Formal declaration of war against informality

The fight against black money intersects with the country’s massive informal economy, which keeps the industrial base narrow and limits the tax-to-GDP ratio


Shrinking the informal economy is essential to India’s sustainable high-growth ambitions. Photo: AP
Shrinking the informal economy is essential to India’s sustainable high-growth ambitions. Photo: AP

On 8 November, when the world was awaiting the outcome of the US presidential election, the Indian prime minister captured the attention of his country with an announcement that currency notes of denominations of Rs500 and Rs1,000 would not be legal tender from the following day. The ripples are still being felt. India had undertaken a similar exercise nearly 40 years ago, in 1978. Thanks to a well-researched piece by Sonal Varma of Nomura Research, we know that in 1978, with a short lag, bank deposits grew, bank credit grew and the credit-deposit ratio of banks came down.

Short-term economic disruptions are inevitable as households and the private sector have to learn to adjust to a new regime. Since India is also simultaneously moving to a goods and services tax (GST), the uncertainty could be compounded, resulting in some adverse economic impact in the short term. Most structural reform measures bring short-term dislocation with adverse consequences. This one would be no exception. That is why the government biting the bullet on this and sending a strong signal is a move in the right direction. This was a needed measure in many ways.

The fight against black money assumes significance because it intersects with the country’s massive informal economy, which keeps the industrial base narrow and limits the tax-to-GDP (gross domestic product) ratio. Indeed, it is not just a fight against black money or fake currency notes issued by forces inimical to India but also an important step in increasing the share of the organized or formal economy in the overall GDP. The benefits of that transition would be manifold and realized over time. As an aside, we would caution against the government entertaining thoughts of “profiting” from the mythical and magical demonetization gains. The arguments are wrong.

An important reason for the very narrow industrial base and low tax-to-GDP ratio is the country’s all-encompassing informal economy. Apart from public revenue loss, the informal economy has a deeply corrosive effect on the transmission of market dynamics and market efficiency, constrains the productivity of both capital and labour, and hampers the effectiveness of public service delivery. Shrinking the informal economy is, therefore, essential to India’s sustainable high-growth ambitions. Because of its pervasive and broad-based nature, action would be needed at multiple levels. They would have to be both financial and non-financial, with the latter revolving around lowering the cost of undertaking economic activities.

On the financial side, the government has already taken several steps in shrinking the informal economy. Apart from rigorous efforts at detection and enforcement, a Special Investigation Team (SIT) has been established, new laws on disclosure of foreign-held black money and to curb benami transactions have been promulgated, a scheme for voluntary disclosure has been announced and strict limits on unverified cash transactions have been put in place. While these measures should be expedited and vigorously implemented, it should be complemented with measures to curtail the origination of the largest informal markets. They would include policies to eliminate the wedge between the market and official guidance values of real estate, and further limits on cash transactions for goods and services, especially for purchases of gold, vacations, educational, legal and medical services, beyond a progressively declining value.

These direct measures have already been accompanied by more fundamental reforms to address the predominance and informality of cash transactions. They include the JAM trinity initiatives that leverage Aadhaar—Jan Dhan Yojana, RuPay debit cards, Unified Payments Interface, direct benefits transfer, etc. Similarly, the GST Network (GSTN), designed to manage the massive chain of indirect tax appropriation and reimbursements, could help capture the vast volume of retail commercial transactions.

This should be complemented with the expenditure information network (EIN) recommended by the Technology Advisory Group for Unique Projects’ 2011 report. The EIN would create a digital trail of all fund releases by governments down to the last recipient, especially important as cash transfers assume greater role in the subsidy regimes.

A combination of all three—JAM, EIN and GSTN—would offer unprecedented network effects encompassing the vast majority of financial transactions. Apart from the obvious benefits of reducing evasion and leakages and better targeting public spending, this system could dramatically increase the efficiency of public service delivery and the utilization of scarce public resources. It would also be a much needed step towards expanding the formal economic base and increasing the tax-to-GDP ratio.

Finally, as Shankkar Aiyar has written in The New Indian Express, any sustainable attempt at curbing black money has to strike at the “business model of politics”. Reforms aimed at greater transparency in campaign finance would also be the strongest possible statement of intent from the government.

If these financial-side measures could complement the various ease of doing business and small enterprise development initiatives, their cumulative effect could significantly dent the informal economy and could be the lasting legacy of this government.

(This column is based on the authors’ joint work, Can India Grow?, published by Carnegie India. It can be downloaded at no cost from CarnegieEndowment.org from tomorrow).

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