<b>A K Bhattacharya:</b> A toolkit for judging demonetisation

With 2016 behind us, it is time to take a look at how 2017 is likely to pan out and how it can make a difference to the Indian economy. In 2016, developments of far-reaching significance and magnitude took place — both domestically and internationally. The election of an inward-looking Donald Trump as the next US president, the Brexit vote that dealt a body blow to European integration, a breakdown in global trading arrangements and a slowing China marked 2016 internationally just as on the domestic front demonetisation of 86 per cent of the total money in circulation overshadowed everything else.

It is a measure of the huge impact of demonetisation that several other significant initiatives taken by the government during 2016 have been nearly forgotten by most people. A quick look at them would be instructive — an amendment to the Constitution to usher in the goods and services tax (GST) regime, passage of the bankruptcy law to facilitate winding up of failing businesses and recovery of debt, creation of an independent and new institutional arrangement to formulate monetary policy, setting a legally bound inflation target and periodic adjustments in petro product prices in small doses to achieve at least three goals in one stroke — pass on the impact of rising international crude oil prices to domestic consumers, gradually link all petro products to a market-linked pricing regime and reduce the government’s fuel subsidy bill.

In the normal course of events, each one of these decisions taken during 2016 would have been hailed as a big step. But such has been the widespread and disruptive impact of demonetisation on the people and the economy that what Prime Minister Narendra Modi announced on November 8 has without doubt become the most defining event of 2016. Even as we enter 2017, the focus of economic commentary and analysis remains mainly confined to assessing the impact of demonetisation on the economy.

There is little doubt that demonetisation was executed poorly, causing immense hardships to people across the country — farmers, small traders and businesses. Its original goal of eradicating black money has turned elusive as almost 97 per cent of the demonetised currency notes appear to have returned to the banks, preparing the ground for a massive and long-drawn fishing expedition by the income-tax department to unearth those accounts that may have received deposits that could be black money. The spectre of a reinvigorated inspector raj lurks quite menacingly.

The need for assessing demonetisation is even greater because in his address to the nation on December 31, Mr Modi did not outline the specific results of his big initiative. Nor has any other senior government representative explained the outcome so far. Statements to the effect that the decision was a success are in plenty, but there are no numbers yet to substantiate such claims. Thus, here is a list of three broad areas which should be closely watched to determine the medium- to long-term impact of demonetisation.

The first area should be the share of cash used in all transactions in six months or a year later. The situation prevailing before November 8 indicated that cash was used for about 90 per cent of transactions by volume and about 60 per cent by value. If demonetisation was indeed expected to push more Indians to digital transactions, both those figures should decline significantly over the next few months. A related yardstick would be the share of cash in India’s gross domestic product. If it was 12 per cent pre-demonetisation, it should be lower by a few percentage points in the coming months. The government should make such data public to help understand how far demonetisation’s secondary objectives were achieved.

The second indicator would be a change in the country’s taxation base. Demonetisation and the drive towards digital transactions must have already brought a large number of economic activities under the tax net that hitherto remained unreported for tax purposes. On the direct taxes front, the current financial year should see a surge in tax collection from individuals as also from companies including small businesses and traders. On the indirect taxes front, a similar increase in the number of transactions reported for taxation purposes can be expected. This augurs well for the launch of the goods and services tax, which also would have captured a larger number of trade deals that earlier would go unreported. If the government has to take credit for demonetisation, it can scarcely rely on its effect on black money. An expansion in the tax base would be one such indicator. Of course, this goal could become easier to achieve if the forthcoming Budget reduced direct tax rates along with removal of exemptions without unduly making a big compromise on the government's fiscal consolidation plan. 

Finally, it will be important to monitor if the banking sector has come under greater stress because of the government rolling out an array of financial sops in its desire to soften the adverse impact of demonetisation on vulnerable sections of society like farmers, women, senior citizens, traders and small businesses. So far it seems the central exchequer will take the hit on account of the many concessions announced by Mr Modi and the banks may be spared. But this is a trend that needs to be watched carefully. This government has often shown signs of deviating from its promised path of minimum government to provide maximum governance. Promises of full-scale privatisation are yet to be fulfilled and the commitment to distance government ownership of banks from their management is not yet adequately honoured. Addressing concerns of demonetisation should not become an alibi for a return to statism.

In short, the impact of demonetisation on black money is going to be severely limited. Therefore, the areas that need to be monitored to assess the impact of demonetisation are the preponderance of cash in economic activities, size of the taxation base and the extent to which the government has shrunk its role in areas that should be left alone to the private sector.