Why fate of Modi’s note ban rests with the taxman

It is too early to pass a verdict as the scheme is still a work in progress. But, when the whole exercise is over, the only tangible outcome that one needs to watch out for is how much unaccounted cash has returned to the system post the exercise. That would define its success or failure

A change in the narrative of the demonetisation by Prime Minister Narendra Modi in his last Mann ki Baat programme from black money to a ‘cashless economy’ has bolstered his critics.

There is almost a month still left before the government deadline to deposit old Rs 500, Rs 1,000 notes comes to end, but the big question is already here: Is the pain inflicted on the common man by the demonetisation-linked cash crunch worth the final outcome? What defines the success or failure of this whole exercise?

It is too early to pass a verdict as the scheme is still a work in progress. But, when the whole exercise is over, the only tangible outcome that one needs to watch out for is how much unaccounted cash has returned to the system post the exercise. That would define its success or failure.

Let’s look at the numbers. There was about Rs 16 lakh crore currency in circulation when Modi announced the plan, out of which Rs 14 lakh crore was demonetized. But, remember, the entire stock of Rs 14 lakh crore was not in use –some of it was hoarded by tax evaders and some was in the banking system.

If the current exercise can force this money back into the system for use, get the taxmen to lay their hands on hoarders – the scheme can be considered as a success.

There are two ways to look at the success of the demonetisation as far as the net recovery is concerned. First, out of the total deposits, how much unaccounted cash (money that has no genuine source/ not taxed) comes back to the formal banking system and gets taxed and put to productive use. Second, how much of the black money is destroyed, ie, out of the Rs 14 lakh crore, how much money is not coming back to the banking system at all. In this case, the currency liability goes down for the RBI and the government can then think of ways to claim that money from the RBI as surplus or dividend.

Now, what if the entire Rs 14 lakh crore comes back? Even if the entire Rs 14 lakh crore comes back into the banking system and no substantial part is found/declared illegal, then the plan didn’t work. We are just getting back the money demonetised. Given the hit on the economy during this process, the economy is then taking a net loss. But, if through the exercise, taxmen manage to get hoarders taxed for a substantial amount, the plan is a success, since that money is now taxed and up for productive use.

The unaccounted cash could come back to the banking system either in the form of voluntary deposits or when the taxman knocks on the doors of tax evaders. In the first case, the tax and penalty will together be around 50 per cent plus 25 per cent of the deposits get locked for four years. If they get caught with the illegal cash, they will have to pay a penalty of 85 per cent.

Certainly, it isn’t an easy exercise for the taxman, for sure, to identify the wrongdoers. Even before the demonetization was announced, between the July-September quarter, there was a massive surge in bank deposits, which has raised the suspicion that black money hoarders who knew about the impending move deposited their money in small dozes into the banking channels to avoid bigger scrutiny post the demonetization announcement. Here, the hoarders can use multiple benami accounts, which aren’t easy to identify for the taxmen.

For instance, a businessman can give a few lakhs each to his several employees and ask them to deposit further in smaller doses in their family member’s accounts as advance salaries for a year or so. But, here again, if the taxman is smart enough, he can track the sudden spike in several related bank accounts to the source and knock his door.

Now, how likely is that the government gets the expected Rs3-4 lakh crore windfall profit at the end of demonetisation pain, which it can use to recapitalize banks, fund infrastructure and build houses for poor?

According to a report by CNBC TV 18, which quoted government sources, over Rs 11 lakh crore out of the Rs 14 lakh crore demonetised currency has already come back to the banking system as deposits. This is with almost a month left for the expiry of the deadline to deposit old currency. This means chances of the rumored windfall looks weak.

If the demonetisation exercise doesn’t lead to a tangible outcome, the government will be in serious trouble to justify the pain the whole exercise has caused to general public and the potential damage the currency ban will inflict on the economy.

As pointed out in earlier articles, the cash crunch will take a major toll on the economy in the approaching quarters, the extent of which is difficult to say at this point.

The GDP forecasts post the note ban deepens the worry. On Thursday, India ratings said that de-legalisation of currency notes will erase about Rs 1.5 lakh crore from fiscal year 2017 GDP and the growth is likely to fall to a three-year low.

“India Ratings and Research (Ind-Ra) has revised its gross domestic product (GDP) growth forecast for FY17 to 6.8 per cent, 100bp lower than its earlier projection of 7.8 per cent (FY16: 7.6 per cent, FY15: 7.2 per cent). The downward revision is a fallout of the disruption caused at various levels in the economy due to the de-legalisation of banknotes of Rs 500 and Rs 1,000 denominations from midnight of November, 8, 2016. Ind-Ra’s analysis shows that the economic cost of the de-legalisation will be Rs 1.5 trillion for FY17,” the agency said.

It isn’t difficult to understand the change in government’s demonetisation narrative, after three weeks of the currency ban, from black money to a cashless economy. It is probably an outcome of its late realisation of the ground realities that corruption and terror cannot be tackled with a currency ban.

True, if the demonetisation inspires more people to shift to cashless payments systems, it is a good thing. But, this shift should have been done in a more gradual manner in a country mainly inhabited by lower-income population, rather than done through an overnight shock therapy. About 80 per cent of the population here is still heavily dependent on cash transactions and even the developed countries, including Singapore and US have not managed yet to get rid of cash.

The short point is this: The success of PM Modi’s demonetisation plan mainly rests with the taxman. The whole exercise could take any turn from here. At this stage, it is hard to say which.

Dinesh Unnikrishnan
(Firstpost.com)