The parallel economy in India

Updated: May 2 2007, 05:30am hrs
India's parallel economy is so deeply entrenched that possession of black money is not even considered worthy of reproach in social reckoning. In fact, custodians of the administrative machinery themselves seem to have joined the race to accumulate such wealth.

Perhaps such attitudes were understandable to an extent during the high noon of repressive taxation and socialist subjugation in the 1960s and 1970s, when anything other than a frugal lifestyle was all but impossible for an honest taxpayer to maintain. Those were days of misery. But tax rates in India today are moderate by any yardstick in the world, and the persistence of the impunity with which black money is held suggests a much older provenance. Looking further back in history, the black sector emerged in India during World War II, when daily necessities were in acute scarcity and the government of the day adopted rationing as a welfare policy, thus introducing a system of controls. With prices no longer set by the natural interaction of market demand and supply, black marketeeringthe surreptitious sale of diverted goods at higher pricesemerged. The continuance of controls, post-1947, that defied economic sense was justified in the context of the prevailing deprivation then. The parallel economy began to expand, and once the control mechanisms were instiutionalised, it attained multifarious dimensions.

Estimates of black money, unrecorded and untaxed, circulating in the economy have varied widely from time to time. In 1967-68, it was placed at Rs 3,034 crore. But by 1978-79, it had soared to Rs 46,867 crores more than 15 times in just 12 years. Black money was estimated to be 9.5% of GDP in 1967-68, rising to 49% of GDP in 1978-79 and 50.7% in 1987-88. This is an alarming rise, and had better information been publicly available on the trend, the pressure for market reforms may have come much soonersaving India the delay that gave China its headstart.

By the early 1980s, the problem was virtually blaring bright red danger signals. By one count, the rate of growth in the parallel economy was higher than that of GDP in the period from 1980-81 to 1987-89; the former rose by 46.7% and the latter by 40%.

Sadly, however, the control raj legacy has not proven easy to shake off. As estimated by the Parliament Standing Committee on Finance, black money in circulation continued to exceed the accounted-for kind in the 1990s. Swiss bank deposits by Indians over the past decade are estimated to have swelled. Thankfully, Indias economic performance and opportunity for high returns have prevented capital flight as classically understood. But in the export sector, under and over-invoicing of dollar deals carry on.

Black transactions skew market information and hurt the process of capital allocation. Clearly, ECBs disguised as equity investments are not the only reform required here
Transparency International, which publishes a Corruption Perception Index, covering 146 countries, places India at rank 91. Some Rs 21,000 crore annually is estimated to exchange hands in the form of bribery in the country, which indicates the extent of the problem.

Take the real estate sector. High taxes result in widespread cash transactions and under-declaration of deals, which skews market information and hurts the process of capital allocation. Clearly, ECBs disguised as equity investments are not the only reform required here.

The existence of black money is injurious not just for tax revenues. It distorts the systematic resource allocation process and upsets the accuracy of economic forecasts. Good economic management requires precise and reliable data.

Industry, meanwhile, needs a business environment that is free of arbitrary controls that may squeeze out bribes. The PHD Chamber of Commerce and Industry reckons that Indian industry loses at least Rs 63,000 crore of investment because of the corrupt business environment. With just a 15% check on corruption, Indias economic growth could get a 1.3% boost, and faster growth means more money to go round. It is good for all. Similarly, mobilising hoarded stashes of money for productive purposes could push up growth.

What are the solutions While policing has its uses, what would work better is a clear incentivisation of above-board transactions. Value added tax (Vat) has already had an impact. To claim Vat credits, large numbers of small shopkeepers are opting insigning on to the formal system of business, keeping their books clean and paying taxes. This kind of movement depends on other business associates doing likewise, and it is good that the word of benefits is going around.

Lower taxes, by and large, beget better compliance. Also, systems of controls that still exist need to be removed. For most rational operators, the risk of being caught on the wrong side of the law is not worth taking beyond a certain point. The job of governance is to make realistic estimates of what precisely these limits are, and then ensure that people are induced to work within the proper framework of law.

This works by taking an empathetic view of business. Under what circumstances does a small trader, for example, feel constrained enough to jump the law A system of rules and regulations that is seen as just and conducive to meeting the goals of individuals would encourage people to abandon parallel activities and participate in the official economy. In other words, high levels of black money should be seen as evidence that reforms in India remain a story of underachievement.

Kewal Raj Dawer is a senior faculty member at ICFAI Business School, Chandigarh. These are his personal views