Statistics Estonia released the consumer price index this week under a new methodology. Annual inflation stands at 3.7 percent. Unfortunately, that still leaves us with one of the fastest price increases in the European Union.

Over the year, the impact of rising food prices on inflation has grown. Food and beverages now account for roughly one-quarter of the consumer price index. This means that movements in food prices have a major effect on the overall inflation rate. While elsewhere in the European Union inflation has been driven mainly by modest increases in services prices, in Estonia expensive food remains the locomotive.

Impact of food prices on coping among the highest in the EU

According to Eurostat, Estonian households spend an average of 19 percent of their income on food. That places us among the top five in the European Union. In only four countries is the share of family budgets spent on food higher than in Estonia. The larger the share of food in a household's budget, the more sensitive that household is to price increases.

Compared with wealthier countries, where food accounts for a smaller share of total spending, price movements have a proportionally greater impact on Estonian families and are reflected more quickly in consumer behavior. This belt-tightening at the expense of food has continued for the past four years, during which the volume of food sales has steadily declined.

As long as food prices remain high, less money is available in household budgets for other expenses and investment and purchasing decisions become more cautious. This holds back the economy's recovery from stagnation — a phase that Latvia and Lithuania managed to climb out of some time ago.

The high price of food and its large share in family budgets most acutely affect minimum wage earners whose purchasing power in Estonia is the second lowest in the European Union. For those earning the minimum wage, food makes up a very large portion of their monthly budget and the level of food prices directly determines whether there is any money left over to cover housing, healthcare and other unavoidable expenses.

Food prices not created in stores

The price of food is shaped by the combined effect of production costs, energy prices, labor costs, logistics and taxes. In Estonia, the value-added tax on food is 24 percent, meaning that roughly one-quarter of the price a consumer sees in the store goes to state tax revenue. That is a very large share — exceptionally high in Europe.

Retailers can no longer do much to lower food prices at the expense of their own costs. Stores have been tightening operating expenses for several years and profit margins are about half the European average at roughly 2 percent. Taken together, all Estonian retail chains earned less profit the year before last than a single large telecommunications company operating on our market. In the food supply chain, the store is like an unpopular goalkeeper, trying to hold back price pressure for as long as possible while not determining its root cause.

That is precisely why slowing inflation does not mean falling prices. If input costs — energy, labor and raw materials — remain high, the final price will also stabilize at a relatively high level. The pace of price growth has slowed over the past year, but the price level itself has not declined in wholesale purchasing costs. Meanwhile, the state has increased its own markup through a rise in value-added tax.

Effect of the tax rate more than theoretical

Because food makes up a large share of the consumer price index, the level of value-added tax directly affects both inflation and purchasing power.

If a family of four spends about €500 per month on food, a lower VAT rate would translate into the following differences in their monthly budget:

• At a 5 percent VAT rate on food, the family would save €77 per month;
• at a 9 percent rate, about €60;
• at a 13 percent rate, the family would spend €45 less on food.

These figures are not price forecasts, but illustrations of the order of magnitude. International empirical studies have shown that in highly competitive markets, changes in VAT are largely passed on to final prices. This means that tax policy has a real impact both on the inflation rate and on families' monthly budgets.

Food prices affecting more than just the shopping basket

If the price level of food remains high, it affects the dynamics of the entire economy. Purchasing power declines, uncertainty increases and pressure on the state budget grows through indexed expenditures, including pensions. In Estonia, where food accounts for a large share of consumption, movements in this component have a systemic impact.

For that reason, the price of food is not a secondary issue. It is a significant component of inflation and a matter of economic policy. If we want to ease price pressures, the discussion must take place where prices are formed — at the level of the tax burden and input costs.

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