The new colour of money

Demonetisation of Rs.500 and Rs.1,000 notes has some benefits, but it cannot stem the flow of unaccounted income to be generated in the future.

Updated - December 02, 2016 02:39 pm IST

Published - November 11, 2016 01:18 am IST

The government had announced that the Rs.500 and Rs.1,000 notes in circulation till the midnight of November 8 will no longer count as legal tender. Demonetisation is a standard tool in any government’s bag of public policy instruments. However, unlike many other tools in the bag, it is also uncontroversial for we know exactly what it can and cannot achieve. Of course, that a policy is uncontroversial does not make it necessary or sufficient in a given context. The demonetisation announced by the Prime Minister in a speech relayed over radio and TV did not contain particularly convincing economic reasons as to why one was necessary at this stage, but he did speak of it as an act of ‘purifying’ the economy and that it would check the growth of corruption. So what could be the economics and politics of this most recent demonetisation?

Pulapre Balakrishnan

On the taxman’s radar A demonetisation that delegitimises a certain currency, or even certain denominations of it, would extinguish wealth held in that form. What we have seen, however, is a less extreme case. In this one, holders of Rs.500 or Rs.1,000 notes can exchange them or pay these into their bank accounts. This does not extinguish wealth as much as it will bring the hoards into the taxman’s radar when their owners draw upon them to make payments. For, as these will be bank transactions there would be a record of them. So existing black money cannot be used to generate more of the same. To this extent the scheme cannot be faulted. Of course, it cannot be assumed that what is in a bank will necessarily be declared to the income tax authorities, but it will certainly come under scrutiny in a way that it was not when stashed under the mattress.

What are some reasons why we may welcome such a move? First, the concealment of income with a view to avoid tax is a crime. So, in a constitutional democracy such as ours, those who do deserve to be punished. Second, in order to evade the law, those with unaccounted wealth proceed to corrupt others, most importantly representatives of the state. This criminalises the system further. If democracy is a way of actualising the public will, such criminalisation of the machinery of government works against the ideal. So, the practice of tax evasion needs to be rooted. To that extent this move of the government may be welcomed.

But how significant is it likely to be in the punishment it metes out to tax evaders and in its ability to control the generation of unaccounted wealth in the future? The quantitative significance of this move depends upon the extent to which unaccounted, or ‘black’, wealth is held in the form of high-value currency notes of the specified denomination. If unaccounted money by Indians is held in the form of foreign bank accounts, the present scheme can do nothing about it. This speculation would suggest that if unaccounted money is not held as Rs.500 or Rs.1,000 notes, the move is pretty much useless. There is, however, the separate issue of counterfeit currency. If there is a significant volume of counterfeit currency circulating in the form of Rs.500 or Rs.1,000 notes, the demonetisation will also extinguish unaccounted money from this source. If counterfeit currency is actually used to de-stabilise the Indian Union, as has been claimed, deflating this route enhances its security. This would count as another reason to welcome the move.

Now to the question of whether the demonetisation will eliminate the black economy of the future. It should be obvious that it cannot by itself. For this we would need a policy that checks the generation of black incomes at source. It would be a good surmise that much of the unaccounted money is generated in the purchase and sale of gold and of property. The markets for gold and property are highly concentrated, with relatively few sellers exerting considerable control over supply. Monopoly power combined with the cultural significance of both a home and gold ornaments in India empowers these sellers to insist that they are paid in cash, leaving many ordinary people in this country to have to abet criminal activity. However, the very fact of property firms, lesser builders and jewellers being highly visible and small in number makes it that much easier for the long arm of the law to control them. For this to take place though, action by the tax authorities alone will not suffice. It would require the Central government to step in and legislate that all transactions in gold and property go through banks. There could be hue and cry following this of course, but you can’t govern crime by being sensitive to the grief of criminals.

To sum up then, we have no idea really how much unaccounted money will be driven overground due to this measure, and can say with certainty that there is nothing in it to ensure that financial transactions of the future will all be accounted for. What, for instance, will ensure that unaccounted income to be generated will not be held in the form of the new Rs.500 and Rs.2,000 notes to be issued by the RBI? Nothing at all. Currency after all is only the medium in which unaccounted wealth money is held. Pulping the stock of money of certain denominations cannot stem the flow of unaccounted income to be generated in the future. Strict oversight of transactions in the areas of the economy where they thrive can alone achieve this result.

A political twist None of this even begins to explain why the demonetisation was necessary in the first place. Historically, demonetisations have been resorted to during hyperinflation, as in Weimar Germany, or periods when windfall profits were made, as in British India during World War II. No similar situation prevails in India today. Inflation is trending downwards and the private sector is facing stressed balance sheets. It is difficult to escape the conclusion that the move has a political component. Note that the government has only just closed a tax amnesty scheme ending September 30. Dire threats had been held out then to those who would not come clean. Did this not flush out all the black money? More to the point, are we to understand that tax evaders will continue to dodge the tax administration and, therefore, demonetisation would have to be resorted to again some time in the future? Surely the government is aware that such data that we have access to do not show anything of the kind of resurgence in the economy promised by this government in May 2014, and we are almost exactly at the halfway mark of its tenure. The demonetisation could be a desperate signal of its determination to act. After all, those with some savvy can see that there may not be too much in it for energising the economy.

In his speech the Prime Minister had invoked the metaphor of a purification of the economy by rooting out black money. But another form of purification can be espied in the action. In the prototype Rs.2,000 note to come, displayed on television, we can see the denomination written in the Devanagari numeral. It is a first. India’s founding fathers had avoided privileging any one language. This principle, so vital to the prospects of this great country, is set to be breached. The demonetisation has also proved to be a cultural opportunity.

Pulapre Balakrishnan teaches economics at Ashoka University. The views expressed are personal.

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