Prime Minister Modi's master stroke on 8th November on black money or shadow economy in India, which, as per a World Bank study, was around 20.7 per cent of the GDP in 1999 and 23.2 per cent in 2007, left everyone shocked and surprised. The stroke left the opposition party leaders speechless, but the earnest tax payers rejoiced and celebrated the Modi stroke.
Though the move is rejoiced by the majority of Indians, there is a chaos and panic among the average citizen of India. Even after one week of the demonetization announcement, there are long queues in front of banks, post offices and ATMs. The banks are not able to meet the demand for currency as 86 per cent of Indian currency is in denomination of Rs 500 and Rs 1000 notes, which now have to be exchanged with existing ones or newly printed Rs 10 or Rs 100 notes or Rs 2000 notes.
The burden of exchange and withdrawal is mostly falling on bank offices as the existing ATMs are not customized to accommodate and dispense the new notes. Poor, farmers and other Indians residing in interiors of India, without access to much banking facilities, are largely hit by the move as these are the segments which carry out most of their transactions in cash. The inability of our financial system to meet the demand for cash is leading to liquidity shortage in the economy and contraction in economic activities.
But the liquidity crunch will be there for a month or so. Once the liquidity eases with the pumping of the sufficient new notes in the economy, Modi government's decision to withdraw 500 and 1000 rupee notes from circulation will not only help in curbing the size of the shadow economy (though not completely eliminating it) but also bring historic changes in the Indian economy. Here are some expected benefits and channels through which the demonetization move will help the economy in the long run:
Reduction in fiscal deficit: India's fiscal deficit is persistently higher than the international norms of 3 per cent of GDP. This year, at the end of first five months, the fiscal deficit has already reached to 76 per cent of full year's target. Withdrawal of high denomination notes will force the public to deposit their unaccounted money into formal channels, declare their source of income and comply with tax laws. This will improve tax revenue and reduce fiscal deficit. The government's strict policy on tax compliance will bring in sustainable gain on this front.
Improvement in productivity: In the presence of increased restrictions on high value transactions in shares, bonds, gold, real estate, etc., unaccounted money is mainly stored in the form of cash. Declaration of high denomination notes as illegal will help in mobilizing the unaccounted money into formal channels- banks and other financial institutions, which will improve the availability of funds for productive purposes. The resultant improvement in productivity will lead the economy on higher growth path.
Reduction in horizontal and vertical inequality: Large unaccounted money accentuates horizontal and vertical income inequality in the economy. Horizontal income inequality takes place when two persons with same amount of income pay different amount of tax. The person with unaccounted income can evade entire tax liability, whereas the person with same income but from only accounted sources ends up paying tax, leading to horizontal income inequality. Vertical income inequality takes place when the person with higher income pays lower tax than the person with lower income. In the presence of unaccounted income, the person with higher income can show lower tax liability than the person with lower income but from accounted sources, leading to vertical income inequality. The world inequality data base puts Gini coefficient (which is a measure of income inequality in a country) as 49.1. A study by Vanneman and Dubey estimate the Gini coefficient as 48 and indicates that this figure is comparable to the inequality level observed in many low and middle income countries such as Peru (51), Colombia (51), Brazil (49) and Mexico (46). Unearthing of the unaccounted income will help in improving the horizontal and vertical inequality in the economy.
Moderation in inflation: The unearthing of unaccounted money will help curbing inflation through various channels.
One, an unaccounted or illegal money fuels wasteful expenditure. Indian marriage functions are glaring examples of such extravagance or wasteful expenditure. Withdrawal of existing 500 and 1000 notes will help in curbing such expenditure and help in reducing demand pull inflation.
Two, depositing of Rs 500 and Rs 1000 notes with the banks and other formal channels will increase the amount of deposits in the country. A large amount of fund mobilization by the banks will help them in lowering the interest rates, which will help the economy in reducing the cost of production and controlling cost push inflation. The interest rates have already dropped to 5 per cent from as high as 30 per cent in the grey market. Many banks have already indicated likelihood of reduction in their deposit and lending rates in the period ahead.
Three, mobilization of unaccounted money into formal channels will improve tax compliance and tax revenue, which will help contain fiscal deficit in India. High fiscal deficit is one major contributory factor for higher money supply and inflation in the country. Reduction in fiscal deficit will reduce money supply and inflation in the economy.
Four, mobilization of unaccounted idle cash into formal channels will improve the availability of funds for productive purposes, which, in the long run, can help in improving productivity and lowering the cost of production and inflation in the economy.
These expected benefits, however, are conditioned on number of factors. These benefits will depend on the manner in which the government will utilize the revenue generated from better compliance, the extent of replacement of the old notes with new notes, the change in the money multiplier, and the government's other efforts to improve productivity and efficiency in the system and stability in the economic environment.
Guest Author
The author is a Professor of Economics at the Institute of Management Technology, Nagpur
