In their recent defence of the Narendra Modi government’s demonetisation and subsequent remonetisation programme, Jagdish Bhagwati, Vivek Dehejia, and Pravin Krishna (hereafter BDK) rebut many of the smaller criticisms levelled against the programme. We agree with BDK that demonetisation by itself cannot be expected to remedy counterfeiting, corruption, and future flows of black money. Other reforms will be needed. Disappointingly, however, BDK disregard the short-term and long-terms costs of the programme. A more balanced evaluation is called for.
BDK regard demonetisation as “a policy designed, in effect, as a one-time tax on black money” and propose that its “success has to be measured by the sum of tax revenue generated and black money destroyed”. They arrive at a back-of-the-envelope calculation of “the net gain” to the government as “Rs1 trillion of black money destroyed”. which will generate government revenue to the extent that the Reserve Bank of India (RBI) issues replacement currency, plus “Rs1 trillion in tax revenue” from the 50% tax on black-money deposits. They add: “The government could reasonably claim this (Rs2 trillion in revenue) as a successful outcome.”
We have no objection to the arithmetic of the BDK revenue guesstimate, only to its economic interpretation. Revenue gained is a very peculiar criterion for “success”. The standard economic approach is to evaluate the economic success of a programme not just by summing up its estimated benefits, but by summing up its benefits and then subtracting its costs. This is well known to BDK, who have written admirably on the benefits and costs of trade policies.
The efficiency of a tax is evaluated by comparing its revenue to its “deadweight cost” or “excess burden”, the sum of economic activity discouraged by the tax plus the costs of tax collection. The most successful or “efficient” tax is one with the least cost per rupee of revenue raised. BDK, however, judge the success of demonetisation as a government revenue programme without accounting for any associated economic losses to the public (we put aside any tally of its injustices).
BDK reject an accounting of the costs of demonetisation as “premature” and “without evidence”. But the facts are on the ground. The Centre for Monitoring Indian Economy (CMIE), an independent think tank, has estimated the total costs accumulated during the 50-day transition from old to new notes at Rs1.28 trillion. This figure represents a 64% deadweight cost of collecting the Rs2 trillion revenue estimated by BDK, making demonetisation a very high-cost tax.
The CMIE estimate includes the Rs168 billion spent in printing, transporting, and circulating the new currency. About Rs150 billion in wages were foregone by households waiting in queues to get new notes. An estimated Rs351 billion in costs has been incurred by banks, putting other business aside to exchange notes. The greatest losses fell on business enterprises hit by the sharp curtailment of currency transactions, estimated at Rs615 billion. The widely cited CMIE report offers a conservative cost estimate, limited to the 50-day window that ended on 30 December.
Various other non-partisan forecasters have estimated that demonetisation will cost the economy between 0.4 and 3.3 percentage points of growth. On an estimated gross domestic product of Rs145 trillion, one percentage point of lost growth equals Rs1.45 trillion. BDK may want to quibble with the various cost estimates, but assigning zero to the costs will not do.
These estimates don’t include the cost of auditing, collecting, and enforcing taxes on unaccounted money that has entered the formal system via banks. These costs may be substantial, given India’s complex tax code and the Prime Minister’s promise to prosecute every single tax evader.
BDK treat the matter of whether the “economic impact post 8 November will be contractionary” as a hypothetical question. They point out that a demonetizing government might prevent a currency shortage by immediately issuing new currency to replace the old. It might, undeniably, but it has not.
The government did not have the new currency ready to prevent a currency shortage. Even economists in the government, like Arvind Panagariya, vice-chairman of NITI Aayog, have acknowledged this: “In the short run, you have a liquidity crunch. It is going to impact economic activity and it is also happening.” Although the shortage is easing, the stock of currency may not be fully replenished before May 2017. The next two quarters may continue to experience a slowdown. The effects of the disruption in cash-dependent sectors like construction and informal manufacturing may last still longer.
Finally, challenging the claim that the botched remonetisation “has damaged trust in the monetary system,” BDK reassure us that the situation is not as bad as a hyperinflation. While trust in the rupee has indeed not been completely destroyed, it has eroded. The rupee has become less attractive as a currency in which to invest or hold wealth. Perhaps the worst casualty is the loss in the credibility of the Reserve Bank of India, which has tweaked rules more than once a day (roughly 60 notifications in 50 days) to deal with the currency shortage.
We need to count both costs and benefits to evaluate intelligently whether this was the best available method of taxing black money, or if the goal could have been pursued by less costly means.
Shruti Rajagopalan and Lawrence H. White are, respectively, assistant professor of economics at SUNY, Purchase College, and professor of economics at George Mason University.