During the initial days of demonetisation, people were talking of Rs 2-3 trillion of black money getting extinguished since, faced with 30% tax rate and a 200% penalty (that works out to an effective tax of around 90%), it made sense for anyone who could not launder his money, to simply burn it. The extinguished funds, newspapers such as this one argued, would be used by RBI to pay the government a special dividend which could, in turn, be used to recapitalise banks—the ‘success’ of the demonetisation, then, was to be measured by how much of the Rs 14 trillion of 500-/1,000-rupee notes which were made illegal tender wouldn’t come back to banks by way of deposits. Since then, though, some former RBI Governors have pooh-poohed the idea of a dividend and several analysts have explained why this is not possible. Based on news reports, it appears the government is no longer looking at this extinguishing-of-cash route and is, instead, looking at lowering the effective tax, including penalties, to around 60%—in addition, some amount has to be locked into 5-year low-interest bonds. For those unable to launder their funds, it then becomes viable to declare it and pay taxes since at least 35-40% of the black money will get saved. Several people may still prefer to burn their cash to getting into the tax net and exposing themselves to the possibility of tax raids later, but it is clear the government has had a change of heart on black money since the days, just a few weeks ago, when the revenue secretary was tweeting about a 200% penalty on those found depositing more than R10 lakh in cash and which didn’t match with their declared incomes in the past.
While this seems a pragmatic way to get more taxes, it is also problematic at many levels. A 60% effective tax is certainly higher than the 45% paid under the recently-concluded Income Declaration Scheme and so represents some form of a penalty, but the honest taxpayer can’t feel happy about the fact that the effective tax for those with black money has been reduced so dramatically. Such frequent changes in tax rates also opens up the possibility of future arbitrage—after all, if the effective tax rate for those with black money can be reduced from 90% to 60% within a few weeks, it can be further reduced. Since a stable tax rate is critical for encouraging long-term tax compliance, reducing penalties so sharply can’t be a good thing.