Why Headline CPI
increases the Wage Gap
The South African economy has historically been plagued by income inequality. Given this socio-economic background, South Africa has a specific interest in reducing their wage gap and uplifting the standard of living of the lower income groups in particular. But what drives this growing wage gap? Inflation data taken for the period 2009 to 2016 indicates that the lower income groups faced a higher instance of inflation than what was reported by Statistics South Africa’s headline consumer price inflation rate. Lower income groups also faced a higher instance of inflation than the more affluent income groups during this period. This paper investigates why this is the case as well as what can be done (practically) to ensure that the wage gap does not increase in real terms.
This paper endeavours to provide insight into the importance of being aware of the wage gap, changes in the cost of living on an individual basis (rather than economy-wide basis) and the impact that these have on individuals’ lives.
According to the World Bank’s calculation of the Gini Coefficient, the South African economy has the worst distribution of income in the world – with a Gini coefficient of 0.63.
Inequality has a strong correlation with a number of social and economic ills which beleaguer the South African economy. These include high unemployment, poor health, high crime, poor education, etc. Removing the unemployed from the Gini Coefficient calculation results in a figure of 0.43. This is larger than the Gini coefficient of the United States of America (0.42). As a result, it is of particular importance in South Africa that a deliberate effort is made to reduce this inequality in the pursuit of better social and economic conditions.
Most employed South Africans receive an annual salary increase which is meant to enable an employee to keep up with or exceed the cost of living.
The most commonly known inflation figure is the headline consumer price inflation rate, as this is the figure quoted in the media when Statistics South Africa (Stats SA) releases their monthly inflation figures.
Despite this figure reflecting the state of inflation in the economy as a whole, it has very little relevance to most individuals in their personal capacity. This is because the share of their individual income that they spend on goods and services differs in quantum and distribution from that of the average economy (which is what headline consumer price inflation measures). A more granular approach to determining the true inflation rate faced by individuals is to consult the inflation rate per expenditure decile. This means which 10 percent of spend the individual falls in from the first 10 percent to the last 10 percent of the whole economy.
On average between 2009 and 2016, the poorer income groups have faced a higher inflation rate than the richer income groups. The effect of this is that if a standardised (identical) increase was given to all occupational levels in the organisation then the wage gap would increase in real terms over this period.
Given the high levels of income inequality in South Africa, it is of paramount importance that those responsible for awarding annual increases are aware of how the cost of living differs between individuals based on the portion of their income that they spend on various goods and services.
3. Literature Review
Inflation is defined as a general increase in prices and fall in the purchasing value of money. In South Africa, Statistics South Africa (Stats SA) records the inflation rate of a wide variety of items that make up a representative basket of goods which is used for calculating headline consumer price inflation. As the name suggests, this is the inflation rate which finds its way into the headlines of newspapers and articles – it is used as measure of the inflation rate that the economy faces as a whole. Although headline consumer price inflation is a measure of the inflation rate the economy faces as a whole, it is important to note that individuals face a different inflation rate based on the portion of their income they spend on various goods and services. As an example, a poorer person would spend a larger portion of their income on food than an affluent individual.
According to Bulir (2001), higher inflation rates negatively affect the distribution of income within an economy. In other words, higher inflation rates affect the poorer households more than the richer households. The effect of this is to drive up income inequality during times of high inflation. The Gini Coefficient is a measure of wealth distribution in an economy and ranges between zero (all citizens have the same wealth) and one (one citizen has all the wealth). South Africa has the highest Gini Coefficient in the world and is currently 0.63 according to the World Bank including the unemployed. According to 21st Century (2017), the Gini coefficient improves to 0.43 if the unemployed are excluded from the calculation. This means that in terms of the distribution of wealth, South Africa is the most unequal society in the world. Although the gross domestic product (GDP) per capita has been steadily growing in South Africa, these gains are not being distributed equitably amongst the citizens – the rich are getting richer while the poor are getting poorer. According to the Kuznets Curve, created by Simon Kuznets (1954), when an economy grows, the first thing that happens is that inequality increases as GDP per capita increases. Over time inequality decreases as the economy matures. Figure 1 is an example of a hypothetical Kuznets Curve.
Figure 1: Kuznets Curve
In South Africa’s economic development life cycle, South Africa sits quite close to the apex of the curve in the Kuznets Curve which has contributed to the growing wage gap. According to Leibbrandt et al, (2010) income inequality has been on the rise since 1993. This increasing inequality has been seen across the economy as a whole as well as within race groups. This importantly indicates that it is not a racial trend but rather a case of the rich getting richer and the poor getting poorer across all race groups.
Purchasing power is the real value of an individual’s nominal income once it has been adjusted for inflation. In other words, it represents what your money is ‘really’ worth and what you can buy for that amount of money. This means that the inflation rate has a significant impact on an individual’s income. In South Africa, it is common practice that employees receive an annual increase in their salary to counter the effect of inflation. According to the 21st Century increase report (2019), over 80% of organisations consult headline consumer price inflation when determining the level of annual increases that they offer their employees. Although this may seem logical, headline consumer price inflation is weighted approximately 50% by the richest 10% of individuals in the economy and only weighted by 0.5% by the poorest 10%. This makes sense from an economic accounting point of view, because the skew distribution of income in South Africa means that the richest 10% do in fact spend 50% of the income in the economy. However, this means that the headline consumer price inflation figure represents the inflation rate faced by the rich rather than the poor. Table 2, indicates how the headline consumer price inflation rate is weighted per expenditure decile.
Table 2: Weighting of Headline CPI by Expenditure
Table 2 indicates that the highest spending 20% provide approximately two thirds of the economies inflation weighting. Conversely, the lowest spending 80% only contribute one third of the economies inflation weighting.
The impact of this is that if the rich and the poor have vastly different baskets of goods and services (they spend significantly different proportions of their income on various goods), then their inflation rates that they face will differ. Due to the rich having such a large impact (two thirds) on the national headline consumer price inflation rate, their inflation rate is quite similar to that of national headline consumer price inflation.
Conversely, the poor could face a very different inflation rate to headline consumer price inflation as their own inflation rate. Table 3 indicates the percentage of their income that each expenditure group spends on each classification of items.
Table 3: Expenditure Deciles by Product or Service Group
Table 3 illustrates how the relative importance of food impacts a poor individual’s spending more than a rich individual – the poor spend 48% of their income on food and non-alcoholic beverages whilst the rich only spend 11%. Therefore, in times of high food inflation such as in 2016 (10.5%), headline consumer price inflation will understate the true inflationary pressure faced by the poor.
If everyone in the economy received standardised (identical) headline consumer inflation increases in their salary (in 2016), then the rich would keep pace with their inflation rate (due to their high weighting on headline consumer price inflation). Conversely the poor would face a higher inflation rate than they are compensated for because of their dependence on food and non-alcoholic beverages. Therefore, their real income or purchasing power will decrease as their true inflation rate is above what they have been compensated for via a salary increase.
Table 4 compares the two largest contributors (transport and miscellaneous goods and services) to the richest expenditure decile’s basket of goods and services with the food and non-alcoholic beverages inflation rate, the largest contributor to the poorest expenditure decile’s basket of goods and services.
Table 4: Comparing the Inflation Rates of the Richest and Poorest Expenditure Deciles
Table 4 illustrates the effect of food and non-alcoholic beverages inflation (green bar) on the inflation rate faced by the poorest expenditure decile (pink bar). Conversely, Table 4 also illustrates the impact of transport (orange bar) and miscellaneous goods and services (blue bar) on the inflation rate faced by the richest expenditure decile (black bar). The trend is that when food and non-alcoholic beverages inflation is high relative to the rest of the CPI basket of goods and services, the poor are impacted the most. In years 2010, 2017 and 2018, the inflation rate of food and non-alcoholic beverages is below the average rate for transport and miscellaneous goods and services which is the main reason for the poorest expenditure decile only facing a lower inflation rate in these years.
The next section will unpack this statement and illustrate how the different income groups’ inflation rates differ from that of headline consumer price inflation. This will demonstrate how using headline consumer price inflation as a measure of all individuals inflation rates can cause the wage gap to increase in real terms.
4. Analysis and Findings
In our analysis and findings we will perform an empirical analysis to answer the question of how headline consumer price inflation can increase the wage gap in real terms. The inflation rate faced by each expenditure decile can be calculated by making use of the weightings in Table 3. Table 5 depicts the inflation rate faced by each of these expenditure groups between 2009 and 2018.
Table 5: Headline CPI by Expenditure Decile by Year
Table 5 illustrates that with the exception of 2010, 2017 and 2018, the inflation rate faced by each expenditure decile has been regressive i.e. the higher the expenditure group the lower the headline CPI. This means that the poorest individuals have generally faced the highest instance of inflation. As a result, expenditure deciles 1 to 8 (the lowest eight expenditure deciles) faced an inflation rate above that of headline consumer price inflation in every year (except 2010, 2017 and 2018). The final column indicates the average inflation rate per annum between 2009 and 2018. If headline consumer price inflation was universally given as the annual salary increase to all employees then the only two expenditure deciles that would be better off in real terms are the two highest expenditure deciles (9 and 10). These two deciles would have gained 0.1% per annum in real terms between 2009 and 2018. Conversely, Expenditure deciles 1 and 2 would have lost 0.2% and 0.3% (respectively) per annum in real terms between 2009 and 2018.
The effect of this is that if headline consumer price inflation was used as the salary increase figure across all levels of the organisation, the wage gap would increase in real terms. The reason for this is that the richest individuals would receive a marginal increase in their real income while the poorest individuals would face deterioration in their purchasing power (a decrease in their real income). This is compounded every year as the real reduction or increase is cumulatively multiplied on all previous years decrease or increase.
This can be illustrated using an example whereby two individuals receive the same income but face differing inflation rates. In this example, individual A will face the same inflation rate that expenditure decile 1 (the poorest) faced in 2016 and individual B will face the inflation rate faced by expenditure decile 10 (the richest) in 2016. For illustrative purposes, both individuals will have a salary of R100 000 per annum. Table 6 illustrates how individual A (poorest) has been affected by inflation.
Table 6: Example Expenditure of Individual A (decile 1)
Analysing Table 6, it can be seen that the high inflation rate of food and non-alcoholic beverages in 2016 (10.51%), together with individual A spending 48.13% of their income on food and non-alcoholic beverages has led to a R5 059 increase in spending on food and non-alcoholic beverages alone. Cumulatively, individual A’s expenditure increased by R7649 in 2016 as a result of the inflation rate that they faced (expenditure decile 1). This means that their effective inflations was 7.6% whilst the headline inflation rate was 6.3%.Table 7 performs the same analysis for individual B (the richest expenditure decile).
Table 7: Example Expenditure of Individual B (decile 10)
In contrast to individual A, individual B’s expenditure on food only went up by R1 129 as a result of the lower share (10.74%) of their income that they spend on food and non-alcoholic beverages. In total, individual B would spend R6 094 more in 2016 as a result of the inflation rate that they face (the richest expenditure decile). This means that their effective inflation rate was 6.1% whilst the headline inflation rate was 6.3%.
If both of these individuals received an annual increase equal to headline consumer price inflation in 2016, then both individuals would receive a 6.3% increase. Since both of these individuals earn R100 000 per annum this means that both of their incomes have increased by R6 300 per annum. As a result of the different inflation rates that each individual faces, individual A had a R1 349 decline in their real income while individual B had a real increase of R206.
This means that the rich (individual B) got richer while the poor (individual A) got poorer in real terms. Ultimately, this results in a cumulative widening of the wage gap if this trend persists year on year.
During the period 2009 to 2018, this trend persisted in all years apart from 2010, 2017 and 2018. As a result, simply applying headline CPI increases to all levels of employees in an organisation would have widened the wage gap in real terms over this time period.
5. Recommendations and Concluding Remarks
The evidence presented in this paper indicates that simply applying a standardised (identical) salary increase to all levels of work in an organisation has an inflationary effect on the wage gap in real terms. Given the magnitude of the income inequality within the South African economy, this would work against efforts that are being directed towards reducing rather than increasing the wage gap. Those tasked with determining the annual increases within their organisation must take cognisance of the inflation rate being faced by each expenditure level and how it differs from headline consumer price inflation. The inflation rate of food and non-alcoholic beverages is a major determinant of the inflation rate faced by the lower expenditure groups due to the large share that these individuals spend on these items. As a result, one should keep a close eye on this figure when determining annual increases as this has a significant effect on the lower expenditure group’s purchasing power. The most effective way of reigning in the wage gap is not to penalise those at the top but to rather uplift the many more individuals at the bottom of the organisational pyramid.
An effective method of ensuring that those involved in determining annual increases are doing so in a manner that promotes increased income equality is to perform regular analysis on Stats SA’s inflation data. The user will be in a strong position to make increase decisions that promote increased equality in real income if they perform a quarterly analysis on the inflation rate faced by each expenditure group (as well as a few other specific items such as food and non-alcoholic beverages). The net effect of this is a narrowing of the wage gap in real terms. This not only promotes greater equality within organisations but across the South African economy as a whole.
There are some limitations to this study if we consider variable pay as well as guaranteed pay (total earnings). It should be noted that although this methodology of awarding increases – with the intention of narrowing the wage gap in real terms – works when applying it to guaranteed pay, variable pay is a large source of income inequality. There are two reasons (based on the design and structure of variable pay) why variable pay contributes to increasing income inequality. Firstly, short and long term incentives increase as a percentage of total guaranteed package as occupational level increases. Secpndly, the prevalence of these schemes also increases with occupational level, with long term incentives being almost exclusively available to executive management.
This means that the task of managing the wage gap is not limited to only narrowing the gap on guaranteed pay but on total earnings. Managing the wage gap of total guaranteed package is only part of managing the wage gap in its entirety – but it is an extremely important part, as it directly affects the real income of the lowest expenditure groups, and hence their ability to keep up with the increasing cost of living.
- 21st Century Pay Solutions Company. (2019), “21st Century Increase Report (April 2019)”.
- Bulir, A. (2001) “Income Inequality: Does Inflation Matter?” , IMF Staff Papers, Vol 48. No 1, pg. 139 – 159.
- Kir, N. (2012) “Real Wage, Labour Productivity and Employment Trends in South Africa: A Closer Look”. IMF Working Paper (WP/12/92), African Department.
- Kuznets, S. (1954) “Economic Growth and Income Inequality”, The American Economic Review, Volume XLV.
- Leibbrandt, M. et al. (2010), “Trends in South African Income Distribution and Poverty since the Fall of Apartheid”, OECD Social, Employment and Migration Working Papers, No. 101, OECD Publishing. http://dx.doi.org/10.1787/5kmms0t7p1ms-en
- Nickel, S and Quintini, G. (2001), “Nominal Wage Rigidity and the Rate of Inflation”, Centre for Economic Performance, London School of Economics and Political Science”.
- Statistics South Africa. Available from: http://www.statssa.gov.za/ , [Accessed August 2019]
B.Com (Hons) Economics
B.Sc Chem. Eng., MBA – Leadership & Sustainability