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Department of Economics, Delhi School of Economics, University of Delhi

On Black Money
Author(s): K. SUNDARAM and V. PANDIT
Source: Indian Economic Review, New Series, Vol. 11, No. 2 (OCTOBER 1976), pp. 121-132
Published by: Department of Economics, Delhi School of Economics, University of Delhi
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we are hopeful that this analysis would be of relevance experience of other developing countries also. It also considers the major policy consequences that follow from analysis. 23 Nov 2016 13:43:29 UTC All use subject to http://about. Gupta. arises from the cumulation of the savings out of black inco ♦The authors are grateful to Prasanta K. Inevitably. Com on an earlier draft by Elizabeth Krishna. Also. wealth tax.208. SUNDARAM and V. but also parts of wealth the full value of which is not declared for tax purpose but acquired out of regular or 'white' savings would also be covered. estate duty. Pattanaik for extremely useful discussions. A basic source of confusion in many analyses of the problem is the failure to tinguish between stocks and flows. This is not very surprising in a situation where the average and the ma tax rates have had to be raised sharply over a short span of time to through plans for accelerated development.205. R. insofar as difficulties of tax accountability do limit the magni- tudes of white savings going into black wealth. it may be easier to estimate the extent of black wealth by following our definition.On Black Money* K. There is the flow of black income. However. stamp duty etc. PANDIT Delhi School of Economics. by virtue of the fact that such wealth would be concealed for the corresponding set of taxes as well. In some discussions black income is defined in a more restricted way as the quantum revenue evaded. operationally.. 2. has been a common feature of fiscal scene of many of the developing countries outside the communist blo [9]. One could also define black wealth symmetrically with the definition ol black income as that part of wealth which is not revealed for the corresponding set of taxes (e. not only would the wealth accumulated from black savings be covered. While our judgements are largely conditioned b Indian èxperience. Delhi Evasion of direct as well as indirect .g. K. savings. a number of empirical judgements have to be made i course of such an analysis.e. neither the concepts relating to it nor its linkages with other mac economic variables such as consumption. the use of our definition would not lead to any serious understatement of the extent of black wealth. which is not declared for direct taxes. Das and an an ous referee are gratefully acknowledged. in which is earned in the process of evading indirect taxes and/or the part of inco however earned.1 On the other hand. With this more general definition. i. giving rise to the problems of w India has come to be known as black money. investment and the price have been analysed systematically. B. 1. wealth. L. The purpose of this paper is to provide an analysis. Despite the attention that 'black money' has received in recent discussion India. This content downloaded from 117.jstor. Krishna.). K. a stock. S. The usual disclaimers apply.157 on Wed. University of Delhi.

Srinivasan shows that a unique X* exists in the interior of (0. ß > 0. T (Y). together deter- mine the fiscal environment. this distinction plays a crucial role in money. 23 Nov 2016 13:43:29 UTC All use subject to http://about.7t) rr'{(i . Of course. for simplicity. Generation of Black Income Typically. the maximand is: ^(y)=«[y-r(y)-xp(x) y] + (i-7t)[r-:r{(i-x) y}] where Y is income. the characteristics of the fiscal environment and of the income flows govern the extent of tax evasion. Therefore. Tf {Y)> 0. Following Snnivasan. Clearly. the tax function.157 on Wed. as such. also fall in this category. SUNDARAM AND V. the penalty function applicable in the event of detection of tax evasion.205. at least in part. such as the tax structure. by itself. n the probability of detection.X») Y This content downloaded from 117. I. Assuming that P (0) = 0. such as the high marginal tax rates.122 K. taking as given the characteristics of income flows in the economy. => it [P (X*) + X*P' (X*)] = (1 . we find that in most UDCs which have a sizeable private sector a not insignificant part of black income arises from the infeasibility of enforcing direct and indirect taxes in a significant part of the economy comprising of a large number of household enterprises. the tight- ness of tax administration governing the probability of detection. V (0) = 0. be held responsible for the extent of tax evasion in an economy. cannot. PANDIT As we shall see. any one of these (1 . can only be reduced over time through changes in the structure of the economy. 1). 4. assume that r' ( Y) = ß Y. Using his notation.X») r} =o Now. Now X* is obtained by setting d Ajfk = 0 ===> 7t[P(x*) + x*P'(x»)] = y + (i . it can be shown that. .3 Incomes from specialised services such as those of doctors and lawyers. 1) such as to maximise A(Y). The amount of black income in this category should be recognised as being struc- turally determined and. a shift in the 'efficiency' parameter would alter the extent of such 'structural' black income. It should be clear that we are talking of 'infeasibility' in the sense of extra efforts at tax collection at given levels of administrative efficiency not being cost effective. assume that the individual is choosing the proportion oí income not disclosed for tax so as to maximise the expected 'after-tax after penalty' income. X the proportion of income not declared and P (X) the penalty rate. and that tt is independent of Y. P' (X) > 0.4 3. T" (Y)> 0.jstor. on the basis of Srinivasan's analysis [8]. P • (X) > 0 for all Xs (0. And several elements. the optimal extent of the tax evasion (from the tax payer's point of view) increases with an increase in the marginal tax rates and vice versa.208.

Incidentally. The fact that the tax has been evaded on the black income implies erosion of the progressi- vity of the tax structure and consequently a greater degree of inequality. Since th stringent restrictions on their transfe them obviously cannot be disclosed fo II. ON BLACK MONEY 123 One important source of black incom have opted for planning as a means to mies.*P => op/OA . of which Prof. Also see Arun Shourie [6].__ w => V= K 1 _ X* where (1 . and possibly cannot be. However. Raj was the Chair- man. 23 Nov 2016 13:43:29 UTC All use subject to http://about. the first example raises the basic question whether it would not be better to subsidise the poor directly by a cash subsidy rather than by allotting them a quota of specific commodities at premium exclusive prices. The Report of the Committee on Steel Control.7 In India. and In One immediate consequence of black i Government. say. the diversion of quota steel by contractors.X*)8 3 X*/0ß > 0 5.A • (1 . of a wide ranging regime of qu intermediate and final goods. see J. say. especially in the sphere of foreign trade. For a penetrating and detailed analysis of the functioning of these controls in India. N. This content downloaded from 117. In India goods ranging from foreign exchange bricks are subject to price controls and of whether and to what extent these c the objectives supposedly underlying th the control prices in force is the exist and the market clearing prices. .6 and in the process of acquiring authorities allotting quotas. It is th black income arising in the process of mium exclusive prices to those users w prices. Wanchoo Comm for 1968-69. It is possible that the welfare significance of such a transaction involving the sale of. Savings. 6.208. X*) [2 P' (X*) + y. To the extent that the ta + t. Bhagwati and Padma Desai [1].jstor.157 on Wed. Consumption. the former may well be a welfare raising situation. contains a lucid discussion of price controls on intermediate products in a situation where the prices of the final products using them are not. controlled [3]. ration sugar by the poorer class of people is not the same as that involving. in the context of black income they are symmetrical. 7.

and inventories of goods. .. has an ad possibilities.and as such it may not be a binding constraint in the case of pients at the lower levels. and shares of public companies etc. it lowers the savings rate. irrespective of its pattern. At the lower levels. our judgement traint on the asset forms is likely to be binding. make for a larger proportion ed rather than saved. In p tent to which such savings can take 'visible' forms . the l the loss of direct control over the use of such savings In the presence of black incomes which can be view varying proportions) regular. by showing high savings out of regular ' the like . The consumption. SUNDARAM AND V. We recognise that to a certain extent black savings can take these visib accounts in the name of minors. .157 on Wed. gold an metals and stones. It a if the equipment in question is imported from abroad under l Government or is domestically produced by large undertaking public or in the private sector translation of black savings into through understatement of the value of equipment etc. Savings out of black income like those out of 'white' income h ed by a corresponding flow of investment. since it uses could have been used for capital formation. an of production tends to divert scarce resources away f uses. 124 K. 'white' incomes. o ence: for the individual saver. on the average. It is possible that a part of the black savings is utilised for investm equipment. the p sumed will. The r of assets in which savings from black income can be the higher levels of depos bonds. where typ form bribery and corruption. tend to be higher. the asset forms that black savin far more restricted than can savings out of 'white' income. is unlikely any significant part of black savings. there is a loss in aggregate savings with the rate of growth. such supplements to lo the character of a redistribution in favour of lower in the proportion of income consumed on average. real ca severely restric obvious forms of holding black savings would be cash. The pattern of consumption (out of bla to be biased in favour of glamorous consumer goo effects on two counts: (z) via its demonstration effect on in the rest of the economy.jstor. This content downloaded from 117. Even if paid out of savings. PANDIT consumption. Partly for this reason. There is. 23 Nov 2016 13:43:29 UTC All use subject to http://about.205. at the higher levels.208. however. One possible way in which this can happen is throu ment of the value of equipment with the difference between the eq price and the declared value being paid out of black savings.

157 on Wed. the black savings held in the real investments in the 'white' sector In an inflationary situation. This content downloaded from 117. and gives r stones there will be a leakage from bla ponding to the value of gold and othe a part of the black savings is not avai It should be emphasised that when a black savings 'invested' in gold etc. gold and other pre absolute liquidity). For. ON BLACK MONEY 125 out of black savings would tend to be using non-standardised equipment pr themselves may be in the unorganise black savings give rise to a further f Apart from cash.jstor.9 In our . Nor would smuggled-in p unorganised sector account for a signifi fore. taken together. Go quences finance additional real invest Equally. the additions to the stock Government bonds. arisin significant. improvements in land or construc transfers. It should be clear that it is the net additio savings and as such only this part can legiti of the term rather than the entire volume mulation.208.205. 9. black savings us inflationary. silver etc. ar the asset portfolio of persons with bl the price of gold. by entirety constitute a leakage. there wou stocks of inventories over and above t asset choice available to holders of bla tunity cost of holding inventories is black savings is likely to be held in th savings held as cash.). It is possible that the capital gains arising for tax purposes and thus adding to the fl 10. a s mere transfers within the economy. 23 Nov 2016 13:43:29 UTC All use subject to http://about. a major part of black savings woul or as addition to the stock of currency of black savings held as currency. shares etc.

This content downloaded from 117. The Problem of Black Liquidity However. It must be emphasised that pub context because holders of black liquidity cannot afford assets and as such it ought to be distinguished from a fa not to build up inventories) arising from a wrong choice put it differently. PANDIT m. black liquidity poses an institutional prob IV. Further. attempts at restrai through credit rationing cannot succeed. t turns on the extent to which black liquidity is in the sh denominations to be demonetised.126 K. to the extent t the form of gold and other precious metals and stones. this po down the price rise. thereby reducing the speculative demand for scar feasible to demonetise currencies of all denominations. This measure is intended to part of black liquidity (on the presumption that holder would prefer to present only a small part of their curren sion).jstor. Thus. The majo from the vast quantity of liquidity which comes into being over time of black savings held as cash. i tisation. insofar as the measure is anticipated conversion of currency in the relevant denominations tak 11. The crux of the problem is that thi any monetary/fiscal policy and that it can move around unpredictable excess demand in several vulnerable sectors to the existence of this vast liquidity. Some Policy Issues (a) Demonetisation Turning now to the policy aspects of the problem.208. The fact that black wealth gets indefinitely accumulated as cash ment's permissive policy with respect to money supply in that put a limit on the total stock of black wealth that can be held as c any addition to holdings of cash will have to be matched by a red of inventories or in the stock of other assets. Nor can the ho persuaded to switch out of inventories into visible financ ing the cost of credit or by raising the returns on asset and Government bonds.205.11 gold and silver ed as black liquidity. it is not so much the flow of black savings in which is the most serious threat to price . 23 Nov 2016 13:43:29 UTC All use subject to http://about. SUNDARAM AND V.157 on Wed. In any event. one of th is currency demonetisation.

as is currently in operation in India. The question therefore should not be one of better enforcement versus a reduction in marginal taxes but whether. In our . It expectations.jstor. (b) Tax Reforms As regards reforms in the tax structure and tax administration. related to concealed income. 12. This content downloaded from 117. it must be emphasised that whatever be the tax rates. Before turning to proposals for reduction in marginal tax rates aimed at reducing tax evasion.205. which is primarily also have an impact on the flow of bla of black wealth come within the purv presenting demonetised currency for holders of black wealth are unlikely to part of their currency holdings for conv sure to which demonetisation succeeds it would fail in curbing the flow of bl Nevertheless. element in the inflationary process.12 Since a m will be into gold and other precious m apart from currency of smaller denom be preceded by a complete ban on all Demonetisation. However.208. the currency of the relevant deno- minations will be convertible only at a discount and to that extent the measure could be successful. insofar as demonetisatio in liquidation of inventory holdings o inventories from the holders of black w a slackening in the rate of inflation. brought about by demon in favour of the measure. Singh [7] has shown how the change in the penalty function relating it to the tax evaded rather than the income concealed suggested by the Wanchoo Committee [3] is likely to be less effective than a penalty function. efforts to enforce them must be pushed to the point where additional expenses on enforcement are just matched by the additional tax revenue plus penalty. the tax rates should be reduced or not.157 on Wed. the exp held by the mass of consumers have. 23 Nov 2016 13:43:29 UTC All use subject to http://about. if demonetisation is anticipated by everybody. given efficient enforcement. T the Government's anti-inflationary p are expected to cause a reversal in the regard to future prices and thereby sl such consumers. ON BLACK MONEY 127 measure is further eroded.

prop would not reduce the extent of tax evasion.V)'Y n2 . we have three income distributions as follows : After-tax income with After-tax income with Pre-tax income marginal tax rate t marginal tax rate ť Income Frequency Income Frequency Income Frequency Y «i Y nx Y nx y(l +0) n2 [1 + 0 (1 . 128 K.k. ev nal tax rates. Whether the duced by the reduction in the marginal tax rates. it does not as proposed in the 1976-77 Budget will also not redu context. we present below a sim- plified model showing the relationship between the effect (of a reduction in the marginal tax rate) on tax revenues and thus on the extent of inequality in the dis- tribution of after-tax incomes. SUNDARAM AND .jstor. Suppose.e. Now. where m^k ^ 0. the exemption limit is Y so that the marginal tax rates appliable to the income levels are 0 and t (say). Suppose next that the marginal tax rate is reduced to ť and let the number of tax evaders in the new tax situation be m . assume further that people make an 'all or nothing' choice about the extent of concealment.13 However if.157 on Wed. e groups. For simplicity. Thus.t)]Y n2-m [1+0(1. i. accruing to nx and n2 individuals respectively. the honest tax payer reveals his entire income whereas the evader conceals his entire income. while Dasgupta [2] may be right in his tion in the marginal tax rates from 95 % to 77 %. is suggestive. 23 Nov 2016 13:43:29 UTC All use subject to http://about. This content downloaded from 117. Turning now to the distribution of after-tax incomes. the success of the recent Voluntary Disclos set at 66%. Then. one can assert that the chances of an ov are higher with a reduction in the marginal tax rate groups than with a uniform reduction in marginal t slabs. It is worth noting here that when the marginal tax extent of tax evasion may not be sensitive to small redu ble that the extent of tax evasion does respond to a mor tax rates. as is likely to tion of the prospective assessees in the lower and m salaried persons who do not.205. and possibly cannot. let m be the number of tax evaders ( m < n2 ) in this tax situation. Consider a simple situation in which there are two income levels.m + k (1+0)F m (1 + ®)Y m-k 13. PANDIT In considering proposals for reduction in marginal t total tax revenue and on the distribution of after-ta inter-related issues to be kept in view. Y and 7(1+0) where © > 0. and the resultant increase in the tax reven in tax revenues from the previously honest tax payers o of empirical judgement..208.

m + k) © ť. the sign of G .jstor. the second term on the right hand side in the expres- sion for H is non-negative.157 on Wed. In other words.w2)' = n .(n2 . since © is assumed to be a positive number. and A'= n + n2 © . ON BLACK MONEY 129 Let us compare the inequality in th to the Gini-coefficient. 23 Nov 2016 13:43:29 UTC All use subject to http://about. Let T and T' denote the tax revenue corresponding to t and t' then it can be seen that 14.ť) («2 .ť) {n2 .nln2 .1 A • A' where # = [kť . Since A Y and AT are the total after-tax incomes in the two tax situations. Also.m (n + n2 ©)] +kť- A = n + n2 © . This content downloaded from 117. For a lucid discussion of the welfare significance of the Gini-coefficient as a measure of inequality.(t .(«2 .208.k) . see Sen [5]. n2. a necessary and sufficient condition for G> G' is that H is positive.14 If we denote with the two after-tax distribution a straightforward calculation shows Gr 0 nxn2 + (nm .m) © t. From this it can be shown that G .kf]ť n . So that.1 n + «20 . Therefore.(t.m(n+n2&)' > 0.205.m)] [nnt .1 n + n2 & . G' = n . = © n1n2 + [n(m . A and A' are both positive.m)] 'nrii .(m .. . H > 0 if [kť .G' depends entirely on that of H. since it is the number of honest tax payers when the marginal tax rate is ť.(n2 .m + k ^ 0.m + k) Qť where n = n1 + n2.(n2 -m) 0/ and G.

when the m t9 is less than the proportion of national income that accrues from income tax. A special case of (c) would arise if k .-L. So that.205.(t-ť) (n2 . This content downloaded from 117. a reversal. the distribution of the after-tax income will improve if th 15. m > m*9 is possible. in a country where a large proportion of the population is liabl income share of the tax exempt (poorest) group might be very small. m > m*. 130 K.m)] 0 Y.157 on Wed.208. SUNDARAM AND V. It is.jstor.e. in the fr model. and m < . and k > 0. 23 Nov 2016 13:43:29 UTC All use subject to http://about. evasion is also high. n±y is the total income of the group exempted from ta is the total pre-tax income. alternative sets of sufficient conditi (a) T' > .. This is likely to be true of all developing countries with a low covera ever. it will not be unreasonable to assume that n2 . PANDIT T' .T = [kť . m < m* amounts to the co proportion of tax evaders in the total population.0. To interpret these conditions note that m <m* ==> . = m* (say «+«20 or (b) T' .m > least one honest tax payer in the tax situation t.< "1 = ni y n n+n2Ç> ( n + n2®)y Now.T and n2 . T'-T ^ 0 « Therefore. Thus. therefore. It has to be noted that in each case we have by construction of the problem n2^ k . So that. expected that in India m <m Further.m > 0 or * (c) T' <T and m > m or (d) m = m*. i.

it should be noted that if the tax revenues increase. n2-m ť k The analogy with a price elasticity is easily seen. For l%2 Wî increase in the number of honest tax payers. which. To summarise. the Government is enabled to pursue more vigorously its policies directed to growth and/or a better dis- tribution via outright transfers. 17. tax enforcement must be pushed to the point where the additions to revenue and penalty are just matched by the additional administrative costs. is a highly simpli- fied one in many ways. In case there are no tax evaders even in the initial situation so that m = 0 and therefore k = 0. .ť is also the proportionate change in the assessed income. This.17 In this context. may prove restrictive from the point of view of generali- sability of our results. And the specifications in respect of the structure of groups. 16. it can be readily seen that G < G' and T ' < T. leave it . possibly.157 on Wed. And ť portionate reduction in the tax rate. is the case which Dasgupta [2] has in view when he compares the two after-tax distributions among the set of honest tax payers.jstor. 23 Nov 2016 13:43:29 UTC All use subject to http://about. the conclusions from our discussion of tax reforms are: (i) irrespective of the structure of tax rates.T >0 as k > ' ~ ť . under certain conditions the effect of such a reduction on the distribution of after-tax incomes is also favourable. This content downloaded from 117. (ii) the acceptability of proposals for a reduction in the marginal tax rates is critically dependent on whether it results in a sufficient reduction in the extent of tax evasion so as to increase the total tax revenue or. See footnote 16.205. in the framework of our model t .208. Since each set of the conditions above is onl G> G* even if any of the set of these conditio exceed G' even if T' < T and m <m*. from which these results follow. ON BLACK MONEY 131 increases or at the least remains unch noted above. (iii) in the event of a reduction in the tax rates leaving the tax revenue unchanged or increasing the same. in the least. the all or nothing choice about evasion etc. becomes intuitively clear in T . We wish to emphasise that our model.

PANDIT (c) Rationalisation of Controls We have seen earlier how black incomes arise under titative controls. 19 [9] Taylor. Ministry of Finance. Fiscal Survey of Columbia. Direct Taxes Enquiry Committee. Report of the Committee on Steel C trol .208. Journal of Public Economics . [2] Dasgupta. however. [3] India. clearly the solu vast majority of detailed controls which are often de ale. A. This content downloaded from 117.205. 1973. and P. Oxford University Press. "Tax Evasion: A Model". India. A. For. [7] Singh. Desai. On Economic Inequality . B.132 K. July. Milton.. [5] Sen. Baltim 1965. K. Delhi. [8] Srinivasan. [4] India. this step would ensure an efficient all It should be emphasised that even if the price mar machinery tightened... November. For instance. say. London. allowing the prices of i their equilibrium levels would merely divert the unearn intermediaries to the producers of the intermediate the producers of these goods are in the organised s to bring the additional profits within the tax net. SUNDARAM AND V. 1973. D 1971. 1970. London. essential that efforts be made to keep th to the minimum. Oxford University Press. References [1] Bhagwati. An important case in point would be the price c mediate products like steel and cement. "Control and the Current Situation: Why Not Let the Hounds Run? .org/terms . so that t their market clearing prices. K. In ad significantly. Special Number. [6] Shourie. A. Ministry of Steel and Heavy Industries. "Tax Concession as a Remedy for Evasion". In such a situation. if and to the extent that credit and/or physical inputs from the Government to coordinate the enforcement of. Planning for Industrialization : Industrialization and Tr Policies since 1951 . J. T. 23 Nov 2016 13:43:29 UTC All use subject to http://about. In of controls converts black incomes into 'white'. Economic and Political Week June 1. August. 1974. "Making Honesty the Best Policy".. Delhi. Final Report .jstor. Journal of Public Economics .157 on Wed. there would continue to be a accruing due to the infeasibility of enforcing tax law It is.. N. et al. 1963.. excise duties facilities. The Johns Hopkins Press.. 1973. Econom and Political Weekly . in a situ price of the final products are infeasible. C.