If, four-and-a-half years into its tenure, the Modi government is struggling to demonstrate visible bounce in the economy, which should ideally reflect in robust growth in jobs, one has to ask what the problem is. One could blame the back-to-back poor monsoon years of 2014 and 2015, or the double balance-sheet problem of undercapitalized banks and overleveraged corporates, but these problems would have been compensated for by cheap oil (till recently) and reviving growth in the global economy over the last two years.

We have to recognize the elephant in the room. The key themes of the Modi administration have been anti-corruption, tax compliance and formalization of the economy, and these themes are—by definition—deflationary in the short term. One uses the term deflationary not to suggest that the economy is sliding into negative territory, but to flag the probability that these themes will depress economic activity for some time. Just as higher taxes on a product can deflate short-term demand for it, a broad-based anti-corruption, anti-black money and pro-formalisation stance can be deflationary.

Consider what black money actually means. It is essentially income on which taxes have not been paid. But as long as this tax-evaded money is sloshing about in the economy, it plays its assigned role in boosting demand. Once it is taxed and/or is heavily penalized on voluntary disclosure (as the Modi government’s anti-black money schemes did in 2015 and 2016), a part of it is impounded in government coffers —or goes underground again. The amount left floating about in the economy is lower than before, and the government’s higher tax collections take some time to return to the economy and boost effective consumer demand and growth.

The other steps taken by the Modi government to eliminate corruption may also have had a similar effect of depressing demand. When you raise lots of money through coal and spectrum auctions, it automatically impacts corporate balance sheets and depresses their ability to invest more—and investment is what has been slow to revive over the last four years. When you end tax breaks for money coming in through the Mauritius, Cyprus and Singapore routes, again the impact on fund flows is constrictive. When you crimp round-tripping of funds, you effectively stop the generation of stock market wealth for the round-trippers, who may have used the money to invest in sinking companies.

When you use the Insolvency and Bankruptcy Code (IBC) to force promoters to part with their best companies rather than their worst (for example, the Ruias lost Essar Oil and Essar Steel, their biggest companies, and the Jaiprakash Group, its most valuable cement business), it reduces a promoter’s ability to generate sufficient funds for investment. This is not to suggest that the IBC is a bad idea—it is a great idea for resolving stressed assets—but in the short term, you do put a crimp in the investment pipeline till the new promoters are able to start reviving these companies.

Consider another point: if the drop in global oil prices is largely captured by government through higher taxes in order to reduce the fiscal deficit, the beneficial impact on consumer demand and corporate costs is minimal. Hence, no growth-boosting potential here.

The government can say it is using the money to build roads or electricity grids or buy defence equipment, but the impact of its spending will come after a time lag. This again means that higher taxes will impact consumer spending first before government expenditure recycles these taxes back into the hands of companies and consumers to boost demand and growth.

Or take demonetization and formalization of employment. We have seen some positive movement in EPFO (Employees’ Provident Fund Organisation) subscriptions, but formalisation always increases employee costs for small and medium companies. So, while this may boost social security for those with jobs, the net impact on jobs and growth may well be muted in the near term.

The short point is this: there is a lag between the time the informal economy is shrunk, which depresses demand, and the formal one is expanded, making up for the loss. This is why anti-corruption and formalization of employment schemes have to be spread out and brought in steadily over a long period of time. When they come all together, they can be deflationary in the interim. The lack of bounce in the Indian economy in the Modi tenure can partly be explained by this.

R. Jagannathan is editorial director of Swarajya magazine.

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