Measures to combat inflation and its effects

In a joint statement, IHS and WIFO propose measures to combat the currently high inflation and its effects.


Inflation in Austria reached 8 percent in May 2022, a level not seen for almost 50 years. Currently, IHS and WIFO expect inflation to be around 6½ to 7 percent for 2022 as a whole, moderating in 2023 but still around 4 percent.

The strong price dynamics are to a large extent due to increased world market prices of imported fossil fuels and increasingly also of agricultural commodities. This is associated with losses in domestic welfare, against which domestic economic measures do not help. However, they can help to distribute the overall economic losses more fairly. Although the government can spread the costs over time by increasing public debt, it cannot undo the economic damage. There is a danger that generous debt-financed compensation measures may even further accelerate inflation because they fuel demand for scarce goods.

To mitigate inflation and, above all, to cushion the loss of purchasing power of private disposable household incomes, the federal government plans to supplement the two previous inflation packages with further measures. In this statement, WIFO and IHS present some scientifically substantiated proposals that can bring short-term relief to households and businesses. These proposals and assessments are embedded in longer-term structural considerations. Finally, it is explained which of the currently discussed proposals for measures are to be regarded as not very effective.

1. Short-term effective measures to cushion the burdens of high inflation

The following proposals for cushioning the loss of purchasing power of private disposable household incomes due to the historically very high inflation are guided by the objective of avoiding social hardship. For households with low incomes and high dependence on fossil fuels, it is becoming increasingly difficult to cope with the additional financial burdens caused by the price increases of necessary goods such as household energy and food.

When selecting (further) support measures, IHS and WIFO recommend paying particular attention to their social impact and to give special support to households that are already affected or threatened by poverty. In addition, budgetary costs of the measures and their compatibility with the climate goals must be included in the evaluation.

WIFO and IHS consider an increase in the tax credits for low-income recipients (pensioner tax credit, supplement to the transport tax credit) as well as the negative income tax, an increase in social benefits that secure a livelihood (equalisation supplement, minimum income support, social assistance, benefits for refugees) and family benefits, especially for low incomes (multiple child supplement in family allowance and additional child amount in the family bonus) to be suitable instruments. In view of the higher inflation rates to be expected in the medium term, an inflation adjustment (also during the year) should be made to safeguard the purchasing power of social benefits. However, automatic indexation is not recommended for the time being, but proposals should be developed on how the social system can be made more robust against inflationary shocks.

However, the higher the inflation and the longer it lasts, the more the group of households that get into financial distress due to inflation expands towards the middle-income group. However, Austria lacks a suitable instrument for targeted support for this potentially expanded target group, as the necessary information is not (yet) available (or compiled). The problems in the implementation of the energy voucher have shown this.

Here, IHS and WIFO propose to create a suitable instrument: on the basis of the individual income data from the tax authorities, on the receipt of family allowance and long-term care allowance as well as on the main residence according to the population register, targeted support should be made possible for most households without application, analogous to the automatic employee tax assessment. Policymakers can then provide one-off, targeted support to households by defining the eligibility conditions (income limits).

2. Structural measures

The short-term relief measures would have to be flanked by longer-term structural measures.

2.1 Fossil energy savings

For the increased use of renewable energy sources as a substitute for fossil energy, approval procedures should be streamlined, for example with regard to plant approval, zoning and spatial planning. Subsidies for energy conversion, for example for the replacement of boilers in households, or for the replacement of gas for the production of process heat in production plants, are recommended.

In addition, energy saving should be promoted in order to reduce energy expenditures, achieve climate goals and reduce dependence on imported fossil fuels. Recommended government measures include, for example, behavioural economic incentives to reduce the energy demand of private households, energy savings in state-owned enterprises (e.g., in the vehicle fleet) and in public institutions (swimming pools, schools and kindergartens, administrative buildings, etc.) or photovoltaic systems on public buildings. In addition, a reduction of the maximum permitted speed on long-distance roads should be considered.

2.2 Restrained fiscal policy

Inflation can be fought by reducing demand. Necessary government infrastructure measures, for example in the context of the energy transition, and government subsidies for energy-saving measures will generate further demand and can potentially contribute to inflation. This should be counteracted by a restrained fiscal policy in other spending areas, especially since the Austrian economic development is currently limited by supply-side problems and not by a lack of demand. In particular, additional government benefits should be limited to support for low-income households. At the same time, the major structural reforms in the public sector that have been pushed in the background by the pandemic, such as reforms in federalism, the system of subsidies, the health care system, or the pension system, urgently need to be put on track in order to gain fiscal space in the medium and long term for future increasing demands on public budgets resulting from climate change, demography, and digitalisation.

2.3 Compensating for cold progression

The sharp rise in inflation makes it more urgent to address the problem of cold progression (fiscal drag). As an immediate measure, a one-time adjustment of all brackets of the tax schedule is appropriate. At the current level of inflation, an adjustment of 5 percent is appropriate. The systematic abolition of cold progression requires a thorough approach and should not be tackled hastily. All elements of the tax and social security system expressed in fixed euro amounts (e.g., allowances, deductions, tax credits, negative income tax) must be adjusted. In principle, only the cold progression should be compensated, not the increase in the average tax rate due to real income increases. Nor should a strict automatism be introduced, but an independent institution should be commissioned to regularly determine the extent of the additional tax revenues due to the cold progression and the distribution of the additional burdens. Similar to Germany, it could then be up to the federal government to decide in what form the cold progression will be compensated.

Inflation-related additional government revenues are not limited to income tax. Inflation also leads to distortions in the taxation of capital income, insofar as nominal increases in the value of assets that do not represent a real increase in value but only an adjustment for inflation are nevertheless subject to capital gains tax. The taxation of nominal gains acts like a wealth tax. An inflation-neutral tax system would tax real, not nominal, capital gains, but changing the tax system in this direction is not practicable in the short term. The resulting additional tax burden represents a substantial contribution of the factor capital to overcoming the crisis.

Inflation also leads to additional VAT revenues, which are not problematic from a tax efficiency perspective and can help finance compensatory measures for households and companies.

2.4 Reduction of non-wage labour costs

As a further structural measure, WIFO and IHS propose a reduction in non-wage labour costs, for example in the form of a reduction in unemployment insurance contributions or contributions to the family equalisation fund or residential building. In this context, compensation payments from the federal budget should not lead to a reduction in the scope of services provided by the labour market service, the family burden equalisation fund and residential building subsidies by offsetting the shortfall in revenue from the federal budget. The aim of the measure is to reduce costs for firms and thereby dampen upward pressure on prices. In the long run, fundamental reforms of the financing of family benefits, subsidies for residential buildings and unemployment assistance are needed, which can permanently reduce non-wage labour costs, and which are fully counter financed.

3. Measures not to be recommended

In principle, measures that intervene in the price mechanism and reduce the relative prices of energy sources are not to be recommended. They counteract the structural goals, namely the reduction of energy dependency and the goal of climate neutrality. Moreover, price reductions are not targeted, and in the case of tax cuts it is unclear to what extent they will be passed on to consumers. Temporary tax cuts then lead to temporarily higher inflation when they expire, and tax rates return to the original level. Moreover, such measures are usually very expensive from a budgetary point of view.

Against this background, a number of measures currently under discussion are not recommended. Firstly, these are tax relief measures for energy products in the form of a reduction in VAT or mineral oil tax. They would not be ecologically sustainable, would not be targeted and would entail high budgetary costs. It should also be taken into account that with the reduction of the natural gas and electricity levy, corresponding tax relief measures have already been implemented, which will be strengthened by the temporary suspension of the renewable subsidy flat rate and the renewable subsidy contribution. For ecological reasons, the planned introduction of the carbon pricing system should be postponed at most only to the point in time when the climate bonus is paid out. At 30 € per ton, the CO2 price is moderate, and because of the climate bonus, private households as a whole will be relieved in net terms. A price stabilisation mechanism also provides that in the event of high energy price increases, the gradual increase in the CO2 price planned for the next few years will be reduced.

Secondly, the reduction of VAT on food is also not recommendable. It is not targeted, and the budgetary costs are high. If only the VAT on basic foodstuffs were reduced, there would be delimitation problems and a high administrative burden.

Thirdly, price-regulating measures such as an energy price cap or a rent freeze are not without problems.

Finally, an increase in certain taxes to finance the additional expenditures for relieving the burden on households and companies is also not expedient. The discussed tax on windfall profits for energy companies is associated with several problems. Besides delimitation problems regarding the tax liability and the determination of the amount of windfall profits, such special taxes bring unrest into the corporate tax system. Moreover, higher profits are in any case captured via the corporate income tax. In the current situation of global economic uncertainty, new taxes could also dampen business confidence and thus their investment activity. This also applies to the proposal to introduce wealth-related taxes to finance the burdens of the crisis. Last but not least, the tax ratio in Austria is already high. Insofar as inflation-related automatic tax revenues (in the case of VAT and income tax due to the effect of cold progression) are not sufficient to finance the crisis-related additional expenditures, expenditures should therefore be shifted (preferably in the form of reducing ecologically counterproductive subsidies) and, if necessary, the deficit increased.


Contact

Dr. Sebastian Koch
koch(at)ihs.ac.at
+43 1 59991 126