<b>Jaimini Bhagwati:</b> Demonetisation trumps all else

The bold decision would substantially enhance financial sector efficiency and provide multiplier benefits for the economy

On November 8, the government announced that to root out illicit cash, Rs 500 and Rs 1,000 notes would not be legal tender past midnight. From the next day onwards, shortage of cash overwhelmed all else in India while the stunned western media reported that Donald Trump had won the US presidential election. On November 13, Prime Minister Narendra Modi indicated the government would next identify benami (nameless) owners of land and gold.
 
On balance, demonetisation can have systemically beneficial implications that are even more significant than the goods and services tax (GST), particularly since the proposed multiple rates have stolen some of the GST thunder. Although there will be many hiccups along the way, over the longer term, demonetisation has the potential to become the most significantly positive economic decision that this government has taken since it assumed office in May 2014.
 

First, the scepticism and shorter-term unintended negative impact of demonetisation. Restriction of terrorism funding is not that convincing an argument since motivated extremists may be able to print lookalikes of the new notes. As the availability of cash has dropped sharply, daily wage labourers and others, who do not have identity papers or access to banks and are perforce part of the cash economy, are finding it extremely difficult to meet their expenses. This distressing situation will persist till banks and post-offices are able to provide cash on demand. It follows that for the next two months the central and state governments should make food and logistical support available free of cost as is done during natural calamities.
 
The current cash crunch is likely to have a dampening effect on inflation but it could also inhibit economic activity and generation of new jobs. The expected fall in real estate and asset prices could lead to further lowering of the credit quality of bank loans as borrowers find it even more difficult to service existing liabilities. As for risks stemming from external sources, Mr Trump’s future policies may lead to a rise in interest rates in the US and cause capital outflows from India. The signals from international capital markets are that the Federal Reserve may raise rates in its December 2016 meeting and portfolio capital could start leaving emerging economies even before Mr Trump takes office.
 
The reality is that many Indians own enormous amounts of unaccounted cash and to evade detection such wealth is held in gold/jewellery, real estate in domestic and foreign locations and hard currency in tax havens abroad. Suspiciously large cash hoards within India will not be declared. The logic is that although there is no upper limit, extremely large bank deposits would amount to an acknowledgment of past criminality. Consequently, an optimistic estimate is that Rs 3 lakh crore, 30 per cent of the total volume of Rs 500 and Rs 1,000 notes in circulation with the public, would not be deposited in banks by December 30, 2016, the last day for depositing these notes. This, in addition to another Rs 1 lakh crore levied as taxes/penalties could add up to Rs 4 lakh crore coming into government coffers.
 
On the down-side, it could be argued that the government-RBI receive seigniorage on cash, which is held legitimately. Currently, the cash held by the public at large, not including institutions, in Rs 500 and Rs 1,000 notes is about Rs 10 lakh crore. That is, it could be claimed that the seigniorage amounts to Rs 64,000 crore annually if the one-year government-securites interest rate of 6.4 per cent is used. For the purpose of comparison,  Rs 4 lakh crore that the government could gain is about 2.7 per cent of the projected gross domestic product for 2016-17 and the fiscal deficit for the current year was estimated at 3.9 per cent. The estimated cost of printing new notes even at Rs 12,000 crore pales into comparative insignificance. Additionally, going forward the “tax gap”, difference between estimated tax receipts and lower tax amounts collected, could decrease.  
 
Taking a step back, demonetisation by itself will do little to reduce the amassing of ill-gotten wealth in the future. Other inhibiting factors that could be used are extremely high penalties for vendors of goods and services who do not report PAN numbers of clients for all transactions above Rs 25,000. In the absence of PAN or Aadhaar cards, some other proof of identity should be mandatory. Of course, this upper limit of Rs 25,000 for cash transactions should be arrived at with caution to not harass those who legitimately pay in cash.
 
The crucial next step should be for government to raise election spending limits, mandate that donations to political parties be only by cheque and that accounts of political parties be independently audited. It is also time to tax agricultural income to prevent hiding of unaccounted income under this head. The books of jewellery shops need to be examined not just in Tier 1 and 2 cities but also in smaller urban agglomerations. And, there should be an ever present threat that demonetisation could be repeated, without notice, in the future.
 
Transactions in high denomination notes make it easier to evade taxes and detection by law enforcement agencies. Hence over the next two years,  the government should withdraw all Rs 500, Rs 1,000 and Rs 2,000 notes. High denomination notes do not foster greater economic activity but help in the accumulation of unaccounted wealth (“Making it Harder for the Bad Guys: The Case for Eliminating High Denomination Notes” Peter Sands, February 2016, Harvard-Kennedy School Working Paper Series No. 52).
 
Transparent and sincere implementation of demonetisation would depend not only on the diligent work of bank and regulatory personnel but also on Indian revenue service, Indian administrative service and Indian Police Service officials at senior and junior levels. The judiciary, too, needs to be supportive such that this process of reducing cash in the Indian economy is implemented without fear or favour.
 
To summarise, demonetisation accompanied by withdrawal of high denomination notes above Rs 100 would encourage individuals and businesses to reduce their cash transactions. The consequent substantial enhancement of financial sector efficiency would result in multiplier benefits for our national economy.

 j.bhagwati@gmail.com
The author is the RBI chair professor at ICRIER