Managing the impact of demonetization

It will certainly be negative and could reduce potential gross domestic product in the medium term


The government should take steps to reduce the incentives for evading taxes. Photo: PTI
The government should take steps to reduce the incentives for evading taxes. Photo: PTI

The Indian government’s decision to demonetize currency notes of Rs500 and Rs1,000 was necessitated by the increase in difficult-to-tell counterfeit notes and a desire to curb black income generation as well as eliminating a part of existing unaccounted wealth held in these high-denomination notes. The authorities’ intent and action are indeed praiseworthy but need to be followed up with subsequent actions to remain effective. These actions relate mainly to structural changes to make the system more rules-based—reduce the discretionary powers of the bureaucracy, make the tax system simple, transparent and less discretionary, make a greater effort to include the informal sector and ensure effective and quick dispensation of justice. Meanwhile, the impact on the economy will most certainly be negative and could reduce potential gross domestic product (GDP) in the medium term and consequently government revenue.

The government, by announcing a tax amnesty scheme before demonetization, has sent a strong signal to tax evaders to declare their incomes in future and avoid evading taxes. This would help enhance the tax base going forward and help reduce the fiscal deficit. However, at the same time, revenue growth is likely to be negatively affected as a result of slower growth.

In the short term, there will be an increase in bank deposits as individuals deposit their high-denomination notes, bringing down yields. This may, however, not sustain as people may have a desire to hold and move back to cash in the new high-denomination notes that will become available over time.

The impact of the demonetization measures would certainly be slower economic growth. As most real-estate transactions entail an element of cash, this market is likely to come to a standstill with property prices likely to fall. This would imply a negative-wealth effect leading to a decline in consumption, and possibly business investment.

Several businesses transact in cash and with demonetization they may become cash-strapped, hurting business—and consequently revenue, employment, consumption and investment. The informal sector in India employs more than a majority of the workers and most transactions are in cash. Disruption to this system could endanger the employment and livelihood of weaker sections of society.

The likely tax investigations following demonetization will affect domestic spending adversely—both consumption and investment in the formal and informal sectors. This would be true as tax laws remain open to interpretation at the mercy of the tax authorities with no real effective legal recourse. The reduction in overall investments, both in the formal and informal sectors, would reduce potential GDP growth.

The authorities need to come up with a stimulatory fiscal spending programme, especially aimed at alleviating the pain in the informal sector, coupled with a weaker exchange rate to compensate for the sharp contraction in money supply. While meaningful structural reforms remain elusive to increase economic growth, the contractionary monetary policy unleashed without a compensating expansionary fiscal- or exchange-rate policy would have a negative impact. The Reserve Bank of India (RBI), which needs to allow a stimulatory weaker exchange rate, has been doing just the opposite since the announcement of demonetization—it has been letting the rupee appreciate in real effective exchange-rate terms.

Unaccounted wealth certainly continues to exist in the form of assets such as property investments and gold, and black income could again be generated if the government does not undertake steps to reduce the incentives for evading taxes. Structural reforms to make the economic transactions more transparent are, therefore, necessary to sustain the government’s current initiative.

A clear, transparent, rule-based system is essential to reduce the discretionary and, hence, the rent-seeking abilities of government officials. Corrupt officials are unlikely to give up on seeking rent for their personal benefit because of their ability to construe rules as they deem fit.

More transparent and open electronic-bidding systems as well as allocation decisions and their basis need to be made public to reduce this menace. Similarly, with lack of clarity and multiple tax rates, corrupt revenue officials will remain open to bribes.

Rule of law is critical for a well-functioning economy. India’s judicial system suffers from several weaknesses that embolden individuals engaged in black-money generation. Additionally, the pendency in courts and years taken to decide most cases discourages honest people from taking on dishonest officials and end up paying them. Reform in the judicial system has been held up and the government needs to fix this through hiring of judges, greater use of information technology in courts and reducing cases where government is a litigant (most outstanding cases in Indian courts today).

If illegal activities (smuggling, drug trafficking) as well as corruption continue, black income will be generated in future. This will be funnelled back into the economy and receivers of this—firms, businesses—will again have to hide these revenues from tax authorities. Generation of black income and, consequently, wealth cannot be eliminated without simple, transparent rules and a rule of law essential for a society to function well-being implemented in earnest. The authorities need to move further in that direction.

Rajan Govil is managing director at Marketnomix and a former International Monetary Fund economist.

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