How to go about chasing black money

  • Blog Post Date 30 January, 2017
  • Perspectives
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Indira Rajaraman

Independent Economist

In the context of demonetisation, Indira Rajaraman argues that the focus of any sustainable reform of the taxation structure must be on reducing flows of tax evasion, not going after existing caches of black money.

The flow of tax evasion every year is what should be the focus of any drive targeting black money, rather than the caches accumulated from past tax evasion. Those stocks certainly existed, but the really large holders of these assets had long ago moved on from physical forms (like cash or gold or real estate) to financial assets. These typically took the form of loans to large commercial construction companies, which simply would not have been able to access the financial capital they needed without borrowing in cash on the informal market. Cash came in particularly handy to pay the wages of construction workers.

The problem is that we did not develop bond markets in the country as we should have, to the point where large construction projects could easily access formal financing. Historically, infrastructure construction worldwide has been bond-financed, including the rail network in colonial India. It was because the bond market today remains so poorly developed that there was such buoyant demand for loans in cash, and therefore for accumulation of black wealth in liquid loanable form. The treasurers of political parties will bear this out.

Lending rates on these channels are astronomically high. The borrowers would have much preferred a regulated bond market where rates would have been far lower, but that market was quite simply missing. Bond markets today call for a whole ecosystem, with credible rating agencies to give lenders the confidence to move into that disintermediated financial space, instead of just being risk averse and placing their savings with banks or other aggregators like the Life Insurance Corporation of India (LIC).

Notwithstanding demonetisation, there still remains a large outstanding stock of loans taken in cash by commercial construction companies, which will have to be unwound. Through formal bank channels? The lenders would clearly prefer payback in cash. There will continue to be cash scarcity in the economy until those demands for cash are fully satiated.

Until then, there will not be enough cash for the kinds of everyday purchases that cannot immediately be shifted to digital platforms. Aggregate demand in the system will continue to be squeezed as a result, imposing a growth cost that we can ill afford. Cash transactions can only be shifted to a digital platform at a measured pace over time. What we do not need are jerky ill-judged moves, such as that by the Delhi Metro, to a particular mobile wallet, that have to be rolled back the next day.

The thing to do is to remonetise the economy fully for now, and to reduce cash dependence in a planned sector-specific manner. Unless remonetisation is complete, growth cannot be restored, employment cannot be generated, and the political popularity of demonetisation will get eroded.

Moving everyday transactions to a digital platform cannot be done overnight. Mobile wallets are in business in pursuit of profit, so if they provide a service they have to be paid for it. What the digital move has done, therefore, is to introduce friction into the payment system. Who is paying? When you digitally pay just the value of your purchase to your vegetable seller, the cost of the service is being loaded on to the seller. He accepts it willingly now, because he does not want his business to be restricted to those with cash. Over time, the cost of the conversion will be loaded on to the final consumer (and it already is, by milk suppliers in Delhi, for instance).

Even though the user base of mobile wallets is expanding by the hour, they are reporting losses. While the volume of transactions has exploded, their total value is reported to have remained flat, because the average value of each transaction has come down. The costs of mobile-wallet companies are a function of the number of transactions they put through, while their revenue is calibrated to value. The losses are worrying because mobile wallets are essentially deposit-taking non-bank financial institutions. I am unclear as to whether the regulatory structure for these new enterprises is in place. A crash of any one of them will be catastrophic. It is also possible that the losses have arisen because of extravagant sponsorships. In the recent cricket Test series between India and England, the name of a mobile wallet sponsor is displayed prominently even on the stumps.

There is already scattered evidence that small retail establishments which initially put up notices to say they accepted mobile wallets, have now firmly gone back to cash, because of initial hiccups which might have been due to server overload. Or maybe these episodes were invented as an excuse for sellers not wanting to pay for the service.

Another reason for retailers retreating from wallets is that their employees still demand payment in cash. Retail employees just cannot afford to receive their salaries any other way since their biggest monthly payment, which is rent for the rooms where they live, can only be paid in cash. House rentals will be among the last bastions to fall when it comes to moving away from cash payments. Doctors, tutors for their children, all demand payment in cash. These are the small channels for tax evasion which will prove stubbornly resistant to change.

That gets us to that infamous beast, black money. The important thing about it is that it comes in many sizes. The sense that the economy is divided into a few large practitioners of the black arts through which black money is accumulated, and the rest who are untouched by it, is completely false. There are many millions who earn incomes well above the taxable threshold, who are below the tax radar and prefer to stay there. They will stay with cash. In a supply-constrained market, like housing, they know that tenants cannot move away. So the cash requirement of the economy cannot be substantially curtailed just yet.

As far as the tax authorities are concerned, these small offenders will have to be overlooked while they focus on the big missed opportunities. Every country which has successfully reformed its taxation structure, such as Chile, for example, has done just that. And for that, the information base for tax tracking was already in place. The available avenues were just not being used. We did not need demonetisation for that.

Take, for example, purchases of big expensive cars, the big labels like Mercedes-Benz or BMW. The number of such cars bought and registered every year is information already in the database of the motor vehicles department of every state. In recent years, no purchase of a car has been possible without a PAN (Permanent Account Number). Why were these databases not tapped to start an investigation on a presumption of taxability? Surely, the owner of a Mercedes-Benz would have income above the taxable threshold? Or clients at high-end hospitals, where the facilities include theatres for both surgery and movie-screening, and pools, spas and fine-dining options for family members accompanying patients?

The very first paper I wrote on fiscal issues was one recommending the use of presumptive methods for taxability. The idea was by no means new. It had been practised in a large number of countries with huge success.

Israel, for example, in its early years needed tax revenue, and it had to do it in a way which would not alienate taxpayers since the country needed to stand united in the face of external hostility. For a big purchase like a yacht or a luxury car by a moneyed immigrant, there would be a presumptive taxable income estimated at some multiple of the value of the transaction. Restaurant owners would be taxed on a presumption of taxability based on capacity. The formula was arrived at through discussions with restaurant associations on what seemed fair, and was not contestable. Those that did not meet the presumptive income had to pay the tax anyway and eventually closed down. The presumptive tax worked as an efficiency incentive. Most of all, these methods are survey-based and formulaic, and thus prevent the caprice and intrusive character of tax terrorism.

Another avenue of trackability peculiar to India is expenditure on high-end weddings. I have heard of events - but never actually attended any - replete with portable air conditioners, which cool open spaces, with a long duct that transports away the heat from the engine. In the summer months, the number of such devices needed and the electricity consumed can well be imagined. It would have been a relatively simple matter to track the leasing points of either the devices themselves or the generators which power them, or the consumption peaks for power pulled off the grid.

But we live in a country where utility companies are not able to collect their dues, leaving public-sector banks groaning under default. A simple administrative requirement for PAN attached to electricity dues or leasing of generators would have led to higher revenue for both the income tax department and power distribution companies.

Large-scale tax evasion has long been practised right in the face of the income tax authorities through political connections. Those without political connections have had to pay their way out. Either way, unless these features of the taxation system are reformed, there is nothing demonetisation can do for tax revenue. What it did was to cause some temporary dislocation at the high end of the wealth and income scale, which lasted for a much shorter period than it did for the rest.

It was that short-lived inconvenience suffered by high net-worth individuals that fuelled the widespread political support for the move, as reported by many opinion surveys. But that French Revolution moment will give way if Madame Defarge finds she cannot buy the wool with which to do her knitting.

This article first appeared in Mint newspaper:

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