Money & Finance

Currency shock: Does the gain justify the strain?

  • Blog Post Date11 November, 2016
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Parikshit Ghosh

Delhi School of Economics

pghosh@econdse.org

On the evening of 8 November, PM Modi announced that 1,000 and 500 rupee notes will cease to be legal tender post-midnight. In this article, Parikshit Ghosh, Associate Professor of Economics at the Delhi School of Economics, contends that there are bigger, juicier and relatively low-hanging fruit the government is not reaching for, in the fight against black money.

On 9 November, I had less than two dollars’ worth of valid currency in my pocket to live on. For one day, this placed me below the World Bank’s poverty line, but quite a bit above the one drawn by the Rangarajan Committee. Before you feel too sorry for me, let me state I also have two credit cards in my wallet, Uber and Amazon apps on my phone, and online banking. The government’s stunning announcement to demonetise 1,000 and 500 rupee notes will pass me by - and the small minority like me who live in a nearly cashless economy. Its effect will be felt most on two groups: the corrupt and the poor. Keep an eye on both!

Academic research suggests that cash circulation, especially in large denomination bank notes, does contribute to black money, corruption, crime and the parallel economy (see this study by Kaushik Bhattacharya and Sunny Singh of Indian Institute of Management (IIM), Lucknow). India also happens to be one of the most cash-reliant economies in the world. 87% of transactions are in cash; a quarter of GDP (Gross Domestic Product) goes unreported; the currency stock is worth 12% of GDP and half the value of bank deposits. Figures for other emerging economies like Mexico and Brazil are much lower.

Some prominent economists like Kenneth Rogoff have advocated that governments in rich countries try to reduce the cash stock, especially in big bills (our leading homegrown advocate seems to be Baba Ramdev). The steps announced by the government are, however, different and more radical than Rogoff’s proposals. For one thing, it is not a phased and gradual change in the volume and composition of currency as he suggests (a less disruptive measure), but an overnight replacement and invalidation of outstanding bills. For another, it increases the denomination of the largest bill to Rs. 2,000!

Whatever else you say of this step, you cannot accuse the government of timidity. It is not easy to predict its effects, since the details of implementation are not entirely clear and there are hardly any similar experiments to draw lessons from. I will make a few general observations.

Scrutiny is key

First, how closely the government scrutinises people as they come in to change the old money will create a trade-off between minimising the burden on the poor and catching or weeding out black money. Obviously, those hoarding a lot of cash will try to slip under the radar by depositing it in instalments, possibly in multiple accounts (expect a healthy growth in new bank accounts in the coming weeks, including benami ones). To identify them, the government needs to collate this information using strict identity checks, link transactions done under a maze of identity proof documents, and distinguish taxable income inflows from non-taxable deposits of legitimate cash holdings. Does it have the means to do so at this scale? The harder it tries, the harder it is for the poor, given that financial inclusion in the country still has miles to go, notwithstanding the advances in JAM1.

Stocks vs. flows of black money

It is also important to underscore the distinction between stocks and flows in relation to black money. People do a lot of transactions in cash to escape paying taxes but they do not necessarily hold on to that cash. They may spend it or convert it to other assets like land, cars or real estate. A lot of this money may be flowing around instead of piling up in one place. I don’t know of good estimates of the fraction of illegal wealth or tax avoidance that is held in cash.

Looking back, not ahead

Also, note that the scheme looks back, not ahead. It may catch or eliminate some of the black money created in the past but it does nothing to prevent the accumulation of black money in the future, the way a reduction of large denomination bills or more stringent tracking of transactions via PAN (Permanent Account Number) might do. People can still go on paying for property with new cash, or buying goods without bills. This is just hitting a reset button.

Redistribution: Towards whom?

To the extent the scheme succeeds in putting some black money out of circulation, it will create some redistribution of purchasing power, but the question is towards whom? The biggest lament centring around the underground economy is that it deprives the government of revenues that could have been spent to improve schools, hospitals, roads and power supply. If some of the black money is recovered in a tax raid, it goes into government coffers rupee for rupee. If some black money is just pushed out of circulation, its purchasing power will be proportionately distributed among honest citizens and the government, with the government’s share around 17% of the recovered value, the tax-GDP ratio. That is a small fraction!

Plug loopholes in the tax system

That brings me to a deeper question – why are we one of the lowest taxed among the major economies of the world? There are many reasons for this. There has been no serious attempt to expand the tax base, especially bring large farmers into the net, no doubt in part due to vote bank considerations. There are also huge tax breaks the government gives out – a storm drain through which revenues disappear with a loud gurgle – and big, fat, regressive subsidies which waste a lot of what little is collected. By some estimates, if these loopholes were plugged, even leaving aside taxation of agriculture, as much as 12% of GDP could be raised. That is enough to fund a universal cash transfer to nearly lift every Indian out of poverty!

The coming days will tell if the government has overreached and put ordinary people under too much strain for too little gain. There is little doubt that there are bigger, juicier and relatively low-hanging fruit it is not reaching for.

This article first appeared on Quint: https://www.thequint.com/opinion/2016/11/10/demonetisation-inconvenience-with-too-much-strain-and-little-gain-rs-500-note-rs-1000-note-narendra-modi-jan-dhan

Note:

  1. JAM is an abbreviation for Jan Dhan, Aadhaar, and Mobile. Pradhan Mantri Jan dhan Yojana (PMJDY) is the Indian government’s flagship financial inclusion scheme. It envisages universal access to banking facilities with at least one basic banking account for every household; financial literacy, access to credit insurance and pension facility. Aadhaar or Unique Identification number (UID) is a 12-digit individual identification number issued by the Unique Identification Authority of India (UIDAI) on behalf of the Government of India. It captures the biometric identity – ten finger prints, iris and photograph – of every resident, and serves as a proof of identity and address anywhere in India.
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