Can the government help maintain spending power without wages and prices rising too rapidly?

Published on: 24 August 2022

Topical issues in the field of economy, (responsible) investment, pension and income: every week, one of APG's experts provides a clear answer to this week's question. This edition: macro-economist and senior strategist Charles Kalshoven on the question whether a loss in spending power can be compensated without ending up in a wage-price spiral.

The Netherlands Bureau for Economic Policy Analysis published some tragic figures last week. The inflation is expected to rise to 9.9 percent this year. The significantly increased price level and the lacking wage increase result in a loss of spending power of 6.8 percent. The government calls upon employers to increase the wages. The subsequent risk would be that employers will pass on those higher wages in their prices. Because of those increased prices, employees ask for higher wages again to maintain their spending power: the infamous wage-price spiral.

Government support
The current inflation mainly results from the significantly increased energy prices and it is difficult to compensate this increase, Kalshoven believes. “Wide-ranging government support is counterproductive in these economic circumstances, as that stimulates the economy with the risk that the inflation rises even further. Inflation arises because the supply - of energy, among other things - is far below demand. This results in an increase of the prices, in order to bring supply and demand more closely in line with each other. If the government decides to compensate citizens for their loss of spending power at a large-scale, this actually adds fuel to the fire: the demand side is stimulated without any margin left on the supply side. You should remember that we became poorer collectively. We have to pay (a lot) more for foreign energy. The pain of that bill can be distributed differently or moved towards the future but cannot be eliminated.”

Lowest incomes
Kalshoven: “On the other hand, it is completely understandable that the government does not want their citizens to be cold this next winter and wants to compensate them for the high energy prices. But it is impossible to compensate everyone, as we are all ‘the government’, and this is also extremely expensive. It would be more logical to provide targeted support to people with the lowest incomes who often have the highest energy bills relatively speaking. However, that also comes with a ‘but’ because it is of course possible to lower the taxes and the VAT, but the positive thing about expensive energy is that it is an incentive to use energy economically.” That makes the Netherlands less dependent on Russian gas and it benefits the fight against climate change.

Political leaders are currently looking more into wealth tax than taxation on labor

“Instead of making modifications to the prices, it would theoretically be better to pay people a fixed contribution. That maintains the incentive to use energy efficiently while families are still able to make ends meet.” Another important question is what source should be used to pay for that government support. “The political leaders are currently looking more into wealth tax than taxation on labor. That is a rather logical step: you want to discourage working as little as possible.” In order to keep government expenditure within limits, Kalshoven can imagine that once the energy prices decrease, the government increases the tax on energy. “Not by 100 percent, but let's say the energy prices decrease by 20 percent, the taxes could be raised by 10 percent. This is a way to maintain the trigger to save on energy consumption and it is a way to avoid having to increase the taxation on labor. This also places the ultimate tax burden partially on the producers of fossil energy.”   

The government could therefore compensate the lowest incomes with targeted support for their loss of spending power. That keeps the costs for the government, and therefore the taxpayer, manageable. Automatic wage compensation for employees, laid down in Collective Labor Agreements, is not a good idea, according to Kalshoven, as that increases the risk of the dreaded wage-price spiral. “We have to bite the bullet of a period with higher prices. It is a national impoverishment and it makes sense to divide up the bitter pill between citizens and companies. The suffering can also be spread over a couple of years. In the sectors with high staff shortages should be room to grant the higher wage demands. “That has to be done, because you want the market to work and to make the sectors with the highest staff shortages more appealing to employees.”

“Sticky” prices
Now that the prices are increasing this year by roughly 10 percent and it will have escaped nobody's attention that the energy bill and the prices of our daily groceries are a lot higher than a few months ago, the question arises whether the prices will also decrease again. “Some prices are “sticky” and some prices fluctuate faster”, Kalshoven explains. “A good example of sticky prices are the ones in the hospitality industry. That sector usually adjusts the prices once a year and it would be rather unique if those prices decrease. That also has to do with the fact that the provision of services is a major cost factor and the productivity gain not very high.” The oil price, on the other hand, is not sticky which is something car drivers notice from time to time when they pay a lower price for fuel. Also the prices in the supermarkets will not continue to rise endlessly. The wheat price, for example, is lower now than before the Russian invasion in Ukraine, what could result in lower prices for bread. “That doesn't mean all prices in the supermarket go down again, but it is a promising sign.”