Economic Survey for IAS by civils360
Print Friendly, PDF & Email

CHAPTER 03

Demonetisation: To Deify or Demonize?

I. Introduction

  • On November 8, 2016, the government announced a historic measure, with profound implications for the economy.
  • The aim of the action was fourfold:
    1. To curb corruption;
    2. To curb counterfeiting
    3. To curb the use of high denomination notes for terrorist activities
    4. To curb especially the accumulation of “black money”, generated by income that has not been declared to the tax authorities

For a basic understanding on Demonetisation Go through this article Click here

  • Series of actions Taken by the government to curb such illicit activities.
    • Creation of the Special Investigative Team  (SIT) in the 2014 budget
    • The Black Money and Imposition of Tax Act 2015
    • Benami Transactions Act 2016
    • The information exchange agreement with Switzerland;
    • Changes in the tax treaties with Mauritius, Cyprus and Singapore
    • The Income Disclosure Scheme
  • Demonetisation
    • India’s demonetization is unprecedented in international economic history, in that it combined secrecy and suddenness amidst normal economic and political conditions. All other sudden demonetisations have occurred in the context of hyperinflation, wars, political upheavals, or other extreme circumstances.
  • Global Financial Crisis (GFC) and events
    • In the wake of the Global Financial Crisis (GFC), advanced economies have used monetary policy to stimulate growth, stretching its use to domains heretofore considered heretical such as negative interest rate policies and “helicopter drops” of money.
    • India has given a whole new expression to unconventional monetary policy, with the difference that whereas advanced economies have focused on expanding the money supply, India’s demonetisation has reduced it. This policy could be considered a “reverse helicopter drop”, or perhaps more accurately a “helicopter hoover”.

II. Background Facts

  • Cash can be understood along two dimensions: its function and its nature/origins
    • In terms of function, cash can be used as a medium of exchange (for transactions) or as a store of value like other forms of wealth such as gold and real estate
    • In terms of nature, cash can be illicit or not.

Two dimensions of cash

  • Dimension of cash Economic Survey mains
    • For example, cash used as a store of value could be white (the savings that all households keep for an emergency), while cash used for transactions could be black (if it was earned through tax evasion and/or corruption).
  • Few facts that lead to Demonetisation:
    • First, India’s currency to GDP ratio has evolved in two broad phases. It declined fairly steadily for the first decade and a half after Independence, falling from around 12 percent in 1952-53 to about 9 percent in 1967-68. Thereafter, the ratio appears to have responded to the growth of the economy.
      • It began its upward trend in the late 1970s when growth increased, and then accelerated further during the growth boom of the 2000s. This ratio declined during the period of high inflation in the late 2000s and early 2010s but it rebounded after 2014-15 to 12 percent when inflation declined again.
      • The value of high denomination notes (INR 500 and INR 1000) relative to GDP has also increased in line with rising living standards
    •  Second, India’s economy is relatively cash-dependent, even taking account of the fact that it is a relatively poor country
      • across the globe there is a link between cash and nefarious activities: the higher the amount of cash in circulation, the greater the amount of corruption, as measured by Transparency International
      • it is useful to look at the size of the notes relative to nominal per capita income. The higher a note is relative to income, the less likely it is to be used purely for transactions purposes. In India’s case, the denomination/ income ratio has fallen sharply over the past quarter century because incomes have been growing rapidly relative to the prevailing highest denomination notes
    • RBI data show that in India low denomination notes have a soil rate of 33 percent per year. In contrast, the soil rate for the Rs 500 note is 22 percent, and the Rs 1000 just 11 percent. One way to estimate black money is to assume that all these notes should soil at the same rate if they were really being used for transactions.
      • But this assumption would be extreme since the lower soil rates for the high denomination notes could arise if they are used in the same way, but just less frequently because there are fewer high-value transactions
    • Using relative soil rates for the US $50 and $20 notes and applying them to comparable Indian high denomination notes, yields an estimate of the amount not used for transactions, and hence potentially black, of about Rs. 3 lakh crore. This is substantial, as it represents about 2 percent of GDP

III. Analytics

  • Table 2. Impact of Demonetisation
  • demonetisation economic survey
 

IV. Benefits

a. Tax on black money

  • Perhaps the most important way to view demonetisation is as a tax administration measure, one designed to tax holdings of black money.
  • The relation between demonetisation and tax administration can be seen through three major difficult choices faced by those with black money. They could
    1. declare their unaccounted wealth and pay taxes at a penalty rate;
    2. continue to hide it, not converting their old notes and thereby suffering a tax rate of 100 percent
    3. launder their black money, paying a cost for converting the money into white.
  • Demonetisation diffi
 
  • Anecdotal evidence suggests there was, indeed, active laundering.
  • Methods used for laundering
    1. One laundering mechanism seems to have been to “re-time” the accrual of income, by constructing receipts that made it seem as if the black money had just been earned in the period immediately before November 8th, 2016. Such schemes might have allowed black money to have been deposited in bank accounts — but only if the income was reported and taxes paid on it.
    2. It was also widely reported that Jan Dhan accounts witnessed a surge in deposits during the 50-day window between November 8 and December 30
  •  In all these cases, black money holders still suffered a substantial loss, in taxes or “conversion fees”. Moreover, bank accounts are still being screened for suspicious transactions, which means that those who engaged in laundering run the risk of punitive taxes and prosecution, in addition to the fees or taxes already paid
  • In this sense, demonetisation has effected a transfer of wealth from holders of illicit black money to the public sector, which can then be redeployed in various productive ways – to retire government debt, recapitalize banks, or even redistribute back to the private sector.

b. Tax compliance

  • Since this action has commanded support amongst the population, demonetisation shows that black money will no longer be tolerated by the wider public, either.
  • There will be two sanctions financial penalty and social condemnation – could have a powerful and long-lasting effect on behaviour, especially if they were combined with other incentive-compatible measures
  • Demonetisation could also aid tax administration in another way, by shifting transactions out of the cash economy and into the formal payments system.
  • With large denominations eliminated, households and firms have begun to shift from cash to electronic payment technologies. As a result, the tax-GDP ratio, as well as the size of the formal economy, could be permanently higher

c. Tax on informal savings

  • It will channel savings into the formal financial system.
  • some of the new deposits will surely remain in the banks, where they will provide a base for banks to provide more loans, at lower interest rates.
  • In the longer-term, if demonetization is successful, it will reduce the equilibrium cash-GDP and cash deposits ratio in the economy. This will increase financial savings which could have a positive impact on long-run growth.

V. Early evidence for potentIal long-term Benefits

  • It will take several years to see the impact of demonetisation on illicit transactions, on black money, and on financial savings.
But there are some signs pointing to change.
 

a. Digitalisation

  • the Watal Committee has recently estimated that cash accounts for about 78 percent of all consumer payments.
  • According to Pricewaterhouse Coopers  India has a very high predominance of consumer transactions carried out in cash relative to other countries (accounting for 68 percent of total transactions by value and 98 percent by volume
  • Why is cash preferred?
    • Cash has many advantages: it is convenient, accepted everywhere, and its use is costless for ordinary people, though not of course for society at large.
    • Cash transactions are also anonymous, helping to preserve privacy, which is a virtue as long as the transactions are not illicit or designed to evade taxation.
  • Significant impediments in digital transactions.
    • They require special equipment, cell phones for customers and Point-Of-Sale (POS) machines for merchants, which will only work if there is internet connectivity
    • They are also costly to users since e-payment firms need to recoup their costs by imposing charges on customers, merchants, or both.
  •  These disadvantages are counterbalanced by two cardinal virtues
    • Digital transactions help bring people into the modern “wired” era
    • They bring people into the formal economy, thereby increasing financial saving, reducing tax evasion, and levelling the playing field between tax-compliant and tax-evading firms (and individuals).
  • Digitalisation can broadly impact three sections of society:
    1. The poor, who are largely outside the digital economy;
    2. the less affluent, who are becoming part of the digital economy having acquired Jan Dhan accounts and RuPay cards;
    3. And the affluent, who are fully digitally integrated via credit cards.
 
  • Facts: One simple measure that illustrates the size of these three categories is cell phone ownership.
    • There are approximately 350 million people without cellphones (the digitally excluded)
    • 350 million with regular “feature” phones
    • 250 million with smartphones.
  • Government’s steps to incentivize Digital Economy:
    1. The launch of the BHIM (Bharat Interface For Money) app for smartphones. This is based on the new Unified Payments Interface (UPI) which has created interoperability of digital transactions.
    2. Launch of BHIM USSD 2.0, a product that allows the 350 million feature phone users to take advantage of the UPI
    3. The launch of Aadhaar Merchant Pay, aimed at the 350 million who do not have phones. Aadhar Merchant Pay will soon be integrated into BHIM and the necessary POS devices will soon be rolled out.
    4. Reductions in fees (Merchant Discount Rate) paid on digital transactions and transactions that use the UPI.
    5. Tax benefits have also been provided for to incentivize digital transactions
 
  • Facts that can be used in an answer: RBI survey data indicates that during December 2016 digital wallets accounted for just Rs 95 billion in transactions and UPI only Rs 7 billion, compared to Rs 314 billion for debit (excluding RuPay and ATM transactions) and Rs 270 billion for credit cards. Still, they are growing rapidly.
 
  • How to make transmission to digital economy inclusive?
    • The impact on the digitally excluded category can be gleaned via transactions in the Aadhaar-Enabled Payments System (AEPS)
    • The impact on the middle category of digitally connected can be gleaned via Rupay transactions
      • data from the National Payments Corporation of India (NPCI) show that RuPay-based electronic transactions increased
    • The impact on the digital-haves can be discerned from credit card and debit card transactions excluding for RuPay cards and ATMs that were affected by cash shortages
  • As people have started to use such e-payment systems, they have discovered that it is more convenient to conduct financial activities electronically
  • The success of digitalization will depend considerably on the inter-operability of the payments system

b. Real estate

 
  • In the past, much of the black money accumulated was ultimately used to evade taxes on property sales.
  • To the extent that black money is reduced and financial transactions increasingly take place through electronic means, this type of tax evasion will also diminish.
  • An equilibrium reduction in real estate prices is desirable as it will lead to affordable housing for the middle class, and facilitate labour mobility across India currently impeded by high and unaffordable rents
  • Weighted average price of real estate in eight major cities, which was already on a declining trend fell further after November 8, 2016.

VI. Short-term Impact

  • Notwithstanding its long-term potential, demonetisation will impose short-term costs on the economy.
a. Impact on cash/money
  • The true extent of the cash reduction was much smaller than commonly perceived, and the true peak of the monetary – as opposed to the psychological – shock occurred in December, rather than November.

VII. Impact on GDP

  •  Demonetisation is potentially: (1) an aggregate demand shock, because it reduces the supply of money and affects private wealth (especially of those holding unaccounted money and owning real estate)
  • (2) An aggregate supply shock to the extent that cash is a necessary input for economic activity  and
  • (3) An uncertainty shock because economic agents face imponderables related to the impact and
  • (4) duration of the liquidity shock as well as further policy responses (causing consumers to defer or reduce discretionary consumption and firms to reconsider investment plans)
The impact of demonetisation. A macro Assessment. 
  • On Agricultural (rabi) sowing;
    • Contrary to early fears, as of January 15, 2016, aggregate sowing of the two major rabi crops—wheat and pulses (gram)– exceeded last year’s planting by 7 percent and 15 percent, respectively
    •  Whether this will lead to a commensurate increase in production will depend on the extent to which farmers’ access to inputs—seeds, fertiliser, credit, and labour—was impeded by demonetisation
  • The high-frequency indicators present a mixed picture
    • Agricultural sowing, passenger car sales, and overall excise taxes bear a little imprint of demonetisation; and sales of two wheelers show a marked decline after demonetisation; credit numbers were already looking weak before demonetisation, and those pre-existing trends were further reinforced after November 8.
  • Indirect tax revenue, as a broad gauge of production and sales;
    • Indirect tax performance stripped of the effects of additional policy changes in 2016-17
  • It would be reasonable to conclude that real GDP and  economic activity has been affected adversely, but temporarily, by demonetisation
    • There may be a change between ¼ and ½ percentage points relative to the baseline of about 7 percent
  • Solutions to reduce short-term Impacts
    • Over the medium run, the implementation of GST, follow-up to demonetization and other
    • structural reform measures should take the trend rate of growth of the economy to the 8-10 percent range that India needs.
 Framework for assessing the impact of the cash crunch on economic activity.
  • if the money supply is reduced, either the remaining stock of money will need to be used more intensively, or else nominal GDP will fall. Some of this fall in nominal GDP would take the form of a reduction in prices.
  • A final and important point to make is that the adverse impact of demonetisation on GDP growth will be transitional. Once the cash supply is replenished, which should largely be achieved by end-March 2017, the economy should revert to normal, perhaps even with a bounce reflecting reversion to the mean. Therefore real GDP growth in 2017- 18 is projected to be in the 6¾-7½ percent range.
Other reasons that could possibly result in lower GDP estimates for this year.
  • Many commentators will be tempted to compare this year’s real GDP growth estimate with last year’s outturn of 7.6 percent. But this would be inappropriate, because many other factors have influenced this year’s performance, quite apart from demonetisation. For example, international oil prices have stopped falling, providing less of an updraft to the economy. So growth would have inevitably differed, even without demonetisation.
  • velocity for cash (Prelims Question)
  • cash velocity

Supply-side effects

  • These estimates are based entirely on the liquidity impact of demonetisation rather than the wealth, aggregate supply, or uncertainty effects.
  • Uncertainty caused consumers to postpone purchases and firms to put off investments in the third quarter. But as the economy is remonetised and conditions normalise, the uncertainty should dissipate and spending might well rebound toward the end of the fiscal year.
  • Demonetisation could also affect supplies of certain agricultural products, especially milk (where procurement has been low), sugar (where cane availability and drought in the Southern states will restrict production), and potatoes and onions (where sowings have been low)
  • Vigilance is essential to prevent other agricultural products becoming in 2017-18 what pulses was in 2015-16 in terms of supply deficiencies and consequential higher inflation

VIII. Redistribution to the Government

  • Demonetisation will also redistribute resources. How?
    1. Black money holders have laundered their money by employing people to stand in queues there could be a positive wealth effect because cash would go from agents with a low propensity to spend to those with a greater propensity to spend.
    2. Perhaps the most important redistributive effect is that it will shift resources from the private sector to the government.
    3. The impact on the overall economy will then depend on how the government responds
    4. Wealth gain: The RBI/government may receive some gains from the unreturned cash.
    5. Income taxes could go up as black money was deposited in bank accounts
  • Against this are three negative effects:
    1. Costs of printing new notes over and above normal replacement
    2. The costs of sterilising the surge in liquidity into the banking system via issuance of Market Stabilization Scheme bonds
    3. If nominal GDP growth declines, corporate and indirect tax revenues of the centre could decline but so far there is no clear evidence.

IX. Markers of Success

  • Demonetisation can have long term benefits. These may not necessarily become manifest in the next six months but evidence should start trickling in over a one-year horizon and beyond.
  • First, changes in the use of digital payment methods across the three categories of digital access identified earlier, namely, smartphone users, regular phone users and the phoneless, respectively. The early signs are encouraging
  • Second, the cash-GDP ratio, which should decline as more saving is channelled through the formal financial system and black money falls.
  • Perhaps the most important marker of success will be taxes. The number of new income tax payers as well as the magnitude of reported and taxable income should go up over time

X. Maximising long-term Benefits, minimising short-term costs

  • Replenish the cash shortage as quickly as possible. The faster remonetisation takes place, the shorter and less severe will be the overall impact of demonetisation
  • Supply of currency should follow actual demand and not be dictated by official estimates of “desirable demand”. In other words, the RBI should re-establish internal convertibility, guaranteeing to give the public the amount of currency that the latter wants.
  • The early elimination of withdrawal limits will help build confidence. By the same token, there should be no penalties on cash withdrawals, which would only encourage cash hoarding.
    • Unless people have confidence that money deposited in bank accounts is freely convertible into cash, and vice versa, they will be reluctant to deposit their cash in the first place.
    • Instead, they will hoard it, starving the formal financial system of resources and the informal economy of the currency it needs for transactions. And this would affect the poor most, not just because they are more likely to work in the informal economy, but because the affluent will likely corner the limited currency available.
  • In the medium term, the impetus provided to digitalization must continue.
  • Digitalisation is not a panacea, nor is cash all bad. Public policy must balance benefits and costs of both forms of payments.
  • Second, the transition to digitalisation must be gradual; take full account of the digitally deprived; respect rather than dictate choice, and be inclusive rather than controlled.
  • To the extent that digitalisation must be incentivised— and the incentives favouring cash neutralised–the cost must be borne by the public sector (government/RBI) and not the consumer or financial intermediaries.
  • To increase trust in digital payments, cyber security systems must be strengthened considerably.
  • One key need is to ensure inter-operability of the payment system, which will be at the heart of increasing digitalisation going forward, building upon the newly created UPI
  • Above all, ensuring that demonetisation indeed proves a catalyst for long-run changes in behaviour will require measures to complement demonetisation with other non-punitive, incentive-compatible measures that reduce the incentives for tax evasion. For this five-pronged strategy could be adopted:
    1. A GST with broad coverage to include activities that are sources of black money creation—land and other immovable property—should be implemented;
    2. Individual income tax rates and real estate stamp duties could be reduced;
    3. The income tax net could be widened gradually and, consistent with constitutional arrangements, could progressively encompass all high incomes.
    4. The timetable for reducing the corporate tax rate could be accelerated
    5. Tax administration could be improved to reduce discretion and improve accountability
  • There must be a shift to greater use of data, smarter evidence-based scrutiny and audit, greater reliance on on-line assessments with correspondingly less interaction between taxpayers and tax officials.
  • Big Data and the digital age, and the promise they offer should also be embraced by the tax administration.

Subscribe to Civils360!

Enter your email address to subscribe to this blog and receive notifications of new posts by email.