Demonetisation: Gain After Pain?

December 30, 2016 marks the end of the "short-term" pain caused by the withdrawal of Rs. 500 and Rs. 1,000 currency notes as legal tender. Or does it?

It's estimated that the Reserve Bank of India (RBI) would have remonetised around Rs. 7.50 lakh crore in new notes by December 30. That would be roughly 50 per cent of the value of old Rs. 500 and Rs. 1,000 notes in circulation before November 8, 2016.

The government's move towards digital payment means that the RBI will not remonetise the full value of old notes, estimated at just over Rs. 15 lakh crore (though an RTI query to the RBI has, oddly enough, revealed a higher figure).

Nonetheless, by January 31, new notes valued at around Rs. 11.50 lakh crore are likely to be in circulation. Cash shortages and bank queues would have begun to ease well before that.

So much for the short-term pain. What about the gain?

There are two kinds of likely medium-term gains and one clear long-term gain. In the medium term (six months) a rapid shift to digital payments will make the economy more efficient. The move from cash to online payments has been faster than many expected. In a cash-dominated society like India's the change to a digitised economy will be evolutionary rather than revolutionary but the benefits to consumers in transparency, speed and efficiency will soon be clearly visible.

The second medium-term gain is for the treasury. The country's low tax base will expand significantly. The audit trail left by redepositing old notes valued at close to Rs. 15 lakh crore into the banking system will create new assessees. Apart from the one-time penal tax on disclosed black income, personal income-tax post-demonetisation will rise substantially on a recurring basis.

The long-term benefit will flow to both citizens and the government. An economy less dependent on cash is likely to cut the scope for siphoning off funds by middlemen to farmers, contract labourers and other workers in the unorganised sector.

The cash-to-GDP ratio should reduce to below 10 per cent, making the economy more efficient. In 2015, currency with the Indian public as a ratio of GDP was 13.01 per cent. In Sri Lanka it was 3.47 per cent. Even Pakistan had a lower cash/GDP ratio than India: 9.29 per cent.

Once the Goods and Services Tax (GST) is introduced, digitisation will be further spurred. Indirect tax collection will become seamless. Revenue is likely to rise significantly in a one-nation, one-tax formulation.

It's crucial in this environment that the Finance Minister cuts both personal and corporate tax rates in the Union Budget on 1 February 2017. He had pledged to reduce corporate tax to 25 per cent by 2018-19 so that leaves a narrow time window to implement that commitment. Personal income-tax, given a broader tax base following demonetisation, is set to be reduced by raising tax slabs

Demonetisation has considerable political implications. Prime Minister Narendra Modi knows that the pain of demonetisation can turn into a political liability if normalcy is not re-established soon.

So far the poor, especially in small towns and villages, have reacted with stoicism to the cash crunch and loss of income. Support for Modi remains strong. Local body electoral results in Maharashtra and Chandigarh underscore that. But public support cannot be taken for granted.

Modi has planned a major rally in Lucknow on 2 January 2017 when he is expected to announce a post-demonitisation road map. With the model code of conduct set to kick in early next year (2017) once the dates for the Punjab, Uttar Pradesh and Goa assembly elections are known, the prime minister will have to move rapidly to turn the demonitisation narrative around into both an electoral and on-ground winner.