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.