One of the biggest issues which helped Prime Minister Narendra Modi capture power in 2014 was the promise to crack down on corruption and black money. Midway in his tenure, he has announced scrapping of currency notes of 500 and 1,000 to curb black money and other illegal activities such as counterfeiting of notes and money laundering. Given the fact that 500 and 1,000 notes account for more than four-fifth of the currency in circulation, the move is likely to create significant chaos in the economy in the short run. Is the pain worth it?

There is no denying the fact that unaccounted income is a major problem in India. A 2010 paper published in the International Economic Journal estimated that the shadow economy accounted for around one-fourth of India’s GDP between 1999 and 2007. Although India fared much better than many Asian and African countries on this count, it fares badly compared to major economies.

Does cash play a major role in this? India’s cash to GDP ratio is much higher than major economies. It is also a fact that the share of higher denomination notes in circulation has grown at a much faster pace than that of smaller value notes. This might suggest that higher value currency notes might have an important role in India’s black economy.

How much would the current move help in curbing black economy then? History is not very encouraging. In 1978, the Janata Party government had also decided to scrap notes of 1,000, 5,000 and 10,000 in the country. A 2012 report prepared by a committee headed by the chairman of the Central Board of Direct Taxes had described the move as ineffective, as only 15% of the higher denomination notes were exchanged at banks, and the rest never surfaced due to fear of penal action by government agencies.

One would have to wait for government figures after the completion of the 90-day window to see how much of the money remains undeclared.

The figure is likely to be much higher than 15% as even common people use 500 and 1,000 notes now in comparison to 1978 when only the super-rich would have been using 5,000 or 10,000 notes.

However, there cannot be a one-to-one extrapolation between the ratio of junked cash to total cash in circulation and the scheme’s effect on black income. Here’s an example to explain this: Suppose a property developer sells a flat worth Rs1 crore to a person. He can declare the entire amount to the tax authorities and pay tax on it. Or, he could offer a deal to the buyer that he would sell the flat for Rs90 lakh but take Rs30 lakh in unaccounted cash, and the official value for the flat would be declared at Rs60 lakh. The seller would lose Rs10 lakh in value but save Rs40 lakh in taxable income. The Rs30 lakh in cash would then become a part of what can be termed as black income in that particular year. Let us assume that the seller makes one such deal every month. In that case he would have made Rs3.3 crore in 2016 (Rs30 lakh each between January to November). If all of this money has been kept in Rs500 or Rs1,000 notes, he would be in trouble. However, that is extremely unlikely. First of all, cash is not the only option to store unaccounted wealth. A 2012 report prepared by National Institute of Financial Management on unaccounted income found that cash was the least preferred option for storing unaccounted wealth.

It is also not necessary that unaccounted income should be held as wealth. For example, the seller described above could be using his monthly stream of 30 lakh in unaccounted earnings to pay wages to his construction workers. In that case, he would have successfully re-routed 3 crore of black income to the construction workers, and would only risk losing 30 lakh which are the proceeds of November. The damage to the seller is thus partial and temporary. He can possibly defer payments to his labour contractors. Once new notes begin recirculating in the economy, he can once again use the new notes to pay off his debts, and wash away his sins in the vast informal network of the Indian economy.

If the total value of cash in circulation in 500 and 1,000 notes was 3,000 crore, and our flat seller were to junk 30 lakh of cash in hand, it would be incorrect to assume that the magnitude of black income was only 0.01%, since the total unaccounted income of the seller is 3.3 crore, which comes to 0.11%. If the cash junked was double the amount, one would arrive at a different estimate of black money for the same amount of unaccounted income.

The short point is, at best, demonetization would only be a small and temporary problem for those who earn unaccounted incomes. Even this can be minimized if they are able to find a substitute for currency in the interim period, a point which has also been made by Ajay Shah, professor of economics at the National Institute of Public Finance and Policy, in his blog on the issue.

The maximum impact this move would have is on those who have been introducing counterfeit currency in the economy. However, the exact estimate of the vice would never be known. There is also no guarantee that future higher denomination notes would be immune to the problem.

Myriad claims have been made that the move would help India’s transition towards a cashless economy. They seem to be rooted more in wishful thinking than facts. A vast majority of India’s working population neither receives its wages through banks or other financial institutions, nor does it deposit them there. The high share of zero (negligible) balance accounts among those which were opened under the Jan Dhan Yojna are a testimony to it. On the other hand, it also needs to be kept in mind that India fares poorly in terms of infrastructure for cashless transactions. An earlier Plain Facts column by Tadit Kundu had discussed this problem in detail.

The fact that the government is going to reintroduce higher denomination notes also means that there would be no long-term disincentive for using cash.

Many people have described the decision to scrap Rs500 and Rs1,000 notes as Modi’s surgical strike on black money. Like surgical strikes on terror camps across the border, they might offer two advantages: one, a temporary setback to black income earners in the country; and two a demonstration of the government’s will to crack the whip on black money. Long-term dividends of both are difficult to ascertain. The downside risk could be much bigger this time. The side effects of surgical strikes across the Line of Control (increased ceasefire violations) are only being felt by those living near it. In the case of demonetization, a vast majority might have to bear the brunt of liquidity crunch and inconvenience in day-to-day lives.

Dipti Jain and Tadit Kundu contributed to this story

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