By Gaurav Dalmia
The government’s focused attack on black money is a welcome longterm initiative. India’s tax-GDP ratio of 16.6 per cent is well below the emerging markets average of 21 per cent. This is because only 5 per cent of Indian adults pay any taxes. This has serious economic implications: suboptimal channelising of savings, distortion in competition and headwinds on economic growth. Add to this a social dimension: misaligned incentives, avenues for corruption.
Demonetisation is a part of PM Narendra Modi’s larger efforts at curbing the parallel economy. The tax amnesty scheme was the carrot and a window to nudge compliance. The tax raids were the stick to raise the burden of non-compliance. The demonetisation announcement is a larger stick along the same lines.
So many 1,000 rupee notes, sigh
Tax amnesty windows are not new. Germany had a scheme in 2004, Russia in 2007, Italy in 2009, Spain in 2012. Indonesia has one on currently, though that seems like a sweetheart deal with only 5 per cent and 10 per cent tax rates on onshore and offshore assets respectively.
Even the almost puritanical tax regime of the US has warmed up to the idea from time to time, particularly after the recessions of 2001 and 2007. The Internal Revenue Service (IRS) estimated that the US has cumulatively collected more than $5 billion in back taxes via various voluntary disclosure schemes for US citizens and residents with offshore wealth.
The corollary of such amnesty schemes is enhanced enforcement. The joke in the US used to be that one is more likely to get held for tax evasion than for organised crime.
Al Capone was accused of various organised crimes but ultimately successfully indicted in 1931for tax evasion. Tax farming — the outsourcing of tax collection to private organisations — has been practised historically in situations of difficult tax compliance, from ancient Rome to medieval Britain. Countries such as Bangladesh have attempted this with customs tax collections in the last decade.
More recently, the IMF’s research has shown that tax compliance has been effective in countries that have followed the troika of third party information, a focus on hard-to-tax segments, and the use of blunt tools that broaden the tax base. The Modi administration seems to have followed this classical path, with the demonetisation move being a part of the final leg of the strategy.
There will be some collateral damage. The short-term pain — apart from the shock value, a good tool — will need to be addressed without unnecessary rhetoric on part of those opposing the demonetisation. Small businesses are likely to face a working capital squeeze, with implications on the economy. Middleclass India may face a payment crisis for day-to-day things as usable currency shrinks for the time being.
There would be price deflation in asset classes like real estate and gold, the traditional havens for unaccounted money. A fall in agri-land prices may extend the rural slowdown. Consumer durable sales are likely to get affected, as one had seen when PAN card information was made mandatory for certain transactions.
Sentiments and uncertainty will have an effect on the stock market, though it will be difficult to immediately attribute how much it is because of demonetisation and how much due to Donald Trump becoming the US president-elect. The government has taken a risk in going ahead with demonetisation.
The BJP’s traditional vote bank, the trading community, is likely to face the brunt of the downside. While cynics point to brownie points for the upcoming polls in Uttar Pradesh and other states, the move seems driven more from a standpoint of governance than statecraft, more using the wisdom of economics than politics, and more with an eye on the long term than the short term.
Nobel laureate Gary Becker and others have pointed out that tax evasion is empirically correlated with five factors: tax rate, detection probability, level of punishment, unemployment rate and dissatisfaction with the government. As Modi tries to change the culture of the public’s interaction with the government, he has to consciously act along all the above dimensions. There has been considerable progress on tax rationalisation. Demonetisation has highlighted the downside risks. The economic upturn is likely to keep a check on unemployment.
However, building trust in public institutions remains a key qualitative and difficult variable. For those who think Modi’s moves are an overreaction, 17th-century British statesman George Savile can be quoted, “Men are not hanged for stealing horses, but so that horses may not be stolen again.”
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