to an increase in the prices of merchandise on international markets and started the inflationary effect.
- Russia’s use of hydrocarbons and foods as weapons against the European Union in the context of the war it launched against the Ukraine. Thus, the price of methane gas in the European Union increased from values between EUR 15/MWH to EUR 30/MWH before the pandemic to a record high of over EUR 340/MWH in August, 2022. Since the electricity market if integrated at the level of the European Union, methane gas is used in generating electricity and the price of methane gas reached record highs throughout 2022, electricity generated through the use of methane gas subsequently registering record production costs. As electricity trading prices are determined based on marginal price, the price of electricity generated through the use of methane gas practically determined the market price of energy. Consequently, the price of electricity reached approximately EUR 700/MWH in August, 2022, compared to values of EUR 50-60/MWH in 2021.
The significant increase in the price of oil in 2022 after the start of the war in Ukraine. For instance, the price of Brent oil, the relevant oil for European countries, reached USD 120/barrel during 2022 (50% more than prior to the outbreak of the war in Ukraine). And the hike in oil price led to an increase in the prices of oil derivatives – the price of gasoline and diesel reaching record highs. Consequently, these extremely high prices for energy products fueled inflation both directly (electricity, methane gas and fuels being part of the consumption basket) and indirectly (second-round effects), these products participating to various extents in the manufacture of goods or provision of services.
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