The war between Russia and Ukraine and related sanctions has led to much higher energy, raw material and food prices that will seriously diminish the real purchasing power of households throughout the world and drive a great number of families into poverty. Furthermore, very large increases in input costs can be expected to result in many businesses cutting back on production and employment.
These developments would cause the economic situation for sizable portions of the populations of European countries to become quite dire, especially if energy and grain supplies from Russia and Ukraine are severely disrupted. For instance, how will lower and even middle-income households in Bulgaria and Greece, countries that are heavily dependent on imports of energy and grain products via the Black Sea, and which have minimum monthly wages of €332 and €773, respectively, cope with much higher prices of energy, transportation and basic foods?
Inflation inequalities
The onset of higher inflation will further widen income, wealth and intergenerational inequalities in countries such as Cyprus, where such inequalities have been exacerbated by the effects of and reactions to the Covid-19 pandemic. Most strikingly in Cyprus, the large gap between highly paid public sector employees and modestly compensated private sector employees has widened considerably in recent years.
Furthermore, so-called inflation inequality whereby soaring prices tax low-income families more heavily than rich ones can be expected to prevail in many countries during 2022 and probably beyond. In most countries including Cyprus low-income families spend a much higher proportion of their incomes on electricity, transportation costs and basic food products than high-income families, the prices of which are rising at a faster rate than other goods and services. In fact, the consumer price index in Cyprus in the 12 months to February 2022 rose by 6.6 per cent, yet the electricity and petroleum products price components, which have a combined surprisingly low weight of just 8.7 per cent in the index, rose more steeply by 22.4 per cent and 28.4 per cent, respectively.
Current EU policy responses
With the prospect that the Russia-Ukraine war and its repercussions, including the harsh imposition of mounting sanctions, will result in prolonged higher levels of inflation in Europe, how should the inflationary consequences be dealt with? Prior to the Russia-Ukraine war EU policy makers were concerned with the impact of rising energy prices on vulnerable persons in the union. Accordingly, the European Commission recommended that governments “make social payments to those most at risk to help them pay for their energy bills” and added that “this can be financed with EU Emissions Trading System revenues”. The Commission called also for “the exemption of vulnerable households from higher energy taxes”.
Most EU governments have stepped in to mitigate the impact of steeply rising energy costs and have made transfers to poorer households to cushion the impact. However, Cyprus is one of the five EU countries among 22 members that have NOT made such transfers and has effected only a 10 per cent discount on electricity bills for all households and businesses and most recently passed legislation to reduce taxes on sales of petroleum products and heating oil. Furthermore, Cyprus has not used or has misused the €300 million of revenue from the EU Emissions Trading System designated for financing these transfers.
Policy recommendations
But with oil and natural gas and other commodity prices including metals and grains rising to extremely high levels and expected to remain elevated during the next half-year or more, policy measures of governments, including those of the EU will need to go far beyond existing actions to protect their populations from soaring prices.
It will be necessary for EU governments to raise social payments to protect more households increasingly at the risk of poverty from higher energy and food prices. At least for elevated energy prices and taking differences in the cost of living into account Cyprus could follow the French example and give monthly payments of €100 euro to households earning less than €1,500 per month.
However, businesses and the economy in general will need to be protected from soaring prices and costs. It is recommended that to help contain inflation, ceilings be placed on the retail prices of petroleum and diesel oil and purchase prices of grains. With reference to higher energy prices that cause other prices to rise, most importantly transportation costs, Cyprus could follow Hungary and place price ceilings of 1.40 per litre on petroleum and diesel oil.
Furthermore, very large price increases in recent months have not been confined to energy and agricultural products. Businesses in the industrial sector including construction are facing sharp increases in input costs, particularly of raw materials such as metals, wood and plastics as well as electricity, which are contributing substantially to boosting industrial output prices, with the index for Cyprus increasing by 18.6 per cent over the 12 months to January 2022.
And higher agricultural and industrial output prices can be expected to be passed on in consumer prices in the coming months further raising the cost of living substantially for most European residents. In this respect, in Cyprus consideration is being given to restoring cost of living adjustments for employees. But such wage adjustments mainly benefit overpaid public sector and bank employees from such adjustments and run the risk of perpetuating surging inflation. However, taking into account that ongoing inflation is adversely affecting lower income households disproportionately, it would be preferable for the Cyprus government to be proactive as indicated above in protecting lower income households from the higher prices of energy, transportation and basic foods with increased social transfer payments.
Financing inflation protection
For many EU countries, including Cyprus, financing the government expenditures required to protect their populations against the ravages of surging inflation will be very challenging. Revenues from the EU’s Emissions Trading System are far from sufficient even to finance social transfers to vulnerable households. And governments with relatively high debt to GDP ratios such as Cyprus (105 per cent at end-2021) would not want to finance higher expenditures by accumulating substantial amounts of debt. In addition, while the EU can be expected somewhat belatedly to provide a facility to assist in alleviating the fiscal costs incurred by governments in protecting their populations, governments need to be proactive at an early stage with domestic financing to safeguard against socio/economic instability.
Although, cutting the bloated public wage bill of Cyprus would help, its only real funding alternative would be tax reform aimed at substantially boosting revenues in order to finance the increased government expenditures required to deal with the consequences of higher inflation. Tax reform would need to include more progressive rates on personal incomes and the introduction of a progressive tax on immovable property that along with very serious efforts to combat prolific tax evasion would immensely raise tax revenues from rich persons and companies that have the ability to pay much more in taxes.
Furthermore, effective reform of the tax system and its administration would enable a significant redistribution of income from rich entities to poorer households via social transfers, that would in turn contribute to the narrowing of the prevailing large income and wealth inequalities. In fact, it is striking that partly because of its relatively low tax collections, especially from income and abysmally deficient property taxes, the Cyprus government in 2020 spent the equivalent of just 13.6 per cent of GDP on social protection, whereas the average for EU countries was 22.0 per cent.
Revision of government budget necessary
The need for the government to undertake expenditure including subsidies and taxation measures to protect persons and businesses against surging inflation as well as other higher costs, such as for supplies, will require the government to substantially revise its budget for 2022. Most notably, the budget approved by the House of Representatives in December 2021 was based on the assumption that prices would increase by 2.0 per cent in 2021 and by just 1.5 per cent in 2022. However, consumer prices increased by 2.4 per cent in 2021 and can be expected to rise by at least 6 per cent on average in 2022, meaning that price levels in 2022 are likely to be over 5 per cent higher than forecast and assumed for this year’s budget.
Leslie G Manison is an economist and financial analyst, specialising in macroeconomic policy analysis, bank viability assessments and international financial relations. He is a former senior economist at the International Monetary Fund, an ex-advisor in the Cyprus finance ministry and a former senior advisor at the Central Bank of Cyprus
