Demonetisation will have no benefits if the government does not follow up with tax reforms, reduce discretionary powers of bureaucrats and reform election laws
By the strangest of coincidences, those opposing demonetisation are almost 100 per cent of those who have opposed every economic decision of this government since day one. It must be emphasised that on non-economic issues, Narendra Modi’s government has faltered on several occasions, which I, and many others, have pointed out repeatedly. Many commentators are confusing the two (economic and social), and it comes out in their exposition. If I am doing the same, please let me know — I am sure I will be told on social media.
The topic under consideration (not a burning topic, nor a burning question) is an economic evaluation of the costs and benefits of demonetisation, and how the implementation could have been better. There is no doubt that people, especially the poor and the emerging middle class (bottom two-thirds of the population) have suffered a fair amount of inconvenience in obtaining cash for their daily needs. I doubt if the rest have suffered much at all (unless there were weddings in their families). Could the move have been costless? Absolutely not, and anybody selling you that is also selling you some Rs 1,000 notes. In the future in India, the terms “snake oil” or the “Brooklyn Bridge” will be used to refer to somebody selling a formerly legal Rs1,000 note. (George C. Parker was the greatest con man in American history and sold the Brooklyn Bridge repeatedly, once for $ 50,000. Snake oil recipes were being sold in Spain in the 18th century).
Could the cost have been significantly reduced? This is a question that will be discussed for the coming months, if not forever. If secrecy was essential — who can argue it wasn’t — then implementation losses were inevitable. There are some who argue that we could have gradually withdrawn old notes and gradually introduced the new notes. A Rs 1,000 saleswoman.
My first estimate is that a significant reduction in the implementation costs was not possible. The key explanation for this conclusion is that the government was driving in the dark — it had no template with which to “anchor” the surgical strike against black money. How do economists and/or policymakers prescribe decisions? You go with your knowledge and training, and Google search. And the conclusion is that, of course, demonetisation had been tried in several countries — of which were democracies — and all had a significant inflation problem: Russia in 1991, North Korea in 2010, Zaire in the early 1990s, Brazil in 1994. Brazil changed its currency — from peso to real — in 1994; its inflation rate in 1993 was 1,830 per cent.
But what about India? We demonetised the Rs1,000 note in 1978, when our inflation rate was 2.5 per cent. True, a democracy with low inflation did demonetise. Today, India has demonetised the Rs 500 and Rs 1,000 notes, which together account for 86 per cent of the total cash in circulation; and our inflation rate is 4.2 per cent, one of the lowest in the last 13 years. In 1977/1978, the demonetised Rs 1,000 note was less than 1.3 per cent of the total cash. I guess the 1978 episode is comparable to 2016, so the government had a precedent and could have performed better.
If there is no template, then can one blame implementation other than on the ground that since we had no precedent, the government should not have undertaken the initiative? That depends on whether one sees this as a package (with more reforms to be delivered) or a one-off morality play? If it is the latter, then the big bang will end up as the biggest thud.
Given that one was operating for the first time — for the world and most importantly for the Indians to see — the government seemed to have given the benefit of the doubt to its “corrupt” citizens. Notice the use of indelible ink for the withdrawal of money. This policy came late in the game and did so because black money holders brazenly misused the government’s (and people’s trust) by sending in hired help to obtain the freely available one-time conversion of old notes amounting to Rs 4,000 for new notes amounting to the same sum — and to do so from several banks on the same day.
Then there is corruption. Every adult Indian, at least since the late 1960s, has indulged in a black money transaction. Who has not been forced to give a bribe to get what is their right? No one. White money is converted into black when an individual bribes to obtain basic services like electricity connection, water supply, or public subsidies. The list is long; as is the room for discretion on the part of public servants. So a necessary part of reducing black money from corruption is to reduce the discretion — it is discretion that provides incomes to the bureaucrats, (including and perhaps particularly, those belonging to the tax department). If Modi does not initiate policies to reduce bureaucratic discretion, the big bang will be a thud.
We also need to look at tax avoidance. Around the world, high tax rates are the cause of black money creation. The rot exploded in the mid-1960s after Indira Gandhi became the prime minister in 1966. In 1969, she nationalised the banks; in 1970-71, she ushered in “tax reform” which guaranteed a high degree of tax evasion (with a corresponding reduction in tax revenue). This reform introduced 11 income tax rates ranging from 10 per cent to 85 per cent. Then there was also a 15 per cent surcharge, which meant that effectively the top marginal tax rate was 97.75 per cent. The rational response was stop working (and no income to support the family) or bribe tax officials. Black money was born big-time. Why did Ms. Gandhi do this? To help the poor, she said.
India has one of the largest cash to consumption ratios in the world — about 18 per cent; the median cash to consumption ratio in emerging markets (EMs) is close to 11 per cent; India is close to the 85th percentile among the EMs. The large Indian cash economy is a consequence of tax evasion, and of bad and/or corrupt administration of the tax regime.
Election funding needs a re-look. Reform of election laws is absolutely necessary for reduction in black money generation. All the political parties have refused an accounting of expenditures, though they have willingly succumbed to the accounting of income. The law in India is that no more than Rs 25 lakh can be spent, per candidate, for each parliamentary seat and no more than Rs 10 lakh per seat in a state election. Former Chief of the Election Commission S. Y. Quraishi was candid enough to admit that actual spending for a Lok Sabha seat was well above Rs 500 lakhs — more than 20 times the ceiling.
So when the books of political parties are checked, income is close to the official ceiling. But expenditures, with a shrug of the shoulders, humein kya pata?A matching election funding scheme has been proposed by former chief economic adviser, Arvind Virmani. Accounting for expenditures is another suggestion. Either way, unless election reform is done, chances of a big thud increase.
In a forthcoming article, I will discuss the reform of policies pertaining to income tax rates and property taxes . Many are looking at the costs of implementation and concluding that since there are no benefits to be seen, there will be no benefits. That conclusion will be right if the government is so senseless that it will cut the tree and ignore the roots. The next step has to be taxation and election reform — if not, the big thud will be on the horizon.
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