November 18, 2016 4:20 pm JST
Singh and Sharma

New notes won't wipe out India's 'black money'

One of the key election promises made by Indian Prime Minister Narendra Modi in 2014 was to track down so-called "black money" -- cash and other assets stashed by Indians in tax havens.

Initiatives such as the Foreign Black Money Compliance Window and the Income Declaration Scheme have been only modestly successful, together recovering money equivalent to 0.5% of the country's annual gross domestic product. This is tiny given the size of India's parallel economy, estimated at 30% of GDP.

Modi's latest idea was to declare on Nov. 8 that existing 500 rupee ($7.34) and 1,000 rupee currency notes, which together account for 86% of the value of notes in circulation, would no longer be accepted as legal tender. The immediate effect of this demonetization has been to cause chaos as millions of people line up to replace old notes.

India has 46 million credit and debit card users, but no more than 10% of financial transactions are processed on digital platforms. Most ATMs are not working, even in big cities like New Delhi and Mumbai, because the replacement notes do not fit without recalibration of the machines.

Small retailers, farmers and traders are losing substantial sales. This will have adverse implications for employment, especially for unskilled workers in the informal sector, which employs 90% of the country's workforce. Farmers' incomes may be hit by difficulties in transporting their produce because of the cash crunch, leading to wastage of perishable items such as fruits and vegetables.

Hotel stays, restaurant visits and sales of jewelry, luxury watches, consumer durables and automobiles are likely to fall dramatically because of the erosion of the wealth of businessmen, traders and professionals who often take payment in cash. Even e-commerce companies will be affected; 70% of their sales are made on the basis of cash on delivery. The real estate sector is already suffering from buyers' disinterest because of completion delays, high prices and quality problems and is likely to suffer a further decline in sales given the dominance of black money in property transactions.

The demonetization however has delivered a significant jolt to fake currency racketeers, terrorist financiers and informal currency exchange dealers as well as hoarders of black money, who are likely to face huge losses. Along with increased digitization of financial transactions, this will bring more people into the tax net, lifting the tax-to-GDP ratio closer to the emerging market average of 21% from the 16.6% level seen in the country's 2015-2016 Economic Survey. The average for countries in the Organization for Economic Cooperation and Development, a club of mostly rich nations, is 34%.

Just over 1% of Indians pay income tax, a low figure even by emerging market standards. Bringing more people into the tax net by squeezing the black economy will increase tax revenues, making the reduction in the corporate tax rate promised in last year's federal budget more feasible.

More money in bank accounts, instead of in suitcases under beds, would also help the banking system to address capital adequacy and nonperforming loan problems and potentially help to reduce inflation and enable interest rates cuts, boosting consumption and investment. Bank deposits increased by 3.75 trillion rupees in the week following Modi's announcement of demonetization.

Wealth destruction

The government estimates that 20%, by value, of 500 and 1,000 rupee notes in circulation will not be exchanged for fear of prosecution or tax penalties. That would amount to wealth destruction of about 3 trillion rupees, which will have a damping effect on consumption. On the other hand, the corresponding reduction in the Reserve Bank of India's monetary liabilities will improve its balance sheet, potentially allowing it to transfer an equivalent amount to the government as a dividend.

Demonetization has plenty of longer term drawbacks, however. For one thing, it attacks the stock of black money, not its future generation, which will be assisted, if anything, by the decision to reintroduce high denomination notes. The new 2,000 rupee note is likely to be particularly popular for this purpose.

Moreover, currency notes are only one instrument for those seeking to hide assets. Gold and real estate are equally popular and may become more attractive if people come to fear further demonetization.

Modi's move is gutsy, especially in light of the potential for a backlash against his Bharatiya Janata Party on the eve of important elections in the big states of Punjab and Uttar Pradesh. However, the prime minister would have been better advised to opt for a multi-pronged strategy focusing more on the generation of black money.

This ought to involve scrapping morality-based laws such as those that prohibit the sale of alcohol and prostitution, leading to cash payoffs to officials to look the other way. The exemption from tax of income from farming encourages the unscrupulous to reclassify income from other sources. Modi has shown no inclination to tax rich farmers, who also appropriate most of the benefit of subsidized power, water and grain procurement by government agencies. A lower tax on capital gains could reduce investors' pursuit of tax avoidance.

But taxpayers shouldn't be the sole focus. Effective mechanisms to check political and bureaucratic corruption by curtailing the discretionary power of politicians and bureaucrats are also needed.

The BJP however has opposed calls to bring political parties under the purview of India's Right to Information Act, which would help to make political funding transparent. The party should revisit this stance, given the strong nexus between politicians, officials and crony capitalists that accounts for much of India's corruption. Fixing this problem would clear the way for a serious and effective attack on black money generation at its source, once the chaos of demonetization has passed.

Ritesh Kumar Singh is a corporate economist and former assistant director of the Finance Commission of India. Prerna Sharma is vice president and head of agriculture, food and retail at Biznomics Consulting, a research and policy advocacy specialist in Mumbai.

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