Sunday, October 16, 2011

Is A CPI Adjustment What It Looks Like?

Last week’s article (Savers Are Losers) generated the most number of queries and comments from readers so far on this column. For the sake of people who may not have read the article, the four main reasons people who save money end up losing instead of making money are:

1. Banks charge account keeping fees;
2. Interest rates on deposits are very low;
3. The government charges interest withholding tax at 15%; and
4. Inflation wipes out most if not all of what savers may earn from interest after taking account of the above three reasons.

One thing about the effect of inflation is that it cannot be seen. Savers can see from their monthly statements the fees that are charges by banks; they can easily see the interest rates that are offered by banks for various types of saving accounts; and they can easily see the amounts the government collects in taxes on interest earned. But they cannot see how inflation works to wipe out the ‘purchasing power’ of both their savings and the interest they earn on deposits.

Savers with the super funds, for instance, may get excited that their so-called retirement savings been growing in recent times. They may have received double-digit returns, but what they may not realize is that high inflation means reduced real returns.

Let me now look at upwards adjustments in salaries working people see in their salaries on account of increases in the Consumer Price Index or CPI.

I have met many people in my personal financial management and investing seminars who have admitted that they have raised expenses or borrowed money when they have received CPI adjustments in their salaries. They have been misled into thinking that their salaries have been increased (so they can now afford to spend more or borrow), whereas the truth is that they have merely been compensated for the reduction in their real incomes on account of rising costs of living.

Such CPI adjustments used to be by the full rate of inflation as announced by the National Statistical Office. In recent times adjustments have gone only part of the way, and that only after employees have raised the issue with their employers. Rising costs also affect employers so they are not so keen to talk about CPI adjustments. My prediction is that CPI will be a thing of the past in PNG as inflation goes into double-digits in the coming years. I also predict that there will be more calls for pay increases as workers find their salaries buying less and less. It will come to a point where workers have to decide between fighting for higher salaries and losing their jobs, or keeping their jobs and being content with stagnating nominal (cash) incomes and falling real incomes, and hence living standards.

The other thing about CPI adjustments is that it has the potential to push workers into higher income brackets, with the result that they end up paying more income tax. Effectively the government gets a raise in income tax every time workers get compensated for rising costs of living. The twin effects of inflation and income tax usually pushes workers back in terms of their standards of living.

So in answer to the question “Is a CPI adjustment really what it looks like?”, the answer is “No”. You simply cannot take things at face value. You have to look deeper at the inflation rate as well as the income tax implications before getting excited whenever the employer announces that you will receive a CPI adjustment in your salaries.

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