“Inflation is like nicotine or alcohol.” The legendary stock market guru André Kostolany already knew this: “It’s stimulating to a small extent, you just can’t become a chain smoker or an alcoholic.” The problem: An optimal inflation rate cannot be determined. There is no evidence that an increase in the price level of zero or one percent is “better” or “worse” than two percent for the economy as a whole.
The inflation target of “below two percent” pursued by the Bundesbank since the 1970s also stems from a more pragmatic approach than an economic analysis. Rather, the Bundesbank wanted to send a clear signal that it would not tolerate the inflation rates of up to seven percent at the time and would counteract them with its monetary policy.
In order to send a similarly strong signal for the euro, the ECB initially adopted this target, but changed it several times to what is now “symmetrically two percent” – which means that even temporarily exceeding this mark is tolerable.
Thanks to globalization and digitization, the increase in consumer prices in Germany and many other EU countries has mostly remained well below two percent in recent decades – and thus below the media perception threshold. Massive amounts of cheap electronics and consumer goods “made in China” and the displacement of many analogue products by cheaper digital counterparts ensured that the typical shopping basket of the average consumer hardly became more expensive. In addition, not least the high level of immigration dampened the price increases for labour-intensive services.
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Those days have been gone for months. In the US, inflation is currently 7.5 percent, in the euro zone 5.1 percent – and there is no end in sight to such inflation rates. According to an Ifo survey, companies’ price expectations for the next three months are currently at an all-time high. Against the background of the geopolitical upheavals as a result of the invasion of Russian troops into Ukraine, a price increase of up to 6 percent this year cannot be ruled out.
Labor costs are rising in China and other emerging markets
Beyond the current price caprioles, several factors also suggest that the price level will rise noticeably faster in the future than in the past few decades. Labor costs have risen noticeably in China and other emerging markets. In addition, the Asian semiconductor manufacturers are likely to use their market power, which has become evident in the current chip crisis, to push through higher prices in the longer term.
In addition, the decarbonization that is being sought, not least in Germany, will drive up prices in the long term. On the one hand, rising CO2 taxes due to higher production and transport costs will make almost all goods and services more expensive. On the other hand, there will be new shortages of certain raw materials and skilled workers, which are likely to result in rising prices. The general lack of personnel due to demographic reasons, especially in Germany, will contribute the rest.
Far from being a defect, relative price changes in a market economy reflect changing scarcities. They are at the heart of the market mechanism that ensures efficient use of resources. However, the prices of almost all goods and services are currently rising. This reduces purchasing power and thus causes a loss of prosperity that is by no means evenly distributed among the population. For example, low earners cannot compensate for higher prices by saving less, since they can hardly put anything aside anyway.
In addition, low earners consistently spend a higher proportion of their income on housing and energy, i.e. on those goods whose prices are likely to rise sharply as a result of decarbonisation. Limiting energy consumption is often hardly possible, as elementary needs are affected.
The traffic light coalition has recognized this problem in principle and has at least initiated (one-off) aid for those particularly affected. In order to counteract the long-term social consequences of the energy transition, however, the state would have to return its additional income from CO2 pricing to private households, as announced in the coalition agreement.
In addition, rising prices provide a second form of redistribution caused by the tax system. In principle, the legislature determines what share of income or sales the state is entitled to in the form of taxes. A significant increase in the price level can change this proportion – usually in favor of the state – without a law having to be changed.
Purchasing power is gradually diverted to the tax authorities via the tax system
A progressive tax rate means that even those increases in income that only compensate for inflation lead to a higher tax burden. The federal government is trying to compensate for this cold progression by regularly adjusting the tax rate. Minor forecasting errors evened out over the years – so far at least. But in autumn 2020, when the Bundestag passed the tariff shift, the government expected 1.17 percent in 2021 – in fact it was 3.1 percent on an annual average. Whether and how this will be made up for is uncertain. Clearer regulation would be needed here to really eliminate cold progression.
Prof. Bert Rürup is President of the Handelsblatt Research Institute (HRI) and Chief Economist of the Handelsblatt. For many years he was a member and chairman of the German Council of Economic Experts and an adviser to several federal and foreign governments. You can find out more about the work of Professor Rürup and his team at research.handelsblatt.com.
In addition, there are numerous threshold values in tax law that are continuously being devalued by rising prices. This applies equally to allowances such as the saver’s allowance, the training allowance or the flat rate for trainers as well as for limit values, such as special depreciation or certain benefits. The specific euro amounts mentioned in the paragraphs are devalued in real terms from year to year due to inflation.
For example, since 2010, taxpayers have been able to claim up to 1,250 euros per year for a home office for tax purposes under certain conditions. What might have been enough for a small study twelve years ago is often barely enough for a storage room today.
The rising price level means that the tax system gradually and continuously diverts purchasing power from taxpayers to the tax authorities. This is particularly striking in the case of inheritance tax. Since the 2009 reform, around 20,000 euros can be transferred tax-free to siblings. In real terms, this is still just under 17,000 euros today. A whole decade with three percent annual inflation would reduce this value by another third in real terms.
Thresholds that have not been adjusted since the reform of 2016 or even since 2009 also apply to the heirs of real estate and business assets. The intention of the legislator that “grandma’s house” can be passed on to the next generation largely tax-free is no longer guaranteed today.
Now these distributional effects do not have to be disadvantageous. There are good reasons for charging heirs or recipients of certain incomes more heavily than the current law provides. Only if politicians want this should they communicate this openly and let Parliament decide on it. However, tax changes always trigger distribution conflicts, the solution of which politicians tend to avoid. But relying instead on the creeping effect of inflation is dishonest and unworthy of a democracy.
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