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ECONOMIC SURVEY 2016-17 Summary Chapter – 3 Demonetization: To Deify or Demonize?


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Following is the Summary of ECONOMIC SURVEY 2016-17 – Chapter – 3 Demonetization: To Deify or Demonize?


INTRODUCTION

Survey describes Demonetization as

“A radical governance-cum-social engineering measure, radical and unprecedented step with short term costs and long term benefits where the aim of the action was: to curb corruption, counterfeiting, the use of high denomination notes for terrorist activities, and the accumulation of “black money” and to signal a regime change, emphasizing the government’s determination to penalize illicit activities and the associated wealth.”

Survey called this move as unconventional monetary policy because, in the wake of Global Financial crisis (GFC) advanced economies used monetary policy to stimulate growth like negative interest rates and “helicopter drops” (referring to expansion of money supply) of money. This move was reverse of it, it has reduced the cash supply, hence it could be considered “helicopter hoover”

India’s action is not unprecedented in its own economic history: there were two previous instances of demonetization, in 1946 and 1978, the latter not having any significant effect on cash

The action was taken as follow-up step to a series of earlier efforts to curb such illicit activities.

  1. Creation of the Special Investigation Team (SIT) in the 2014 budget;
  2. The Black Money Act, 2015;
  3. The Benami Transactions Act of 2016;
  4. The information exchange agreement with Switzerland;
  5. Changes in the tax treaties with Mauritius and Cyprus; and
  6. The Income Disclosure Scheme.

The public debate on demonetisation has raised three sets of questions.

 

  1. Broader aspects of management, as reflected in the design and implementation of the initiative.
  2. Its economic impact in the short and medium run.
  3. Its implications for the broader vision underlying the future conduct of economic policy.

This Survey is not the forum to discuss the first question and the third is discussed in Chapter 1.

This chapter focuses on the second question.

BACKGROUND FACTS

What motivated demonetisation move?

  • India’s currency to GDP ratio rebounded after 2014-15 to 12 percent when inflation declined. The value of high denomination notes of 500 and 1000) relative to GDP has also increased in line with rising living standards
  • Second, India’s economy is relatively cash-dependent, even taking account of the fact that it is a relatively poor country.
  • This might seem to suggest that some of the cash holdings were not being used for legitimate transactions, but perhaps for other activities such as corruption.
  • The presumption is especially strong because across the globe there is a link between cash and nefarious activities: the higher the amount of cash in circulation, the greater the amount of corruption, as measured by Transparency International
  • In this sense, attempts to reduce the cash in an economy could have important long-term benefits in terms of reducing levels of corruption.

How high were India’s high denomination notes in terms of their use for transactions relative to store of value?

 

  • The most conclusive evidence on the extent to which Rs 500 and Rs 1000 notes are used for transactions comes from data on “soil rates,” that is the rate at which  notes are considered to be too damaged to use and have been returned to the central bank.
  • RBI data show that in India low denomination notes have a soil rate of 33 percent per year. In contrast, the soil rate for the Rs 500 note is 22% and the Rs 1000 just 11%.
  • One way to estimate black money is to assume that all these notes should soil at the same rate, if they were really being used for transactions. This would yield an estimate of money that is not used for transactions at Rs. 7.3 lakh crores.
  • Using relative  soil  rates  for  the  US $50 and $20 notes and applying them to comparable Indian high denomination notes, yields an estimate of the amount not used for transactions, and hence potentially black, of about Rs. 3 lakh crore. This is substantial, as it represents about 2 percent of GDP.

 

Analytics

 

Understanding the benefits and costs of demonetisation requires spelling out the analytics of demonetisation, which are rich and complicated.

 

Analytically, demonetisation should be seen as comprising the following:

  • a money supply contraction but only of one type of “money”—cash;
  • a tax on unaccounted private wealth maintained in the form of cash – black money; and
  • a tax on savings outside the formal financial system.

 

 

BENEFITS

  1. Tax on black money

The Demonetisation scheme included a screening mechanism, aimed separating “white” income from “black”. Cash holdings arising from income that had been declared could readily be deposited at banks and ultimately exchanged for new notes. But those with black money faced three difficult choices.

They could:

  • declare their unaccounted wealth and pay taxes at a penalty rate;
  • continue to hide it, not converting their old notes and thereby suffering a tax rate of 100 percent; or
  • Launder their black money, paying a cost for converting the money into white.

Anecdotal evidence suggests there was, indeed, active laundering.

  • One laundering mechanism seems to have been to “re-time” the accrual of income, by constructing receipts that made it seem as if the black money had just been earned in the period immediately before November 8th, 2016. Such schemes might have allowed black money to have been deposited in bank accounts — but only if the income was reported and taxes paid on it. In this way, demonetisation would have brought black money into the tax net.
  • Other schemes would have required black money holders to pay a percentage to private intermediaries as a price for converting it into white. For example, some holders reportedly paid individuals to queue up at banks to exchange or deposit money for them.

 

In all these cases, black money holders still suffered a substantial loss, in taxes or “conversion fees”. Moreover, bank accounts are still being screened for suspicious a transaction, which means that those who engaged in laundering run the risk of punitive taxes and prosecution, in addition to the fees or taxes already paid.

 

The taxes thus received could be used in productive ways – to retire government debt, recapitalize banks, or even redistribute back to the private sector. In addition, one needs to add the taxes collected on money declared under disclosure scheme (PradhanMantriGaribKalyanYojana, PMGKY), as well as the “taxes” paid to intermediaries who laundered money.

 

  1. Tax compliance

Demonetisation can also be interpreted as a regime shift on the part of the government. It is a demonstration of the state’s resolve to crack down on black money, showing that tax evasion will no longer be tolerated or accepted as an inevitable part of life.

These two sanctions – financial penalty and social condemnation – could have a powerful and long-lasting effect on behavior.

In this case, evaders might decide in the years to come that it would be better to pay a moderate regular tax, rather than risk having to pay a sudden penal tax. Corruption and compliance could be permanently affected.

Demonetisation could also aid tax administration in another way, by shifting transactions out of the cash economy and into the formal payments system. With large denominations eliminated, households and firms have begun to shift from cash to electronic payment technologies.

As a result, the tax-GDP ratio, as well as the size of the formal economy, could be permanently higher.

  1. Tax on informal savings

Beyond reducing tax evasion, demonetisation could have other far- reaching effects. For example, it will channel savings into the formal financial system. Without doubt, much of the cash that has been deposited in the banking system will be taken out again, as the cash withdrawal limits are eased and the note supply improves. But some of the new deposits will surely remain in the banks, where they will provide a base for banks to provide more loans, at lower interest rates.

In the longer-term, if demonetisation is successful, it will reduce the equilibrium cash-GDP and cash-deposits ratio in the economy. This will increase financial savings which could have a positive impact on long run growth.

 

 

Early Evidence of Potential Long-term benefits:

 

There are some signs pointing to change.

  1. Digitalisation
  • One intermediate objective of demonetisation is to create less-cash or cash-lite economy, as this is a key to channeling more saving channeled through the formal financial system and improving tax compliance.
  • Currently, India is far away from this objective: the Watal Committee has recently estimated that cash accounts for about 78 percent of all consumer payments.
  • Cash transactions are also anonymous, helping to preserve privacy, which is a virtue as long as the transactions are not illicit or designed to evade taxation.
  • Digital transactions help bring people into the modern “wired” era. And they bring people into the formal economy, thereby increasing financial saving, reducing tax evasion, and leveling the playing field between tax-compliant and tax-evading firms (and individuals).

 

In the wake of the demonetisation, the government has taken a number of steps to facilitate and incentivize the move to a digital economy. These include:

 

  1. Launch of the BHIM (Bharat Interface For Money) app for smartphones. This is based on the new Unified Payments Interface (UPI) which has created inter-operability of digital transactions.
  2. Launch of Aadhaar Merchant Pay, aimed at the 350 million who do not have phones. This enables anyone with just an Aadhaar number and a bank account to make a merchant payment  using  his biometric identification. Aadhar Merchant Pay will soon be integrated into BHIM and the necessary POS devices will soon be rolled out.
  3. Reductions in fees (Merchant Discount Rate) paid on digital transactions and transactions that use the UPI. There have also been relaxations of limits on the use of payment wallets. Tax benefits have also been provided for to incentivize digital transactions.
  4. Encouraging the adoption of POS devices beyond the current 1.5 million, through tariff reductions.

 

National Payments Corporation of India (NPCI) show that RuPay-based electronic transactions increased by about Rs. 13,000 crore in case of POS transactions and about Rs. 2,000 crore in e-commerce, an increase of over 300-400 percent.

 

  1. Real estate

 

  • Demonetisation could have particularly profound impact on the real estate sector. In the past, much of the black money accumulated was ultimately used to evade taxes on property sales.
  • To the extent that black money is reduced and financial transactions increasingly take place through electronic means, this type of tax evasion will also diminish.
  • An equilibrium reduction in real estate prices is desirable as it will lead to affordable housing for the middle class, and facilitate labour mobility across India currently impeded by high and unaffordable rents.

 

Adverse impact of demonetization

It is first important to understand the analytics of the demonetisation shock in the short run. Demonetisation is potentially:

  • an aggregate demand shock, because it reduces the supply of money and affects private wealth (especially of those holding unaccounted money and owning real estate);
  • an aggregate supply shock to the  extent that cash is a  necessary  input  for economic activity (for example, if agricultural producers require cash to pay labour); and
  • an uncertainty shock because economic agents face confusion related to the impact and duration of the liquidity as well as further policy responses causing consumers to  defer or reduce discretionary consumption and firms to reconsider investment plans.

 

 

Short-term costs of Demonetization

 

  • Inconvenience and hardships- especially of those in the informal sectors and cash intensive sectors of the economy who may have lost income and unemployment.
  • Reduction in consumption there by Growth slowed, as demonetisation reduced demand (cash, private wealth), supply (reduced liquidity and working capital, and disrupted supply chains), and increased uncertainty.
  • Job losses, decline in farm incomes, social disruption, especially in cash-intensive sectors
  • Uncertainty increased, as firms and households were unsure of the economic impact and implications for future policy Investment decisions and durable goods purchases postponed.
  • Demonetisation could also affect supplies of certain agricultural products, especially milk (where procurement has been low), sugar (where cane availability and drought in the Southern states will restrict production), and potatoes and onions (where sowings have been low).

 

Macroeconomic consequences of Demonetization

 

After the demonetization move, bond yields have increased in almost all major economies, but it decreases in India by 32 basis points. (for ex, US bonds increased by 58 basis points.)

 

The Macro assessment is made on five broad factors:-

 

  • Agriculture (rabi) sowing
  • Indirect Tax revenues – as a measure of production and sales
  • Auto Sales-as a measure discretionary consumer spending
  • Real Credit growth
  • Real estate prices

 

  • Agriculture sowing has increased for wheat and pulses when compared to last year by 7% and 10.7% contrary to fears, probably because of good monsoon and favorable weather conditions.
  • Indirect tax revenues have increased, probable because the dues were allowed to be paid in demonetized notes.
  • Passenger cars and two wheeler sales have decreased.
  • Credit growth has weakened
  • Real estate prices have seen a drop in all the major cities.

 

Clearly, the cash crunch must have affected the informal economy, which depends heavily on bank notes for its transactions and has been estimated to account for nearly half of the overall economy. This may even be an underestimate if consumer payment transactions were in any way indicative of the extent of cash-dependence of the economy in production.

 

Equally clearly the cash crunch would have had little direct impact on the formal economy, which depends instead on the banking system, where liquidity has actually improved.

 

 

A final and important point to make is that the adverse impact of demonetisation on GDP growth will be transitional. Once the cash supply is replenished, which should largely be achieved by end-March 2017, the economy should revert to normal.

 

 

REDISTRIBUTION TO THE GOVERNMENT

 

The most important redistributive effect is that it will shift resources from the private sector to the government. The impact on the overall economy will then depend on how the government responds.

 

Demonetisation will affect the fiscal accounts in the following ways.

  • Wealth gain: The RBI/government may receive some gains from the unreturned cash.
  • Short-term flow impact: Income taxes could go up as black money was deposited in bank accounts. There are also reports of increases in tax payments at state government levels and accelerated payments to Discoms.

 

Against this are three negative effects:

  • Costs of printing new notes over and above normal replacement.
  • The costs of sterilizing the surge in liquidity into the banking system via issuance of Market Stabilization Scheme bonds.
  • If nominal GDP growth declines, corporate and indirect tax revenues of the centre could decline but so far there is no clear evidence.

 

Overall, the total cost will be clear at the end of the full year.

 

MARKERS OF SUCCESS

 

Demonetisation can have long term benefits. They may not necessarily become manifest in the next six months but evidence should start trickling in over a one-year horizon and beyond.

 

And it is not difficult to identify the future markers of success.

  1. Changes in the use of digital payment methods across the three categories of digital access identified earlier, namely, smart phone users, regular phone users and the phoneless, respectively. The early signs are encouraging.
  2. The cash-GDP ratio, which should decline as more saving, is channeled through the formal financial system and black money falls. On one estimate of black money, the cash-GDP ratio could decline permanently by about 2 percentage points.
  3. The most important marker of success will be taxes. The number of new income tax payers as well as the magnitude of reported and taxable income should go up over time.
  4. To the extent that demonetisation has also raised the costs of non-compliance with indirect taxes, we should also expect to see an increase in registration under the service and excise taxes and under the states’ VATs. These should drift up steadily in the future.

 

Maximizing Benefits and Minimizing costs

 

  • The faster remonetisation takes place, the shorter and less severe will be the overall impact of demonetisation.
  • Supply of currency should follow actual demand and not be dictated by official estimates of “desirable demand”. In other words, the RBI should re-establish internal convertibility, guaranteeing to give the public the amount of currency that the latter wants.
  • The early elimination of withdrawal limits will help build confidence.
  • There should be no penalties on cash withdrawals, which would only encourage cash hoarding.

 

Internal convertibility is bedrock of every single financial system in the world, unless people have confidence that money deposited in bank accounts is freely convertible into cash, and vice versa, they will be reluctant to deposit their cash in the first place. Instead, they will hoard it, starving the formal financial system of resources and the informal economy of the currency it needs for transactions.  And this would affect the poor most, not just because they are more likely to work in the informal economy, but because the affluent will likely corner the limited currency available.

 

  • Meanwhile, the government windfall arising from unreturned notes should be deployed toward capital-type expenditures rather than current ones.
  • And since the windfall will be one-off its use should be one-off and not lead to entitlements that create permanently higher expenditures.

 In the medium term, the impetus provided to digitalization must continue.

 

A few principles must guide this effort going forward.

 

  • Digitalisation is not a panacea, nor is cash all bad. Public policy must balance benefits and costs of both forms of payments.
  • The transition to digitalisation must be gradual; take full account of the digitally- deprived; respect rather than dictate choice; and be inclusive rather than controlled.
  • To the extent that digitalisation must be incentivized– and the incentives favoring cash neutralized–the cost must be borne by the public sector (government/RBI) and not the consumer or financial intermediaries.
  • Incentivization should be strictly time-bound because as volumes increase digitalisation should become privately profitable.
  • To increase trust in digital payments, cyber- security systems must be strengthened considerably.
  • One key need is to ensure inter-operability of the payment system, which will be at the heart of increasing digitalisation going forward, building upon the newly created UPI.

 

CONCLUSION

 

Above all, ensuring that demonetisation indeed proves a catalyst for long-run changes in behavior will require measures to complement demonetisation with other non-punitive, incentive-compatible measures that reduce the incentives for tax evasion.

 

 

Demonetisation was a potentially powerful stick which now needs carrots as complements. A five-pronged strategy could be adopted:

  • a GST with broad coverage to include activities that are sources of black money creation—land and other immovable property—should be implemented;
  • individual income tax rates and real estate stamp duties could be reduced;
  • The income tax net could be widened gradually and, consistent with constitutional arrangements, could progressively encompass all high incomes. (After all, black money does not make fine sectoral distinctions);
  • the timetable for reducing the corporate tax rate could be accelerated; and
  • Tax administration could be improved to reduce discretion and improve accountability.
  • Finally, it is imperative that the effort to collect taxes on newly disclosed (and undisclosed) wealth does not lead to tax harassment by officials at all rungs of the hierarchy.

 

There must be a shift to greater use of data, smarter evidence-based scrutiny and audit, greater reliance on on-line assessments with correspondingly less interaction between tax payers and tax officials.

 

At a time when the GST will be providing so much more data on individual transactions, greater information sharing between the direct and indirect tax departments at the centre, along with coordination with the states, could lead to greater compliance through non-punitive means, not just in relation to indirect but also direct tax collections.

 

Big Data and the digital age, and the promise they offer, should also be embraced by the tax administration.


 

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