Chapter 03 – Demonetization: To Deify or Demonize?- Highlights of Economic Survey 2016-17

Demonetization: To Deify or Demonize?

Union finance minister Arun Jaitley tabled the Economic Survey 2016-17 in Parliament during the first day of the budget session. Here are the major highlights from the Chapter 3 of Economic Survey 2016-17.

The most anticipated chapter for many in the Economic Survey had to be regarding Demonetization. Chapter 3 mentions the exercise in detail, its rationale, impact, costs and future framework to supplement and complement the exercise.

Why demonetization was conducted?

The drive aimed to curb the following,

a) Corruption

b) Counterfeiting

c) The use of high denomination notes for terrorism activities

d) Accumulation of black money.

What have been the earlier efforts to curb the above-mentioned illicit activities?

a) Creation of the Special Investigative Team in 2014 budget

b) The Black Money and Imposition of Tax Act 2015;

c) Benami Transactions Act 2016;

d) The information exchange agreement with Switzerland;

e) Changes in the tax treaties with Mauritius, Cyprus and Singapore;

f) Income Disclosure Scheme.

When was the previous demonetization exercises carried out in India?

1946 and 1978

Moving forward, The Economic survey also introduces the concept of “Helicopter drops” and “Reverse helicopter drops”

A helicopter drop is a hypothetical, unconventional tool of monetary policy that involves printing large sums of money and distributing it to the public in order to stimulate the economy. This measure was widely followed by all countries post the Global Financial Crisis of 2008.

The Economic survey regards Demonetization as a “Reverse helicopter drop” or “Helicopter hoover” strategy, which aims to reduce the money supply instead of expanding it.

What were the issues debated on regarding the Demonetization drive?

• Broader aspects of management, as reflected in the design and implementation of the initiative.
• Its economic impact in the short and medium run.
• Its implications for the broader vision underlying the future conduct of economic policy.

The Economic Survey 2016-17 however does not discuss the broader welfare and other non-economic dimensions. It also admits that there have been reports of job losses, declines in farm incomes, and social disruption, especially in the informal, cash-intensive parts of the economy (EFFECTS OF DEMONETIZATION exercise in the short run) and that a systematic analysis could not be included due to paucity of macro-economic data.

The Economic Survey 2016-17 goes onto discuss the rationale for the exercise and provide background facts for the same.

What are the functions of Money/Cash?

a) cash can be used as a medium of exchange (for transactions)

b) a store of value like other forms of wealth such as gold and real estate.

Evolution of India’s Currency to GDP ratio:

*Currency to GDP = Amount of cash in circulation / total GDP value.

The Economic Survey highlights that there have been two phases in the evolution

a) From 1952-53 to 1968, where the ratio declined from 12 percent to 9 percent.

b) Growing from 1970s till the Global Financial Crisis and high inflation in 2010. (The ratio showed a declining trend till 2014-15 post which it has improved)

The Economic Survey also notes that India is a highly cash dependent country (even when compared to countries in the same income group. This seemed to suggest that some of the cash holdings were used for illegitimate activities.

This presumption is especially strong because across the globe there is a link between cash and nefarious activities: the higher the amount of cash in circulation, the greater the amount of corruption, as measured by Transparency International.

Why high denomination notes were targeted in Demonetization?

a) High value notes are associated with corruption because they are easier to store and carry, compared to smaller denominations or other stores of value such as gold

b) RBI data show that in India low denomination notes have a soil rate of 33 percent per year. In contrast, the soil rate for the Rs 500 note is 22 percent, and the Rs 1000 just 11 percent. One way to estimate black money is to assume that all these notes should soil at the same rate, if they were really being used for transactions. (But as you can see, that’s not the case and some money is not used for transaction)

What is soil rate?

“Soil rates,” is the rate at which notes are considered to be too damaged to use and have been returned to the central bank.

IMPACT OF DEMONETIZATION:

The Economic Survey 2016-17 views demonetization as follows, a money supply contraction but only of one type of “money”—cash; a tax on unaccounted private wealth maintained in the form of cash – black money; and a tax on savings outside the formal financial system.

It can also be viewed on the following lines,

an aggregate demand shock, because it reduces the supply of money and affects private wealth (especially of those holding unaccounted money and owning real estate); 


an aggregate supply shock to the extent that cash is a necessary input for economic activity (for example, if agricultural producers require cash to pay labour); 


an uncertainty shock because economic agents face imponderables related to the impact and duration of the liquidity shock as well as further policy responses. 


BENEFITS OF DEMONETIZATION:

a) Tax on Black Money:

Demonetization has effected a transfer of wealth from holders of illicit black money to the public sector, which can then be redeployed in various productive ways such as to retire government debt, recapitalize banks, or even redistribute back to the private sector.

b) Tax compliance:

Demonetization could aid tax administration by shifting transactions out of the cash economy and into the formal payments system. As a result, the tax-GDP ratio, as well as the size of the formal economy, could be permanently higher.

*The tax-to- GDP ratio is the ratio of tax collected compared to national gross domestic product (GDP).

c) Tax on informal savings:

Some of the new deposits will surely remain in the banks, where they will provide a base for banks to provide more loans, at lower interest rates.

The Economic Survey 2016-17 goes onto state certain potential long-term benefits

a) Digitization:

One intermediate objective of demonetization is to create a less-cash or cash- lite economy, as this is key to channeling more saving channeled through the formal financial system and improving tax compliance. *Watal Committee has recently estimated that cash accounts for about 78 percent of all consumer payments.

Impediments/Roadblocks in the move to digitization:

They require special equipment, cellphones for customers and Point-Of-Sale (POS) machines for merchants, which will only work if there is Internet connectivity.

They are also costly to users, since e-payment firms need to recoup their costs by imposing charges on customers, merchants, or both.

Advantages of digitization:

Digital transactions help bring people into the modern “wired” era. They bring people into the formal economy, thereby increasing financial saving, reducing tax evasion, and leveling the playing field between tax-compliant and tax-evading firms (and individuals).

*Some quick trivia from the Economic Survey 2016-17: There are approximately 350 million people without cellphones (the digitally excluded); 350 million with regular “feature” phones, and 250 million with smartphones.

Steps to facilitate digital transactions:

• Launch of the BHIM (Bharat Interface For Money) app for smartphones. This is based on the new Uni ed Payments Interface (UPI) 

• Launch of BHIM USSD 2.0 

• Launch of Aadhaar Merchant Pay 

• Reductions in fees (Merchant Discount Rate) paid on digital transactions and transactions that use the UPI.
• Encouraging the adoption of POS devices beyond the current 1.5 million, through tariff reductions.

b) Real Estate:

In the past, much of the black money accumulated was ultimately used to evade taxes on property sales. To the extent that black money is reduced and financial transactions increasingly take place through electronic means, this type of tax evasion will also diminish.

Also, this measure can lead to reduced real estate rates. Reduction in real estate prices is desirable as it will lead to affordable housing for the middle class, and facilitate labour mobility across India currently impeded by high and unaffordable rents.

COSTS OF DEMONETIZATION:

The Economic Survey 2016-17 does not get into the details of the costs associated with demonetization exercise citing lack of relevant data and if certain impact can be measured in the correct sense.

It does mention that aggregate sowing of the two major rabi crops—wheat and pulses (gram)– exceeded last year’s planting by 7 percent and 15 percent, respectively.

The Economic Survey suggests that it would be reasonable to conclude that real GDP and economic activity has been affected adversely, but temporarily, by demonetization.

The question is: how much? The short answer is between 1⁄4 and 1⁄2 percentage points relative to the baseline of about 7 percent.

Projected Growth:

The Economic Survey 2016-17 states that the adverse impact of demonetisation on GDP growth will be transitional. Once the cash supply is replenished, which should largely be achieved by end-March 2017, the economy should revert to normal.

Therefore real GDP growth in 2017- 18 is projected to be in the 63⁄4-71⁄2 percent range.

How Demonetization affects the Government?

Positively,

a) Demonetization will redistribute resources – from the private sector to the government.

b) Wealth gain: The RBI/government may receive some gains from the unreturned cash.

c) Income taxes could go up as black money was deposited in bank accounts.

Negatively,

a) Costs of printing new notes over and above normal replacement. 


b) The costs of sterilizing the surge in liquidity into the banking system via issuance of Market Stabilization Scheme bonds. 


c) If nominal GDP growth declines, corporate and indirect tax revenues of the centre could decline but so far there is no clear evidence. 


Moving forward, economic Survey points that the emphasis must be on maximizing demonetization’s benefits while minimizing its costs.

STRATEGY TO COMPLEMENT DEMONETIZATION:

1.  A GST with broad coverage to include activities that are sources of black money creation—land and other immovable property—should be implemented; 

2.  Individual income tax rates and real estate stamp duties could be reduced; 

3.  The income tax net could be widened gradually and, consistent with constitutional arrangements, could progressively encompass all high incomes. (After all, black money does not make any sectoral distinctions); 

4. The timetable for reducing the corporate tax rate could be accelerated; and 

5. Tax administration could be improved to reduce discretion and improve accountability. 


(You can refer to Appendix 1 if you need examples of Demonetization exercise in other parts of the world.)

Also Read : Top 10 Key Highlights of Economic Survey 2016-17 for UPSC Aspirants

Also Read: Chapter wise highlights of Economic Survey 2016-17

Chapter 01 – Economic Outlook and Policy Challenges

Chapter 02 – The Economic Vision for Precocious, Cleavaged India

Chapter 03 – Demonetization: To Deify or Demonize?

Chapter 04 – The Festering Twin Balance Sheet Problem

Chapter-05 – Fiscal Framework: The World is Changing, Should India Change Too?

Chapter 06 – Fiscal Rules: Lessons from the States

Chapter 07 – Clothes and Shoes: Can India Reclaim Low Skill Manufacturing?

Chapter 08 – Review of Economic Developments

Chapter 09 – Universal Basic Income

Chapter 10 – Income, Health, and Fertility: Convergence Puzzles

Chapter 11 – One Economic India

Chapter 12 – India on the Move and Churning

Chapter 13 – The ‘Other Indias’ – Highlights of Economic Survey 2016-17

Chapter 14 – From Competitive Federalism to Competitive Sub-Federalism