Reducing Black Money in the Economy

Reducing Black Money in the Economy

What is black money? Black money is the money on which no taxes are paid. There are several channels through which black money gets generated. Let us consider three main channels

1.    Money Generated in Black Markets: Black markets emerge either when the State is weak or when the State effectively cedes control by, for example, prohibiting (ex: banning the sale of alcohol in Bihar and Gujarat) or limiting (license-quota raj) certain activities that are then picked up by daring entrepreneurs. All the gains generated in black markets take the form of black money.

2.    Bribe/Business Malpractices: An elected official or a government employee can not declare any bribe that he receives. He doesn’t  pay any taxes on this earning. This money, typically, doesn’t get invested in the white market and many times lies in the proverbial mattress. This is also black money as it gets generated through illegal means.

3.    Grey Money: When a seller doesn’t report the money (on which taxes have been paid- white money) received from a buyer of goods or services and pays no taxes, the money acquires the color black. Again, when the seller uses this money to purchase some other goods or services, and this new seller  pays his taxes, the money becomes white. In this case, the underlying economic activities are not illegal. Tax evasion is the only reason that the money becomes gray.

There are different ways of tackling the black money generated in these different categories. Black markets would not just cease to exist because the government has demonetized the higher denomination notes. The problem is of prohibition and license-quota raj. When I was young, hardly a day passed when I would not read a story of gold smuggling in newspapers. Now, we don’t hear such stories. What has changed? When the liberalization lead to the lifting of prohibitions, smuggling became a losing proposition. The only way to dismantle black markets is by removing prohibition and  liberalizing the market. Once the market is liberalized, those daring entrepreneurs join the legalized market and generate surpluses for the whole economy.

Curbing bribe and business malpractices are more difficult. We Indians believe in discretion rather than rules. Out bureaucrats and elected representatives enjoy  an amazing level of discretions. This discretion gets translated in favors which promote all sorts of corrupt practices. The process to fix corrupt practices is long and arduous and involves reforming state’s administrative setup. India embarked on the path of reforming the economy in 1991 which, in turn, lead to the removal of many discretions. Unfortunately, India didn’t complete the task and, more importantly, never tried to reform the administrative setup seriously.  

The origin and flourishing of gray money solely depend on  the tax regime in the country. The tax is collected for providing public goods and redistribution to the poorer section of the economy. In our country, the highest  income tax slab is approximately at 33%, which is way lower than what we traditionally had. As an extreme, in 1973, we had a whopping 97.5% as the tax rate. High tax rates (income/corporate/others) promote tax evasion. Lowering the income tax rate to the current level not only increased the tax base (people who pay taxes) but also increases the total income tax collection. The income tax rate should be reduced further. Many economists argue that the current rate is appropriate. They invariably compare India with  western countries, where the income tax rate is comparable to what we have or higher. Just to note, in some Scandinavian countries, the income tax rate is as high as 60%. The quality of public goods and for that matter redistribution of income is of far superior quality in western countries. It is not fair to compare India’s tax rate to those of western countries.Taxpayers in India don’t feel that they are getting a fair return for the taxes they pay for. They consider the current rate high. This high rate deters the income earners to declare their earnings correctly. Less than 5% of  the Indian populace pay the income tax. A higher proportion of total tax collection comes from indirect taxes, which is not a good idea as the rich and the poor pay at the same rate. I believe that decreasing the tax rates across the board not only will help broaden the tax base but also will increase the total tax collection. The demonetization has already  shown the stick to public, now it is the time that the government should show carrot by decreasing the tax rate so that more and more people declare their income and pay the taxes.

It seems that the time is ripe to carry out  the tax reform. The GST is being launched. It should bring more and more merchants/traders within the ambit of the tax regime. The government through the GST council and the general budget should commit to a complete road map to reduce both indirect and direct tax rates.

Side-effects of Demonetization

The downside effect of demonetization is a liquidity (absence of money as the medium of exchange in the economy) crunch.  The two main functions of money are to act as a medium of exchange and store of value. The logic behind demonetization is: 1. to put a stop on using these currency notes as a store of wrongfully gained value, 2. to stop the use of counterfeit notes from circulation. The problem is that demonetization has also jeopardized the medium of exchange function. In absence of currency notes, many desired transactions can not take place. An economic transaction between a buyer and a seller takes place because the buyer is willing to pay a price higher than the cost to the seller. The transaction generates a surplus to the society as both the buyer and the seller gain. This liquidity crunch would severely affect the economy. Prof. Ajay Shah in his article published in Business Standard paints a very scary picture. He says that removal of currency notes will decrease the liquidity to the extent that the country may go into recession. Prof. Shah recommends the restoration of a stable monetary system as soon as possible.

Prof. Shah’s logic is based on two facts: 1. India transacts in cash, and 2. currency notes of INR 1000 and 500 constitute 86% of the total cash volume. In absence of cash, major economic activities (86% percent: Prof. Shah’s estimate) would come to halt. This would adversely affect the income of potential sellers of goods and services(a demand shock) as well as adversely affects the mobility of the would-be buyer (a productivity shock). As there may be many small traders who would not be able to withstand this temporary shock, Prof. Shah thinks that the economy may not be able to bounce back  even when the system returns to normalcy.

The situation is bad, but probably, not as bad as Prof. Shah makes it out to be. However, the restoration of the stable monetary system is of utmost necessity. If this demonetization has to succeed, the government needs to pay immediate attention to ameliorate the liquidity crunch. Unfortunately, Prof. Shah doesn’t suggest anyway to improve the situation.

Let us, first, understand why I think that the situation would not lead to a recession.

Not all these demonetized currency notes were used as the medium of exchange. A fair proportion was used only as the store of value (in the proverbial mattress). All the arguments supporting the demonetization rely on this proportion being higher. Come December 30, we will have a fair idea of this proportion. If this proportion comes out to be low, the demonetization would be a colossal economic waste.      

More importantly, potential buyers and sellers would not waste economic opportunities because they don’t have cash.  I am not talking about barter. As two can barter only when there is a double coincidence of want meaning one has something that the other wants and the other has something that the first person wants.  It is difficult to find such  double coincidences. The solution lies in technology.

The Way Forward: Use of Technology

India, the principal provider of digital services to the world, lies far behind in the use of digital cash. Achieving a higher degree of cashlessness in the economy requires multiple and complex steps.  Fortunately, barring some crucial stages, all necessary ingredients to make our economy a digital economy is present in the country.

Fortunately, India has amazing mobile penetration. There are more than 103 crore mobile connections and more than 13 crore broadband connections. We all know how to top up/refill cash in our mobiles.  One can top up in the mobile account/ deposit accounts such as paytm, or all the banks can come up with such mobile cash accounts. This mobile cash can be used as a medium for transactions. The only innovation required is to top up without cash.  I am thinking of something like the ubiquitous STD booths at every corner  that we used to see at every corner in India  in the late nineties and early two thousands. These can be present in villages, cities, everywhere. People can go to these booths and top up their electronic cash account. The plus point would be that all these money would remain legally traceable. The government needs to act fast to come up with and promote such  platforms.

Political Aftermath of  Demonetization

According to the United Nation ( other estimates are also in the same ballpark), the per capita income in India in nominal terms in approximately USD 1585 which in rupee terms translate to INR 108000  per annum or  INR 9000 per month or INR 300 daily. Please remember, that the income distribution is positively skewed, meaning that the median earner in India earns much less than INR 300 a day. How many thousand rupees (strike that), 2000 rupee or for that matter 500 rupee currency notes, does an average Indian keep? A Jan Dhan account which allows deposits up to INR 50000 in this Nov9-Dec30 period and daily exchange limit of INR 2500 are more than enough for the average person.  The debate on demonetization is largely a political and monetary debate for the middle class.  An average Indian doesn’t care either for this demonetization or the debate. My belief is that he or she is happy that the government has done something to eradicate black money.

In consequence, I expect to see some political realignments. Losing the Bihar election was a big eye opener for the Bhartiya Janta Party (BJP). It figured out that it would lose whenever the opposition parties would cobble together a united opposition. Its traditional coalition of  upper caste north Indians, traders, and the urban middle class is not good enough to retain power in 2019.  The pan-Indian support that it got in 2014 may not be so solidly behind It in 2019. It needs to expand its base to all over India, particularly in the rural parts.  If BJP is able to manage this demonetization successfully, its potential to extend its reach significantly is likely to be realized.

Modi’s Move: A Retrospective Study of the Background

There are two hypotheses concerning corruption in India: greasing the wheel and sanding the wheel. The proverbial wheel represents the Indian economy.  The idea is that India has dysfunctional institutions and an obdurate bureaucracy, so corruption works as the lubricant and helps things advance, thereby enhancing the economic performance of the country. ‘Sanding the wheel’ notion alludes to the detrimental effect of corruption on the economy.

Not surprisingly, many scholars have found empirical evidence in support of the ‘greasing the wheel’ hypothesis. It means that corruption in India does help in achieving higher economic efficiency. What it doesn’t mean is that corruption is good for the country. Corruption is good only in the absence of good institutions. To put it simply, the best is to have good institutions which work without corrupt practices. And, the second best option is to turn a blind eye to corruption if institutions are dysfunctional.

Improving institutions involves lengthy and costly political processes. There are always people who thrive on the current setup of institutions. Any change/attempt to change the setup brings stiff opposition from these people. Even the economic liberalization of 1991 which improved the economic health of the country manifold had to face opposition from different quarters.

Mr. Narendra Modi became the Prime Minister of India in June 2014. It is not wrong to say that development and curbing the use of black money were two of his most important poll planks. By 2014 the process of institutional reforms had slowed down. The Congress party which ushered the economic reforms found itself unable to carry out any more reforms. The growth rate had deteriorated. Corruption was rampant. Anna’s movement against corruption became a testimony of public anger against corruption. The people of India wanted development and wanted to be ridden of rampant corruption. They voted for Mr. Narendra Modi with great expectation that he would be able to fix the twin issues of development and black money.

What made corruption so rampant and growth rate so low in India? [Between 1960 and 1980, India had a very low growth rate: 1.5% on average, it was jokingly called the Hindu rate of growth.] Despite the availability of cheap factors of production such as land, labor, and minerals, businesses didn’t thrive in India. The system that we had in place was called the license and quota raj which was antithetical to domestic investment and inflow of foreign capital in productive sectors. The license and quota raj also promoted several corrupt practices. For example, it became almost a norm to pay a bribe to get a license to start a factory. These corrupt practices were largely supported by the use of black money. Narasimha Rao’s government (1991-96) dismantled the license-quota raj to a large extent. Unfortunately, the corrupt practices and use of black money didn’t go away; it not only remained rampant in the economy but also permeated to the lowest level.

To experience a high growth, the kind which the Indian public was expecting, the kind which South Korea and Singapore experienced, it became necessary to have fair, honest and efficient institutions which promote domestic investment and inflow of foreign capital. The presence of corrupt practices and black money has stifled the both. Black money cannot be reinvested back in the formal sectors. So, people invest their black money in land, real estate and gold which creates excess demand causing the rate of return to rise in these sectors. Increased rate of return attracts even those investors who have no black money. The presence of corrupt practices and black money distorts the business environment which decreases the inflow of foreign capital.

India lacks the political consensus for reforms. Only strong political leadership at the prime ministerial level in the presence of dire economic situation is able to force economic reforms in the country. The Modi government has been trying its  best to reignite the engine of growth. However for Modi, the political math: the number in Rajya Sabha (the upper house of the parliament) is not in  favor. The Modi government’s attempt to pass the land acquisition bill failed. The entrenched interest of organized labor resists any reform in labor laws. Fortunately enough, the parliament was able to pass the GST bill. The government is carrying out piecemeal reforms, but the country is not able to achieve the high growth rate that is expected of it. The government gets A for the effort but a mediocre B- for the result.

The question was how Modi could Trump this game? There are two main ways of treating a disease: one is described in Ayurveda and another is popular in Allopathy.  Ayurveda emphasizes treating the root cause and fixing the system while allopathy believes in curing the symptoms. More than a half-way through his tenure, Prime Minister Modi sees that time is running out. For one reason or the other, he is unable to follow Ayurveda and is not able to fix structural problems of the economy. What worried him the most was his inability to make any progress on the account of bringing back black money. His government needed to do something fast. He needed to do something out of ordinary. And, it seems that Mr. Modi has found that something extraordinary: an allopathic tool to tackle the twin political issues of growth and black money.

One must appreciate Mr. Modi, as this move is not only extraordinary but also risky. Fight against corruption and black money in India is considered a difficult proposition for the simple reason that almost all of us have some black money and/or have used corrupt practices for some short-term gains. We all talk about the need to curb corruption but none of us really want the complete elimination of black money and corrupt practices. After all, it helps us lubricate our inefficient institutions.

The short-term impact would be chaotic.  Modi will need his leadership skills to manage this transition. There is a high probability (>0.5) that this move may not achieve the desired result. If this happens, Modi will be remembered as one term prime minister who squandered his chances on a crazy idea. But, I still appreciate his gumption that he decided to handle the black money in this particular way. There is also a good probability (less than 0.5) that he would be able to get the desired result and reap the electoral benefit in the next election.