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Demonetization: Cure and Care


There is no magic bullet that can reduce black/unaccounted income in an economy. The process that generates black money in an economic system is complex. Before acting on a remedy it is important to understand the process of black money generation. It is generally argued that complex tax system, high rates of tax on high value transaction, absence of modern technology in tax administration makes ‘probability of detection’ of tax fraud very low and thus, tax evasion easier. This, in turn, contributes to the black/unaccounted income. Thus, tackling black money requires multi-pronged actions, few short-term and few certainly structural and long-term. In my view, “Demonetization” as executed is a short-term measure to reduce the volume of black money.  As unaccounted cash hoarding in the form of INR 500 and INR 1000 notes does not hold any legal value any more, it certainly sends a signal that hoarding unaccounted income in the form of cash can prove very costly. In that sense, those who hoard black money would have to find more sophisticated methods of hoarding instead of cash. At the same time, as “demonetization” does not happen every day, unaccounted/black income would always be a part of the system in various forms including cash hoarding even in future. However, demonetization has certainly created a fear in the minds of hoarders of black income and could act as a deterrent only for those who hoard black money in the form of cash. Those who have sophisticated means of hoarding other than cash would continue to hold black money unless structural changes are brought in, which includes a relook of relationships with various tax havens outside India. “Demonetization” does not address the structural issues of tackling black income generation.


What is the Magnitude?
The currency taken out of the system through demonetization is around INR14 lakh crores, which is around 11 per cent of GDP. Certainly the entire 11 per cent is not black or unaccounted. We have no clue what proportion of this is black? By the end of 31st December, 2016, we would know the difference between what was in circulation and what has come back to the banks for deposits and exchange. The difference between the two would be the amount that has been flushed out of the system as black money through “demonetization.” Adding to this the income declaration done in the income tax disclosure scheme that was in operation up to September 30, 2016. Government of India has received around INR 67,000 crore under this scheme. The aggregate of the two would give the estimates of cash clean up done through these two processes by the Government of India in the fiscal year 2016-17.
At What Cost?
Apart from banking transaction cost, wherein people are standing in long queue for hours, which in itself is a deadweight loss to the society, withdrawal of 86 per cent of the currency in circulation from the system has contracted economic activity both in formal and informal sector. Cash crunch has affected agriculture and rural economy. Short-term impact of this will be severe across sectors, especially the poor and the vulnerable. If one considers seasonality of employment in rural India, monthly data on MGNREGA employment show that in the month of October and November, the share of MGNREGA employment is lowest at 3.7 per cent compared to 17.3 per cent in the month of May. This is not surprising, given the harvesting season, most of the workforce in agriculture gets absorbed during this time of the year in normal economic activity and does not require MGNREGA support. Given the timing of demonetization loss of employment in agriculture will be much more. Hardship in the rural economy could have been less if this scheme was introduced in lean agricultural season.
Macroeconomic Challenges
The immediate macroeconomic challenge is to make the banking system up and running by infusing as much currency at lower denomination as possible to ease out the cash crunch and by recalibrating the ATMs. Simultaneously, a close monitoring of inflationary situation is a must. Due to the cash crunch, there is artificial suppression of demand now. But as soon as cash starts flowing, demand will rise, especially for items of basic necessities particularly food and agricultural produce and if these items then are in short supply because of the contraction in economic activity or because of supply chain management, inflation may go out of hand in the next quarter. On the budgetary front, entire fiscal arithmetic for the fiscal year 2016-17 has been done on the nominal GDP growth assumption of 11 per cent. Since, as per the monetary policy framework, target inflation rate is 4 per cent, it is expected that the real GDP is expected to grow at 7 and 7.5 per cent.  One is unsure whether India will be able to achieve a 7 per cent plus real GDP growth rate post demonetization. Since there is visible contraction in economic activity, GDP growth may be far lower than the target growth rate. A declining GDP growth could reduce revenue growth and thereby, increase fiscal deficit which is already above the FRBM target. Though last two years have seen visible improvement in fiscal situation of the Union government, a derailment of that can have larger macroeconomic consequences in terms of interest rate, investment and savings. 
Long-term Issues
Long-term issues are structural in nature. “Demonetization” has certainly sent a signal that it is no longer a business as usual scenario as far as black income is concerned. This fear might slow down the process a bit but generation of black money cannot be stopped unless we bring about structural changes in our tax system. The most telling indicator of a complex tax system is the revenue locked up in tax dispute.  For the Government of India, outstanding tax locked up under dispute is to the tune of INR 7000 billion in FY 2014-15. 80% of this accounts for direct tax disputes. Incremental revenues locked up in tax dispute is 10% of tax revenue.
Fundamental reforms are required in our tax system to change this with an objective to simplify, modernize and rationalize and change the mindset of tax administrator to consider the tax payer not as a thief to be caught but a person to be served who helps in nation building by paying taxes. Information plays a key role in identifying ‘tax fraud’. Broadening the base and lowering of tax rate can go a long way in simplifying the tax system.
The author is Professor, NIPFP. Click here for detailed profile.
The views expressed in the post are those of the author only. No responsibility for them should be attributed to NIPFP.
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