Now that the debate on demonetisation is simmering down, it is a good time to go into its root causes. The problem is the generation of black money, which would be a non-issue if there were no taxes. That, however, is unthinkable since the state requires revenues for defence, welfare, infrastructure, the administrative machinery and so on. Once there are taxes, however, there is always the temptation to evade them, specially if they are too onerous.
Tax evasion goes back to the time when trade took place between nation states through land and sea routes. That taxes are important is endorsed by the fact that Adam Smith in his later years was appointed Customs Commissioner in Edinburgh. The history of tax evasion during and after the Industrial Revolution is a long and chequered one. In India, tax evasion (not tax avoidance, which is within the bounds of the law) became rampant after the 1960s, when
a nexus developed between business and politics. Politicians needed funds which were outside the ambit of audit and businesses generating black money by and large became a social reality.
The term “crony capitalism” began to do the rounds and was spurred by the licence permit raj: Even those who abhorred it got drawn into the vortex of corruption.
The reforms of 1991-92 did away with many of the licence-permit restrictions and the country enjoyed over two decades of high growth. However, this was the result of only the first phase of reforms after which there were a number of half-hearted attempts at taking the reform process further, but without any major success.
This brings us to the current story of demonetisation. The ostensible purpose is to root out black money which, given the above background, is laudable but highly ambitious: It involves breaking the nexus between political parties, businesses, public institutions, the bureaucracy and the people at large. Needless to say, there is much scepticism about its success. While people accepted the inconvenience of standing in line for hours every day before banks and ATMs, they did so in the belief that this would somehow do away with the corruption associated with black money.
There are in fact two aspects to this; the stock of money and the flow of money. ‘Stock’ would typically comprise hoarded cash, gold and jewellery. The immediate impact of erasing the value of Rs 1,000 and Rs 500 notes was to make them worthless overnight, thus destroying nearly 80 per cent of the money in circulation. There was a stock of money with citizens, a portion of which could be explained as savings from legitimate income as well as that which could not — the latter formed part of tax evasion and was a major component of black money.
Firms which likewise kept money off the books stored it away from banks and the tax authorities. There were ingenious ways of holding black money, through benami land and a network of companies at home and abroad, which often proved a nightmare for the authorities. In the sudden sweep of demonetisation, there is no doubt that a good amount of black money was cancelled, thus appearing as revenue for the government.
The problem is with the “flow” side: Undoubtedly, digitisation will help in plugging leakages but it will be a time-
consuming project. On the other hand, Aadhaar and other identification methods, given vast computer memory banks, will make it easier to track the mismatch between legitimate income on the one hand and expenditure plus savings on the other.
With regard to GDP growth, however, what does economic theory tell us? Economists mostly rely on Irving Fisher’s equation which says that the stock of money M times its velocity of circulation V should equal the quantity of goods and services sold Q times the average price level P. During demonetisation, M went down and V declined, thus impacting both Q and P.
GDP should thus have declined. The latest figures tell us that the GDP growth rate has remained steady at 7 per cent. There could be two reasons for this. First, agricultural growth has shown a spurt of 6 per cent and second, the non-capital expenditure of the government shot up during this period, thus adding to the white money stream in the country. While statisticians are yet to fully sort out the reasons for the GDP growth rate, let us look at the future.
The whole story begins with the attempt of the government to root out black money. Since this results from tax evasion, let us see what economic theorists have to say about optimising taxes. Arthur Laffer believes that if we plot the tax rate on the horizontal axis and tax revenue on the vertical axis, revenue will be optimised at a sweet spot, where the tax rate is not too onerous and the revenue is maximum. This is shown on the bow-shaped Laffer curve where its maximum horizontal distance from the vertical axis shows the optimal point. If we travel above this point, the tax rate will be so high that revenue will be suboptimal. Below this point, the tax rate will be so low that the government will forego revenue.
Keeping in mind that there is a sweet spot for both direct and indirect taxes, the government will have to design a system for all economic activity. These sweet spots will have to be derived through trial and error and, of course, good judgement.
So far, more or less all taxes on goods and services as well as on political parties are in the ambit of government planning — except land and real estate as so well argued by Arvind Subramanian in his article GST and the litmus test of land (IE, March 3). If land and real estate, as he says, can be brought under GST, this will plug a major leak in the fight against black money.
The need for reducing cash transactions, meanwhile, has its limits. Developed countries use cash transactions to the extent of between 5 and 10 per cent of their GDP.
In India, which has a long way to go towards digitisation, a figure of 10 per cent or Rs 15 lakh crore seems more realistic.