People who evade taxes can use the money saved in multiple ways. To pay for consumption; keep it in cash; if possible in benami bank accounts in other names; invest it in gold and jewellery where it will not earn a return except through capital appreciation; invest it in real estate which has a black and white component but poor return except from capital appreciation; send it abroad to safe tax havens to be kept in banks; or use it in production and generate more unaccounted for money. On November 8, 2016, India only stopped the then R500 and R1,000 notes from being legal tender; there was no demonetisation.
Apart from tax evasion, other sources for creation of unaccounted money are bribes and corruption, received in India or abroad.
India has been plagued by increasing amounts of ‘black’ money and assets since the 1960s. People were avoiding paying the high income and wealth taxes, escaping import restrictions and high import duties, or earning from criminal activities.
Over the ages, India developed an informal banking system. It was based on trust and had little paperwork. To send money from one place to another, the hawaladar in the first location took the cash and his counterpart in the other location was told to hand over the cash to the designated person. Hawala is grounded firmly on trust between all the parties concerned. Today, it is an illegal banking system. It enables the transfer of money without its physical movement.
In modern times, with high rates and different forms of taxation (income, wealth, excise and customs duties, sales taxes, state entry taxes, town entry taxes), each tax provides opportunities for tax collectors to negotiate commissions for themselves for enabling tax evasion, creating black money. Hawala is a way to transfer money that is earned illegally. It is unaccounted or ‘black’ money.
In India, the black economy is an impotent part of the whole economic system. Black money might be held as cash, real estate, high-value electronic items, gold, jewellery and also be part of the production process, and invested in plant and materials. It is an integral part of the Indian economy. It generates incomes and wealth, and is held in the domestic economy as well as overseas.
A sophisticated system exists all over the country to convert black money into overseas holdings in banks, where it might be kept liquid or invested in real estate or businesses. Participants are not only shady underworld characters, but also legitimate members of the financial system. The cash is converted at an agreed rate of exchange and a receipt given for the agreed holdings abroad. The black cash is recycled into the domestic system.
To enable illegal foreign holdings to come back as white money in India, government officials devised double taxation agreements with some small nations, mainly Mauritius. Any investment from there to India (of hawala money converted into their currency) was not subject to Indian capital gains tax. It was the Mauritius tax which was zero. Such foreign investments, mainly in the stock markets, became white. A money laundry was created for black money.
When held as cash, it has been in high-value notes, till recently of values R500 and R1,000—the larger proportion being R1,000 notes. A good part is cash for daily transactions and some is cash acquired through corruption and tax evasion. Their sudden devaluation to zero value was without warning. The desire to put it back into bank accounts or exchange it for legal currency caught was suddenly made difficult.
The black money holders safeguarded a proportion by using Jan-Dhan accounts and other small holders of bank accounts, for a fee. But a good part of the black money would have lost value altogether because the holder would not want to disclose the illegal ways in which it was acquired. This adds to government income since it no longer has to honour those notes. The fake notes (principally from Pakistan) in circulation will have no value anyway since no bank will touch the fake notes.
No doubt that there has been disruption of economic activity. Legitimate activity in trader, agriculture, business, and cottage and small-scale industries (all paying wages in cash) was curtailed by shortage of legal cash. The black production activity would have been halted.
In a society that is far more cash-based than many others, a shortage of cash in lower-value notes (R100 and R500 or less) prevents transactions unless credit and credit cards can replace them immediately. This could not happen.
Further, the withdrawal as legal tender of R500 and R1,000 notes might has temporarily halted corruption. But the ‘demonetisation’ is only one of the many steps required to be taken. By itself, this sudden withdrawal of a substantial amount of legal tender would have adverse effect for some time.
India, unlike many other countries, uses much more cash in its transactions than plastic or bank online transfers. It is also an economy, which, until about 30 years ago, had confiscatory levels of taxation. The marginal rate of income tax was 98%. If you were also subject to wealth tax, you had to sell assets to pay taxes!
Up until the 1980s, many imports were banned and what was allowed was also subjected to very high rates of import duties. This resulted in large generation of corrupt black money.
Before 1991, the economy was tightly controlled by the government, with many procedures and rules that required many applications for licences and permits, to start a new business or factory, its location, where it would get its machinery from, what would be the capacity of the plant, where the technology would be sourced from, what would be the royalty to be paid, and so on. These applications to different government departments were then subjected to many formalities with complex rules. In the process, bureaucrats who had mastered these complicities were in great demand. Many made extra income by easing the path for applicants. Since a licence or permit enabled the earning of large profits, politicians and bureaucrats were the intermediaries who benefited from this corruption and bribery.
Withdrawing from legal circulation of high-value currency is a small step to prevent black money and corruption.
Double taxation agreements with Mauritius and others have been revised so that their investments will be subject in three years to Indian capital gains tax, closing money laundries. Some black money was taxed in an amnesty scheme.
A move to reduced use in cash and more plastic and bank transfers will begin, but take time to have effect. Changes in ‘doing business’ in India might reduce government corruption. However, these procedures and rules were created by the bureaucracy. It would not be surprising if some of them were created to enable illegal earnings for people in government. A concerted drive to a less cash using economy over the years will help. The change in defence procurement from imports to local manufacture must also be commended. Measures to make political and election funding transparent and honest, speedily introducing stringent legislation on real estate and its independent regulation, persuading state governments to revoke rent control and such restrictive laws, are all essential to control corruption and black money. Laws must be made much more stringent so that illegal earnings are punished severely.
‘Demonetisation’ is a small and short-term step for cleansing the Indian economy. Many more things must be done. Indeed, some have been. We must look forward to a cleaner society.
The author is former director general, NCAER, and was the first chairman of the CERC. Views are personal