Given prevalent political funding practices; deeply entrenched role of cash in real estate transactions; and the sheer growing brazenness of those earning unaccounted incomes; demonetization seemed to be an impossible measure. But Modi has done it. He has surprised us all by taking this bold step, which some of us had suggested when he took office in 2014. The demonetization of Rs 500 and Rs 1,000 currency notes, that account for as much as 85% of total value of currency in circulation, will directly and significantly push back the parallel economy. In conjunction with the GST, it may result in a steadily declining role of cash, encourage credit and digital currency transactions and a rolling back of the black economy. Modi has walked the campaign talk. Cynics and critics rest in peace.
The mechanics of the measure are straightforward. From midnight of 8/9 November, existing Rs 500 and 1000 notes are illegal and valueless. They can however be used until 11th November for specified purposes like payment at hospitals, pharmacies, transport and funeral services and purchases at cooperative societies. Beyond the 11th they will be completely worthless.
However, the honest tax payers and ‘white income earners’ have been protected. They can convert up to Rs. 4,000 in old high denomination notes for the same amount in new Rs 500 and Rs 2,000 notes at any commercial bank or post office. Individuals can also deposit any amount (without any upper limits) of old currency in their bank accounts by giving an adequate ID proof and completing a requisition slip, specified by the RBI. In cases where appropriate ‘know your client’ (KYC) information is not available, such deposits will be limited to Rs.50,000. These facilities are available until the end of 30th December 2016 and will be reviewed and extended if required.
This measure will, in one stroke, essentially kill the black economy, which is conservatively estimated at more than a fifth (20%) of the formal economy and up to 45% by some observers. Even at the conservative lower estimate, this amounts to a staggering Rs 30 lakh crore or about $400 billion. If even 50% of this is held in higher denomination notes, it will imply the injection of nearly $200 billion or Rs 15 lakh crore in the formal economy through bank deposits. These will be taxed, hopefully, at penal rates and thus provide substantial revenue additionality. Moreover, those depositing large amounts would surely be identified by the tax departments for inclusion in the direct tax net. Parallel economy operators would now rue not having taken the prime minister’s warnings more seriously that penal action awaits those who fail to declare their unaccounted wealth under the IDS, which lapsed on 30th September.
The measure will directly affect real estate and land markets where cash transactions are rampant. Real estate will finally cease to be the conduit for money laundering by unscrupulous politicians and businessmen. This should result in a marked softening of house prices, which will benefit first time ‘real buyers’ as opposed to ‘investors’ who thrive in real estate speculation. Ostentatious consumption, incurred from ill-gotten and black economy activities, will also be curbed, thereby encouraging savings and capital formation. People have argued that large volumes of these high currency notes will be traded down to poor people who don’t have Rs 4000 of their own to convert. Even if that is true, poor people will stand to make good money in this exchange, which can only improve equity.
Direct tax collections should increase significantly. Professionals, brokers and builders will be warier of being paid in cash. The move will reward those who have been honest tax payers and kept away from the parallel economy. This will encourage better tax compliance and help India improve its rather abysmal direct tax to GDP ratio. Thus, both the stock and flow of black money will be controlled. Government should now also move with alacrity to monetize gold stocks and identify those holding large quantities to further curb the space for ‘black economy transactions.’
It is well known that thousands of crores of unaccounted money is spent in cash by all major political parties for fighting elections. Political leaders are known to collect mountains of cash in individual contributions of less than Rs 25,000 as that is the official limit for cash donations. All these cash hoards are now worthless. Not surprising therefore, that the Trinamool Congress, and Rahul Gandhi have denounced the step and demanded its immediate withdrawal. The cynics will of course argue that the ruling party has perhaps gained an unfair advantage arising from advance information. This is pure speculation and unsubstantiated. It is also somewhat petty minded given the enormity of the measure now implemented.
Finally, a major blow has been dealt to the counterfeiters and fake currency dealers who fund terrorists, extremists and traffickers. New Rs 500 and Rs 2000 notes will likely embody advanced technical features that will make counterfeiting far more difficult. The Jaish E Mohammed and Lakshar E Toiba will find it that much more difficult to subvert our democracy. This is a bold, historical measure with multiple positive impacts for which the Prime Minister deserves our congratulations and cooperation.
Author is Senior Fellow CPR and Founder Director Pahle India Foundation.