Inflation tax masquerading as dividend income

In May, the Reserve Bank of India (RBI) paid a huge dividend of Rs 99,122 crore to the Government of India (GoI), and this is not an isolated case. How come?

The basic though simplified story is that the RBI regularly issues new money. Such issues of money hardly cost the RBI anything. But the money has purchasing power in the marketplace, given its status as the legal tender. So, the RBI has been able to “earn” massively over years. In recent years its payment to the GoI in the form of “dividend income” has gone up substantially. 

A good part of the new money issued by the RBI on a somewhat ongoing basis is in excess of what is required to meet the needs of a growing economy; at the end of the day, in one way or another the excess issue of money causes inflation, or it accommodates and sustains inflation that originates elsewhere. It is true that this analysis does not apply to, say, the US over the last decade but the conditions there are different (1). 

The so-called dividend income from the RBI to the GoI enables the latter to buy more in the marketplace. But this “income” is not based on production. So, the public gets to buy less. The GoI gains and the public loses. What we have is effectively a tax though it is subtle and non-transparent as it is collected indirectly through the RBI. The economics literature recognises this as inflation tax though the public authorities almost always call it dividend income!

Inflation tax is unlike, say, income tax, which is progressive. The income tax rate increases with income, and low-income earners are given complete exemption. The story of inflation tax is very different. The inflation tax falls primarily on people whose income or assets do not keep pace with inflation. Such people include disproportionately the ones who are less well-off or less well-informed or have low bargaining power. So, the inflation tax tends to be regressive.

There are two different questions with regard to the “income” of the kind discussed above. First, should it be shared adequately by the RBI with the GoI — more so, when the country is facing a crisis related to Covid-19? Second, should the RBI “earn” such a high income of this kind? The answer to the first question is yes. On the second question, we need a bit of background here. 

In the past, the inflation rate often stayed above 7 per cent for a long period of time. Then based on deliberations over the period 2013 to 2016, the RBI was officially given the mandate to target a relatively lower 4 per cent inflation rate with a leeway of 2 percentage points around the target — as and when the leeway is needed on a temporary basis. So, there is, in principle, an improvement with regard to the inflation tax over the past. The question is whether or not the RBI is, in practice, consistently respecting the mandate of targeting 4 per cent inflation in letter and spirit? 

Inflation targeting was phased in over the period 2013 to 2016 informally at first, and then formally. The inflation rate did move down (and possibly a bit abruptly) towards the targeted 4 per cent rate. However, in 2020, the inflation rate went up again. It was 6.6 per cent for the year as a whole, which is 65 per cent above the target of 4 per cent! This year the inflation rate did come down but it appears from the statements and actions of the RBI at this stage that the economy is once again being steered towards a higher inflation rate and accordingly a higher inflation tax. 

The RBI may be inclined towards higher inflation at this stage with the view that this will help with achieving higher output and employment. However, time and again the overall experience in the past on such a path has not been good. So, there is a need for course correction. There are other policies to help the real economy but that is a different story (2).

The US went through inflation that was lower than its target of 2 per cent for about a decade. So, the Fed is now encouraging inflation that is higher than 2 per cent so that the average inflation rate gets close to 2 per cent in the US. By that logic, in India after the high inflation in 2020, going forward the RBI should be moving towards inflation that is less than 4 per cent in India. At least it should not in one way or another nudge the economy to an inflation rate that is higher than 4 per cent. By implication, it should avoid raising the inflation tax. The GoI can raise funds through other taxes (3).

The writer is visiting faculty, Indian Statistical Institute, Delhi 

1.https://www.ideasforindia.in/topics/macroeconomics/covid-19-recession-in-india-and-policy-lessons-from-other-countries.html

2.   https://www.ideasforindia.in/ topics/macroeconomics/a-ten-point-programme-for-economic-recovery.html

3. https://www.ideasforindia.in/topics/macroeconomics/ budget-2021-22-missed-opportunity-for-increasing-tax-collection.html