November 29, 2016

1.25 Billion People Were Shocked on November 8, 2016

Shruti Rajagopalan

Senior Research Fellow, Indian Political Economy and Emergent Ventures India
Summary

Until the reasons for the generation of the black money are addressed, demonetization only treats a symptom, not the disease. In the process, the uprooting of citizens' lives is treated as collateral damage by a thoughtless government, with little benefit to the economy.

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1.25 billion people got a shock on November 8, 2016-but the cause was not the result of the U.S. presidential election. It was because Narendra Modi, India's Prime Minister, announced that at midnight on November 9, the Indian government demonetized the 500 and 1000 rupee notes (approximately $7.50 and $15 bills) removing 80 percent of the currency in circulation, and unintentionally hurting the poorest among them.

The reason for this drastic move was to smoke out "black money"-income and wealth on which taxes have not been paid. The demonetization policy and the transition to new notes, which include a revamped 500 rupee and a new 2000 rupee note, are based on poor economic assumptions.

The first assumption is that targeting cash can eliminate black money. Sophisticated individuals launder much of their black money through front companies in India and abroad and through untraceable bank accounts. De-monetizing currency only punishes the financially unsophisticated. It will incentivize tax evaders to hold their black money in other currencies and jurisdictions in the future, instead of keeping and spending the cash in India.

The government's second mistake is to equate large cash holdings with black money-by solely targeting cash transactions and cash deposits during this transition. This is especially painful because India is still, disproportionately, a cash economy. The reason for such a strong cash preference in India is the poor penetration of banking and formal financial services.

According to a March 2016 report by the Reserve Bank of India, which is in charge of implementing the demonetization, about 600 million Indians do not have bank accounts. Only 39 percent of individuals with a bank account hold a debit card. But 94 percent of the total value of debit card transactions are actually ATM cash withdrawals. The average number of all credit and debit card transactions per individual in India is 6.7, among the lowest in the world.

The ongoing transition has been painful because of the lack of cash substitutes. In a very poorly thought out transition to new notes, the government has imposed a restriction on the maximum number of available new notes in exchange for old demonetized notes ($30), per individual, per day, for the first few weeks.

As a consequence, there are long lines outside ATMs, and cash transactions have been choked. Only a fraction of the citizens, the wealthy urban elite, are managing without cash. The ramifications are serious; close to fifty Indians have died due to stress, anxiety, heart attacks, and health emergencies, caused or exacerbated by the unavailability of new currency notes. The poor are the worst hit; daily wage laborers remain unpaid and are down to one meal a day, vegetable vendors have lost their entire stock of perishables, small business cannot operate, and the elderly and children are stranded, unable to pay bus fares.

Women are disproportionately affected because of poor access to identification papers and bank accounts. Poor women often prefer to be paid in cash in small amounts daily or weekly, to protect their income from abusive husbands and controlling families. The government has maintained a remarkably callous attitude toward these problems, calling upon the citizens to undertake a small sacrifice for the greater good.

Supporters of demonetization claim that the benefits from cracking down on black money-which could be up to 75 percent of the GDP, as per a confidential 2013 report of the National Institute of Public Finance and Policy-is well worth the transition problems. This optimism is severely misguided. Demonetization only addresses the existing stock of black money through the end of the fiscal year. It does nothing to prevent the problem from happening again in the future.

Black money in India is a consequence of a highly inefficient tax system. Only 1 percent of Indians pay taxes on income, and the poor pay a large proportion of their income in consumption taxes when buying food and other necessities. In this highly regressive tax system, both small traders and poor consumers prefer cash to avoid taxes.

For the middle class and the wealthy, real estate is the biggest source of black money. The buyer of a new home typically settles the whole or a part of the transaction in black money to evade paying stamp duty, typically between 4-8 percent of the transaction. Similarly, the seller accepts cash to evade paying capital gains on the appreciation of the asset, about 20 percent.

And yet, the most recent tax reform, which seeks to create a common market with simplified indirect taxes across India, left out real estate. These inherent structural problems cannot be resolved by demonetization. It's the tax system that needs an overhaul.

In the absence of further tax reform, once the new 500 and 2000 rupee notes are in circulation, the future black money generated will be held in those denominations, and larger sums will be held in other currencies and gold.

Until the reasons for the generation of the black money are addressed, demonetization only treats a symptom, not the disease. In the process, the uprooting of citizens' lives is treated as collateral damage by a thoughtless government, with little benefit to the economy.