Demonetisation has hit growth rate

The economy continues in the slow lane. Growth rate has slowed down from 7-8 per cent to 5-6 per cent. Demonetisation and the push towards a digital economy have contributed much to this slowdown.

One major objective of demonetisation was to clean up the financial system. Most analysts agree that the share of black economy was at least 50 per cent before demonetisation. Thus, generally speaking, at least 50 per cent of the cash in circulation before demonetisation would have been ‘black’. Most of this has become white.

The Reserve Bank of India has calculated that 99 per cent of the notes in circulation before demonetisation have been deposited in the banks. Large numbers of transactions were being undertaken in cash earlier. These transactions were not disclosed in the sales tax or income tax returns.

For example, a hardware shop sold one-half of the plywood sheets in cash. He obtained cash from the purchaser and made payment to the plywood factory in cash. He did not pay either sales tax or income tax on the profit earned in these transactions and kept the earnings in currency notes. Demonetisation forced him to deposit those notes in the banks.

He would now have to disclose the source of this income to the income tax authorities. The government will now be able to collect taxes on this money. I know of people who have deposited monies in excess of Rs 2.5 lakh in their accounts after demonetisation and have received notices from the Income Tax authorities.

Thus, the government will certainly collect higher taxes in the financial year 2016-17. Similarly, many businesses started undertaking business through the banks, that is, in ‘white’, in the aftermath of demonetisation. They are paying higher amounts of Sales Tax, and now GST, than previously. These have been the beneficial impacts of demonetisation.

However, primary objective of trapping black money has been utterly defeated. Businessmen have deposited 2.5 lakh each in the bank accounts of hundreds of their employees. Others have showed this as income from agriculture or savings kept in cash. Large amounts of old notes have been converted into new notes with the connivance of bank officials.

We may, therefore, assume that 50 per cent of the currency notes were being used to hoard black money. However, 99 per cent of the ‘black’ notes have been converted into white and deposited in banks. Only 1 per cent of the black money has been weeded out. The main positive impact of demonetisation is increase in tax collection because of shift of ‘in cash’ business to bank-based transactions.

However, this shift may happen only in the short run. A friend of mine is refurbishing his house in Kolkata. All items such as boards, plywood and paints are available in ‘cash’ without payment of GST—just as they were available before demonetisation. ‘No 2’ economy has bounced back.

Nevertheless, the finance minister is right that demonetisation has led to an increase in tax collection. Question is whether this impact will endure? Demonetisation failed to trap black money because the bank officials recycled old notes into new. Similarly, the increase in tax collection will depend on the Income Tax officers. Preliminary indications are not good.

One person gave a bribe of Rs 4 lakh to an Income Tax Commissioner in Mumbai only few days after demonetisation. The Commissioner made fun of the government: “Where is the trap of black money laid out by Mr Modi,” he asked. Modi has certainly appointed honest officials at the highest posts. But the lower bureaucracy is ensnarled in No 2 as previously.

The fact is that business in No 2 flourished earlier because of the connivance of the tax officials. The same tax officials are now managing the income tax and GST systems. The corruption prevalent among the earlier tax administration did not control the black economy.

The same corruption among the post-demonetisation tax administration will not control the black economy today. For this reason, I reckon the beneficial impact of demonetisation on tax collection will be short lived.

The main positive impact of demonetisation has been on terrorists and illegal immigrants. A friend from Assam told me recently that previously large numbers of Bangladeshi immigrants were coming into India with fake currency. They would convert these into genuine notes at about 40% discount. Then they would pay about Rs 2 lakh to get an Aadhaar card made and slip seamlessly into the Indian labour market.

This racket has come to a standstill because the Bangladeshi counterfeit printers have not been able to print the new notes as of now. Similarly, the fake note racket that was funding terrorist activities has come to a standstill.

It is to be seen whether and how soon the counterfeit printing presses across the borders are able to print the new notes. If they are successful, then the positive impact will be temporary. But even that would be well worth the Rs 21,000 crores spent on printing the new notes. This is perhaps the biggest success of demonetisation.

Demonetisation has, however, dealt a death blow to small businesses in the country. A hosiery maker from Tiruppur in Tamil Nadu was in anguish. He was no longer able to compete with those in Ahmedabad, he said, because the latter had reestablished ‘cash’ transactions with great speed. Even otherwise a single shock translates into a long-term loss for small business.

Let us say a consumer was buying wheat flour from the street corner shop earlier. She started buying from organised retailers in the aftermath of demonetisation. She may not return to the street corner shop ever simply because she has got used to organised retail now.

The final balance sheet of demonetisation is like this. On the plus side demonetisation has dealt a short-term blow to terror and illegal immigration; and led to a short- term increase in tax collections. On the minus side demonetisation has had a long-term negative impact on the small businesses.

This negative impact has brought down the growth rate in the current year and is likely to keep it down in the coming year except for minor improvements. Author was formerly Professor of Economics at IIM Bengaluru

By Dr Bharat Jhunjhunwala