1. Demonetisation effect: A big bang or a big thud?

Demonetisation effect: A big bang or a big thud?

The notion that there will be no benefits from demonetisation will be right if the govt cuts the tree and ignores the roots

By: | Published: November 19, 2016 6:14 AM
notes-reu The topic under consideration (not a burning topic, nor a burning debate) is an economic evaluation of the costs and benefits of demonetisation, and how the implementation could have improved. (Source: Reuters)

By the strangest of coincidences, those opposing demonetisation are almost 100% of those who have opposed every economic decision of this government since Day-1. It needs emphasis that on non-economic issues, 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) in their minds, and it comes out in their exposition. If I am doing the same, please let me know—as I am sure I will be let known in social media!

The topic under consideration (not a burning topic, nor a burning debate) is an economic evaluation of the costs and benefits of demonetisation, and how the implementation could have improved.

Implementation

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 they were having weddings). Could it have been costless? Absolutely not, and anybody selling you that is also selling you some 1,000-rupee notes. In the future, in India the term “snake oil” or “the Brooklyn Bridge” will be somebody selling a formerly legal 1,000-rupee note. (George C Parker was the greatest con-man in US history; he had 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? A question that will be discussed for at least the next 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 There are some who argue that we could have gradually withdrawn old notes and gradually introduced the new notes.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 1,000-rupee note salesperson.

My first estimate is that a significant reduction in 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 policy makers prescribe decisions? You go with your knowledge, and training, and Google search. And the conclusion is that of course, demonetisation has been tried—and by several countries to name a few—and none of them was a democracy, 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%.

Ah, but what about India? We demonetised the 1,000-rupee note in 1978, when our inflation rate was 2.5%. True, a democracy with low inflation did demonetise. Today, India has demonetised the 500- and 1000-rupee notes, which account for 86% of the total cash in circulation; and our inflation rate is 4.2%, one of the lowest in the last 13 years. In 1977-78, the demonetised 1,000-rupee note was less than 1.3% 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’s no template, then can one blame implementation other than on the grounds 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 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 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 the people’s) trust by sending in hired help to avail of the free, one-time conversion of old notes totalling up to Rs 4000 in value for new ones totalling up to the same value—doing this at several banks on the same day!

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 to get? None, precisely. 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 the public servants. So, a necessary part of reducing corruption/black money is to reduce discretion—it provides incomes to the bureaucrats (including, and perhaps particularly, those belonging to the tax department). If prime minister Modi does not initiate policies to reduce bureaucrat discretion, the Big Bang will be a Big Thud.

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’s succession as 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% to 85%. Then there was also a 15% surcharge, which meant that effectively the top marginal tax rate was 97.75%.

Rational response: Stop working (and no income to support the family) or bribe tax officials. Black money was born big-time. Why did Gandhi do this? To help the poor, she said.

India has one of the largest cash-to-consumption ratios in the world—about 18%. The median cash-to-consumption ratio in emerging markets (EMs) is close to 11%; 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.

Politicians and election funding.

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 R70 lakh (in most states and Union territories) can be spent, per candidate, for each parliamentary seat and no more than R28 lakh per seat in a state election. Former chief of the Election Commission, SY Querishi, was candid enough to admit that actual spending for a Lok Sabha seat was well above R500 lakh, or more than 20 times the official ceiling.

So, when the books of political parties are checked, income is close to the official ceiling; 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 (including stamp duty and capital gains). 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.

The author is contributing editor, The Financial Express, and senior

India analyst at Observatory Group, a New York-based macro policy advisory group. Twitter: @surjitbhalla

Views are personal

Please Wait while comments are loading...

Go to Top