Inflation and the Economy

If a cup of tea that cost ₹5 a decade ago now costs ₹15, that is inflation at work. Inflation is a general rise in prices over time. It affects everyone by eroding the value of money in our pockets. Understanding what causes it, whom it hurts, and how it is controlled is central to macroeconomics and to everyday life.

Inflation is a sustained rise in the general level of prices in an economy over time. Its direct effect is to reduce the purchasing power of money: each rupee buys less than before.

Inflation is measured by price indices such as the Consumer Price Index (CPI) and Wholesale Price Index (WPI). These indices track the average prices of a basket of goods. A little inflation is normal in a growing economy. The danger arises when it becomes high or unpredictable. (The opposite, a fall in the general price level, is called deflation.)

The two main indices differ in what they cover and how they weight it.

• Coverage: the WPI covers only goods traded at wholesale prices. It does not capture the prices of services. The CPI includes services such as health, education and transport, because consumers actually buy them.
• Food weight: food carries a higher weight in the CPI than in the WPI. Food inflation therefore moves the CPI more sharply than the WPI.
• Frequency: the WPI is released monthly.
• Policy anchor: the RBI now uses the CPI, not the WPI, as its headline inflation measure when setting policy interest rates.

The WPI itself has been revised over time. The series with base year 1993-94 became effective from April 2000, replacing the earlier 1981-82 base. In that revised series, the weight given to electricity increased. (As a related marker of the same period, India's foreign exchange reserves crossed USD 125 billion in 2004.)

India also publishes consumer indices for specific groups. The Consumer Price Index for Industrial Workers (CPI-IW) is compiled and published by the Labour Bureau, which works under the Ministry of Labour and Employment.

Year-on-year inflation compares prices today with prices a year ago. The base effect is the impact of that previous year's price level on the calculated inflation rate. If prices were unusually low last year, the same prices today show a high inflation rate, even without any fresh price rise. A high base last year has the opposite effect and makes current inflation look low.

Inflation generally arises in two ways:

• Demand-pull inflation: when total demand exceeds supply: too much money chasing too few goods. This can happen in a booming economy or when the money supply grows too fast.
• Cost-push inflation: when the costs of production rise (wages, raw materials, fuel), and firms pass these higher costs on to consumers as higher prices.

A rise in global oil prices, for example, can cause cost-push inflation across many goods at once.

Food prices in India have often risen faster than other prices, and for structural reasons rather than passing shocks.

• Changing consumption patterns: rising incomes shift diets towards protein-rich foods such as milk, eggs, fruits and vegetables. Demand for these items grows faster than their supply.
• Supply-chain constraints: weak storage, poor transport links and long marketing chains limit how quickly food supply can respond, so shortages translate into higher prices.

One claim sometimes made is false: the area under food grain cultivation has not fallen by anything close to 30 per cent. Shrinking acreage is not the cause of India's persistent food inflation.

Inflation has uneven effects:

• it hurts savers, fixed-income earners and the poor, whose money loses value, and
• it can benefit borrowers (who repay in cheaper money) and some businesses, at least for a while.

High inflation creates uncertainty and can harm growth. Governments and central banks therefore work to control it through:

• monetary policy: the central bank raising interest rates or reducing the money supply to cool demand, and
• fiscal policy: the government adjusting taxes and spending.

Keeping inflation low and stable is a key goal of economic policy. This must be balanced against the need to support jobs and growth.

Fiscal policy runs on taxes, so the tax system deserves a closer look. Taxes fall into two broad classes. A direct tax is paid by the same person on whom it is levied, and its burden cannot be shifted to anyone else. An indirect tax is levied on goods or services, and the seller passes its burden on to the final consumer.

• Direct taxes: income tax, corporation tax (tax on company profits), wealth tax, Fringe Benefit Tax (a tax on perks employers give employees), Interest Tax, and the Securities Transaction Tax (a tax on stock-market trades). All of these fall directly on the assessee.
• Indirect taxes: customs duty (on imports and exports), excise duty (on goods manufactured within the country), service tax, and sales tax or VAT. Their burden travels down the chain to the consumer.

Service tax, levied before GST replaced it, was an indirect tax of the Central Government, imposed under the Finance Act. Two fine points from income-tax law are frequently tested. Agricultural income is exempt from income tax, but income from allied activities such as poultry farming and wool rearing does not count as agricultural income and is taxable. Separately, rural agricultural land is not a capital asset under the Income-tax Act, 1961, so its sale does not attract capital gains tax.

The Constitution divides taxing powers between the Union and the States. Who levies a tax, who collects it, and who keeps the money can be three different answers.

• Sales tax: a State subject in the pre-GST era. The tax on everyday purchases like toothpaste was both imposed and collected by the State Government.
• Securities Transaction Tax: taxes on transactions in stock exchanges and futures markets are levied and collected by the Union, not the States.
• Article 268: stamp duties on financial transactions such as bills of exchange and cheques are levied by the Union but collected and appropriated by the States.
• Article 270: income tax is levied and collected by the Union and then distributed between the Union and the States on the recommendations of the Finance Commission (the constitutional body that decides tax sharing).
• Article 271: surcharges on Union taxes belong exclusively to the Union and are not shared.

Corporation tax sits in the Union List (Entry 85). It is levied by the Union, and its proceeds traditionally belonged to the Union exclusively, outside the shared pool. The 80th Amendment (2000) later brought all Union taxes into a common divisible pool, but the classic position remains that corporation tax is a Union levy that the States cannot claim as their own.

India has reformed its tax system in waves. A constant motive is black money, income hidden from the authorities. Its chief harm to the government is the loss of revenue to the state exchequer through tax evasion, which starves public finances.

• Minimum Alternate Tax (MAT): introduced in the Union Budget of 1996-97. It makes companies with large book profits pay a minimum tax even when exemptions wipe out their normal liability.
• Uniform sales tax rates: the Standing Committee of State Finance Ministers recommended in January 2000 uniform floor rates of sales tax across States, to end tax competition between them.
• Kelkar proposals: the task forces under Dr Vijay L. Kelkar (2002) recommended sweeping tax reforms, direct and indirect. The direct-tax task force recommended abolition of the Wealth Tax, which raised little revenue relative to its cost.
• Equalization levy: a 6 per cent tax on online advertisement services supplied by non-resident entities, introduced in 2016. It was brought in through the Finance Act, not the Income Tax Act, and foreign firms cannot claim credit for it under Double Taxation Avoidance Agreements.
• Base Erosion and Profit Shifting (BEPS): an OECD initiative to curb tax avoidance by multinational companies that shift profits to low-tax jurisdictions and erode the tax base of countries where they earn.

Value Added Tax (VAT) replaced the old cascading sales tax in the States. Its defining features: it is a multi-point, destination-based tax, it is levied on the value added at each stage of the production-distribution chain, and its burden is ultimately borne by the final consumer. One thing VAT was not: a central tax. VAT was a subject of the State Governments, not of the Centre.

The Goods and Services Tax (GST), launched in 2017, carried this logic nationwide. Its most realistic advantage is that it replaced multiple taxes collected by multiple authorities and created a single national market. Claims that GST would slash the Current Account Deficit or let India overtake China are exaggerations, not genuine benefits.

GST keeps basic items out of the net. Hulled cereal grains, chicken eggs and newspapers (even those carrying advertising material) are exempt. But processed and canned fish is a manufactured product and attracts GST.

Aggregate tax numbers move with the economy, and they do not move in straight lines. India's tax-to-GDP ratio has fluctuated over the past decade rather than rising steadily. The fiscal deficit as a share of GDP has likewise risen and fallen with the cycle, with no steady upward march.

Within gross tax revenue, the composition has shifted. The share of excise duty in gross tax revenue declined significantly in the years before 2010, as rates were cut and many goods were exempted. Direct taxes such as personal income tax and corporation tax grew in relative importance over the same period.