The Government has taken a bold step in demonetising notes of 500 and 1000 denominations and should be congratulated for the same. Factories in Pakistan were printing counterfeit notes and supplying to terror groups in the country. Political parties had stashed away large amounts of notes to finance the upcoming elections in UP. Real estate barons were making deals in black money. These nefarious activities will take a hit. The common man will give a sigh of relief. Income tax was being deducted from his salary while the big sharks in realty and jewelry sectors escaped paying taxes. The common man will face some problems immediately in making payments for his daily needs. But these will be short lived while the impact of demonetisation will be deeper.
Demonetisation, however, will not hit at the generation of black money. The system that leads to the generation of black money remains intact after demonetisation just as cancer is not cured by pain killers. Black money is generated by a combination of high rates of taxes and a corrupt tax administration. Say a factory owner produces desert coolers worth Rs 1 crore every month. He has to pay excise duty, sales tax and income tax on this sale. The total burden of taxes comes to about 35 per cent. He has to pay taxes of Rs 35 lakh every month. It is profitable for him to pay Rs 2 lakh to the corrupt tax officials and save Rs 33 lakh. Next, the excise inspector as well as the factory owner has to invest these savings. So they buy property or jewelry in the black market. A part of the money collected by the corrupt officials is collected by the politicians by the “transfer industry.” Politicians auction plum postings among officials. The official offering the highest bid is given the posting. Thus, the politicians have large amounts of black money. The corrupt officials collect monies from the factory owners and allow them to evade taxes, and the politicians provide protection to the officials. This system runs on the twin combination of high tax rates and a corrupt lower bureaucracy.
Demonetisation does not dismantle this nefarious system. On the contrary it will lead to an increase in corruption. One businessman of Delhi was paying a bribe of Rs 1 lakh per month to the excise inspector for removing goods without the payment of excise duty. The inspector demanded that the amount be increased to Rs 2 lakh per month after demonetisation, saying that there is lot more strictness from the top. Therefore, the present stock of cash with the politicians, bureaucrats, property dealers and jewelers will take a hit but the system will regenerate the same black money again. The counterfeit printing factories in Pakistan too will upgrade to the manufacture of the new high security notes. Black money will be back.
The beneficial impact of demonetisation will be negative for another reason. Let us say, it leads to a higher level of tax compliance. Factories that cannot afford to pay the bribe of Rs 2 lakh per month, the excise inspector will close down. Only big factories that manufacture branded goods and sell them at a high price will pay the taxes and survive. The consumer will have to pay a higher price because only tax-paid coolers made by large companies will be available in the market. He will not be able to buy the desert cooler that small companies sold for Rs 4,000 because these have closed down, and he will not be able to buy the desert cooler sold by big companies sell for Rs 8,000 because that is beyond his budget. He will purchase a table fan instead of the desert cooler. This will lead to less demand in for desert coolers in the economy. The standard of living of the common man will decline. He will get system that is clean but collects more taxes from him and lowers his standard of life.
This negative impact of demonetisation can be nullified and the action made beneficial for the people if government revenues are used productively. The government may make highways, increase the wages given under MNREGA, or manufacture advanced weapons in the country with the increased revenue. The highways will lead to lower cost of transportation and buoy the business of the manufacturer. The increased wages under MNREGA will put more purchasing power in hands of the common man and he will buy a desert cooler instead of a table fan. Manufacture of weapons in the country will generate demand for workers and equipment and put more incomes in the hands of the common man.
On the other hand, if the Government puts more money in corrupt Public Sector Banks, pays higher wages to corrupt government employees who buy more imported gold, and spends more on the imports of weapons, then the economy will take a hit. More money with the Public Sector Banks will enable their officers to give out more bad loans (such as to Mallya). The government servants will buy more gold and diamonds with white money and the white money will go to South Africa and Russia which produce gold and diamonds. The Government will buy imported weapons like the Rafael Fighter Jet planes. The money spent for this purchase will go out of India.
Whether demonetisation turns out to be good or bad for the economy, it will depend on the use of the increased revenues. The signs are not favourable. International rating agencies Standard and Poor and Fitch have refused to upgrade India’s rating saying that the state of government finances is not stable. They have pointed to the weak condition of Public Sector Banks. This indicates that the quality of government expenditures in not good.
In consequence, reduction of black money will reduce the purchasing power in the hands of the common man, lead to more money going out of the country for import of gold and weapons, and the economy will take a hit.
The same demonetisation would have a positive impact if the Government immediately reduces the rates of tax and controlled corruption by the lower bureaucracy. That would reduce the tax burden on the consumer. Simultaneously, the direction of government expenditures should be turned towards productive domestic activities such as making of highways and domestic production of weaponry. Demonetisation will then become a boon for the country.
The author was formerly Professor of Economics at IIM Bangalore