Prime minister Narendra Modi’s decision to demonetize the existing 500 and 1,000-rupee notes will, undoubtedly, help destroy a part of India’s famed stock of black money, but how much will depend upon a variety of factors, including how much of the illicit funds are kept in cash. Against the pros that many analysts have enumerated – like increased bank deposits and lowered real estate prices – are pretty serious cons as well as incorrect assumptions. For instance, a very large part of the economy, including agriculture, is out of the tax net by law, so assume the high-denomination notes are all black is incorrect – yet, everyone in this segment will be inconvenienced and subjected to harassment while converting their old notes to new ones. Also, since the black economy is a big driver of consumption, anything that affects this will slow economic growth.
Certainly the government’s ability to get those with black money to declare around Rs 1.2 lakh crore of this is laudable – around Rs 65,000 crore was got in the Income Declaration Scheme last month. But this represents under 0.5% of India’s GDP while the government’s press release on demonetization itself talks of the black economy being around Rs 35 lakh crore – that is, while the government has got Rs 1.2 lakh crore of declarations from the stock of black money, the annual generation of black money is around Rs 35 lakh crore. The picture isn’t too different when you look at the value of the high-denomination notes that are to be demonetized. RBI data puts the value of Rs 500/1,000 notes at around Rs 14 lakh crore. Assume half of this represents black money – also assume, though incorrectly, that the money that cannot be laundered since all bank accounts are being linked to a PAN number and taxmen will keep tabs on suspicious bank deposits. That’s Rs 7 lakh crore which will have to be destroyed as compared to the Rs 35 lakh crore that gets generated every year. Which is why, it is critical the government keep working on trying to increase the tax-to-GDP ratio by collecting more information on tax-dodgers – implementing GST will help since there will be a lot of information on where goods and services are being produced/consumed. Between FY08 and FY16, however, India’s tax-to-GDP ratio fell instead of rising, from 11.9 to 10.6 – just being able to maintain the old levels would have fetched the government Rs 1.8 lakh crore in FY16, and that number would rise by 12-15% each year just based on GDP growth.
Apart from whatever amount of black money stocks the government is able to destroy with its demonetization move, the prime minister would do well to take action on political parties who collect large sums by way of cash. According to the Association of Democratic Reforms, between FY05 and FY12, over three fourths of funds collected were from unknown sources – according to the law, parties do not have to declare the donors names if the donation is below a certain value, potentially opening a big window for those with black money to contribute to them. Changing the law to ensure all donor names have to be made public – and then keeping a check on spending during elections – will go a long way in arresting black money since, if political parties don’t needs funds, they will be tougher on those generating black money.