The Impact of Demonetisation on India, Part II

The Impact of Demonetisation on India, Part II

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Harsh Tiwari, Assistant Editor, Fiscal Policy

The first part in this two part article series covered the short term effects of the sudden demonetisation of higher denomination currency on November 8th, 2016 in India. This article will examine the potential long term effects of Demonetisation. 

It will be recalled from the first part that demonetisation led to a considerable contraction of the GDP and the real GVA of the Indian economy in the fourth quarter of FY’17. However, the measure did lead to a notable reduction in inflation and a rise in non-cash payments. This second part of this series will assess the long term fallout of these short term effects whilst seeking to ascertain whether demonetisation has truly cracked down on tax evasion and ‘black money’ (money that is hidden from tax authorities).

The contraction of the GDP and real GVA in the fourth quarter of FY’17 was rather serious, as it led to India losing its status as the fastest growing economy in the world. There are two questions that arise after the aforementioned facts are considered. Firstly, is this contraction of the GDP one that can be absorbed by the Indian economy? And secondly, is this contraction of the GDP justifiable on the ground that it will lead to transparency and reduced corruption in the economy by ending the illegal economy? It will be quite clear to readers that the answer to the second question will be in the affirmative if demonetisation has truly led to a significant reduction in black money. Therefore, this question will be explored in the next section of this article which will examine whether demonetisation has truly cracked down on tax evasion and black money. The first question may be answered by analysing the status of the Indian economy and by a study of the different government policies that have been implemented after demonetisation.

Government Policy post-Demonetisation brings much cause for optimism with regard to the Indian economy’s ability to recover from the GDP-reducing effect of Demonetisation. Firstly, India has adopted a most novel and appreciation worthy tax reform- the Goods and Services Tax. As I have stated in an earlier article, “[t]he GST overhauls a taxation system that was plagued by complications and compliance issues. The GST subsumes many taxes collected by the States of India and the Federal Government under a single tax regime. The GST can safely be called the crowning glory of the current Prime Minister Narendra Modi’s economic agenda which seeks to end the “tax terrorism”” In fact, the positive impact of the GST is already visible. The Economic Times reports that “[t]he distance travelled by trucks per day has increased by at least 30% post the rollout of goods and services tax (GST), according to a document prepared by the road transport ministry on the impact of GST on logistics sector.” Earlier, trucks would have to stop when travelling between different Indian States as all States had different tax jurisdictions, now, due to a unification of these jurisdictions trucks do not have to make stops for tax compliance. The GST does have its limitations and chief among them is the fact that the GST has different tax rates for different commodities which makes it complicated. Also, the GST excludes real estate which has been hurt due to the GVA in Q4 of FY’17 for Construction seeing a contraction of 3.2% from the previous quarter. However, it seems quite unarguable that the effect of the GST will be a net positive and that the GST will go a long way in reviving the economy from the woes of Demonetisation.

Demonetisation had the very good short term effect of reducing India’s Inflation woes. Inflation hadcooled to 3.41% in December 2016 on account of Demonetisation that led to a reduction in the price of vegetables. Inflation has been on a downward trend since then and has fallen to a record low of 2.18% in June, according to the Ministry of Statistics and Programme Implementation.  This lowering of Inflation provides many opportunities for the Indian economy’s growth to bounce back. Firstly, it prevents the GST tax reform from unreasonably increasing prices and thus reducing demand in different sectors. Secondly, it allows the Reserve Bank of India (India’s central bank) to reduce bank rates significantly and thus spur economic growth via greater availability of credit.  However, the RBI’s activities in this regard have been worrisome. In fact, the RBI had gotten its inflation forecasts wrong. According to livemint.com, “Headline retail inflation in March undershot RBI’s forecast of 5% by a massive 111 percentage points to come in at 3.89%.” But there is still cause for optimism, The Economic Times reports that India's Central Bank has cut repo rate(a variant of the Bank rate) by 0.25%. This may not be substantial but it still is a step in the right direction.

Financial Markets have been cheerful with the Bombay Stock Exchange’s (BSE) index- the Sensex and The Nifty 50 index of the National Stock Exchange in Delhi closing at record highs on Thursday, July 26. The BSE Sensex closed higher by 154 points, or 0.48%, to 32,382.46. The Nifty 50 closed at a record high of 10,020.65, clocking a growth of 56 points, or 0.56%, breaching the 10,000 points barrier. Industrial Production however seems to not have a strong showing. The Index of Industrial Production in March grew year-on-year to 3.75% (up from the provisional estimate of 2.7%) but went down from there to 3.1 %(provisional estimate) in April, according to The Economic Times. The IIP went down further in May to a low of 1.7%(provisional estimate).

The whole of the available data, thus, strongly indicates that the Indian economy is headed towards higher growth and revival after the shock of Demonetisation. Industrial Production may be down but there is considerable evidence that indicates that it may grow in the future. The combined effect of lower inflation, the GST and a very likely rate cut will predictably lead to a growth in production.

This brings us to the next part of our analysis which concerns the seminal question of whether Demonetisation has produced the desired effect of reducing black money and cracking down on tax evasion. It must be noted that the obvious constriction of cash in the economy has led to a rise in non-cash transactions that make use of technology( see previous article for details). This rise in non-cash transactions will go a long way in making transactions transparent and available for scrutiny to the tax authorities. Non-cash transactions reduce government spending on the production of currency, even if marginally. Furthermore, non-cash transactions promote greater e-commerce which in turn leads to an expansion in technological innovation and the furthering of business. However, this effect of Demonetisation has not been lasting, The Hindu reports “that the value of non-cash transactions up to May 28 is only marginally higher than the amount transacted in November, the month demonetisation was announced, and significantly lower than the amount seen in subsequent months….November saw [Rupees] 95,249.1 billion worth of non-cash transactions, while the first 28 days of May saw a marginally higher [Rupees] 95,601.5 billion worth of transactions.” The purported benefit of Demonetisation, which could have had laudable consequences, seems to not have been sustainable.  

The issue of whether Demonetisation has had the effect of reducing black money cannot be assessed completely due to the fact that the demonetized cash is still being counted. If there is a significant discrepancy between the value of the notes issued and the value of the demonetized notes returned, the move will successfully have fulfilled his purpose. Preliminary reports and assessments seem to have very modest results. The Hindustan Times reports that “[b]lack money worth [Rupees] 5,400 crore[Rupees 540 million] was detected during tax raids between November 9, 2016 to January 10, 2017.” Firspost.comstates that “[t]he tax department is said to have identified 18 lakh [1.8 million] people where cash deposits do not match their income profiles. But, there is a long wait before we see any result here considering the staff constraints of the I-T department and magnitude of the exercise.” There may be a very strong reason as to why Demonetisation has had no drastic impact on the reduction of black money. It seems that the commonly held notion that black money is stashed by Indians in the form of hard cash may be untrue. According to expert estimates black money in cash is only about 1/20th of the black economy. The hordes of illicit wealth held in the form of gold, financial instruments, real estate, deposits in foreign banks etc. has largely been untouched by Demonetisation and the extent to which Demonetisation has affected black money in cash seems to be meager.

It appears that the Demonetisation measure has not been a good one. It has only modestly fulfilled its purported aim  and this due to the fact that flawed assumptions have informed its formulation. It has, on the whole, had a significantly negative impact on the economy which, although recoverable, is definitely serious. Its positives, such as the promotion of cashless transactions or reduced inflation, have been temporary and unexploited. Additionally, Demonetisation has had a serious social impact and has impacted the general populace very negatively. Demonetisation, therefore, seems to have been a failed move that has not achieved much good and has caused considerable harm.   
                                                                                                  
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For the Sake of Our Economy, We Need Tax Reform

For the Sake of Our Economy, We Need Tax Reform

The Impact of Demonetisation on India, Part I

The Impact of Demonetisation on India, Part I