Taxing the poor… through inflation

Imagine you are spending half of your income on something whose price suddenly increases by a quarter. Seems impossible? This is how in fact inflation has hit the poor in many developing countries, especially Kenya.

This September, overall inflation reached a record high of 17.3 percent. One year ago it was just above 3 percent. Why has it increased so sharply even though Kenya has followed prudent macro policies? The short answer is: food and fuel. In Kenya, food accounts for 36 percent of the average person’s expenditures; energy and transport another 27 percent. The urban poor spend more than 43 percent on food. Since January, food prices have increased by almost 25 percent (see figure), partly as a result of international trends but also due to Kenya’s- agriculture policies. Maize prices tripled between January and June until they retreated a little once the government waived import duties and the 2011 harvest started trickling in. 

Figure – Rising inflation in Kenya

 So if you are exposed to high inflation, there is no choice but to cut down on food or on other expenses, many of which are vital, such as school fees or health care. This is why inflation is the worst tax on the poor.

Kenya’s National Bureau of Statistics is calculating inflation for different income groups in Kenya and it is interesting –although perhaps not surprising- to see that the rich and the middle class only have a moderate problem. They experience price increases of about 10 percent. But for the poor, those who earn less than Ksh 200 a day, inflation now stands close to 20 percent. The rich can also move their money out of the country if inflation becomes too high – an option the poor don’t have. What about poor farmers? Don’t they benefit from higher food prices? They should but often they don’t. Two thirds of Kenyan farmers are net food consumers and are therefore hurt by rising food prices – although to a lesser extent.

High inflation is also a major headache for Central Banks. The Central Bank’s core mandate is to fight inflation, and there are several tools to do this, such as setting interest rates which will influence the amount of money in the economy. When interest rates go up, then the cost of borrowing money increases as well, discouraging borrowing and subsequent expenditure. This should normally bring inflation down. The Central Bank of Kenya has begun to increase interest rates but inflation is still going up.  How come?

The reason is “supply shocks”: higher import prices that are the result of external factors beyond Kenya’s control. An example was the spike in international oil prices following the “Arab Spring”. The tools available to the Central Bank mainly affect “core inflation” which is all the items beyond food and fuel which people use and consume (phones, rent, cement, etc.). This year, the fuel bill alone will likely be as large as Kenya’s total exports. Investors become wary of investing in countries with high inflation, which is one of the reasons why the exchange rate has been plummeting, and why it is so important for any country, not just Kenya, to focus squarely on fighting inflation.

What will happen in the coming months? There are many reasons to believe that Kenya has reached the peak of inflation and, in the absence of any additional shocks we can expect moderate inflation in the coming months. First, food and fuel prices have started to come down and there is a possibility that global commodity prices will decline further if Europe’s economies enter a full-fledged crisis. Second, the “base effect” will materialize in the first quarter of next year – 12 months after relatively high inflation.  Third, the Central Bank has embarked on tighter monetary policies, increasing the core interest rate to 7 percent.

What can Kenyan policymakers do, especially as they cannot influence the price of several key import prices, especially petroleum? In the short-term, the Central Bank could still tighten monetary policy further to slow down domestic expenditure and avoid price increases of other goods and services.

This is often an unpopular measure because it cools the economy and could lead to increased unemployment. However, such “tough love” measures are often critical to lowering inflation and restoring consumer and investor confidence. In the medium-term, a reform of Kenya’s maize sector would help a lot. Kenya’s traditional high-price policy and inefficient marketing systems are hurting the average Kenyan enormously. If Kenyan maize prices simply came down to international levels, which is in fact what one would expect to see, it would already give the poor and the middle class enormous relief. In the long-term, Kenya will only rid itself from inflation and shocks through growing richer and developing a more robust export sector.

This is easier said than done, but the country’s Vision 2030 agenda provides the right framework and emphasis on clean government and better performing infrastructure, especially the port, rail and energy. Kenya will still not be able to influence international food and fuel prices but higher incomes would protect Kenyans as they would only spend a smaller share of their income to meeting essential needs. High food and fuel prices may still be reason for complaint but not a source of suffering.