Demonetization and Black

Money
Past, Present, and Way
Forward
 Presentation Outline
• Meaning of black money and its measurement in
India

• Demonetization Objectives: Government’s Version

• A brief history of demonetisation

• Will demonetization succeed in the long run?

• What is the way forward to curb black money?

 Introduction

• Black Economy affects policymaking, directly and also by

making it difficult to obtain correct data, thereby leading to
policy failure.
• All macroeconomic variables such as the rate of growth,
savings, and investment, and microeconomic variables such
as the quality of education and health are affected by the
black economy
• Since the black economy vitiates data, it affects analyses
carried out by experts who rely on official data.
 Impact of Black Economy
• The extent of the effect of a black economy on a
nation’s life depends on its size.
• If the black economy is small—as in the Scandinavian
countries—its societal ramifications would be
negligible.
• However, if it is large—as in many developing
countries—its impact will be large and cannot be
ignored.
 Need to Quantify Black Economy
• Baran once argued that brandy consists of water
and alcohol, and if we cannot separate the two,
we cannot say it is only water or only alcohol.
• Similarly, if we cannot measure the size of the
black economy accurately, it does not mean that
we can treat the economy as only consisting of
the white economy.
• Even a crude estimate is worth it.
 Need to Quantify Black Economy
• After all, even the white economy is estimated and it
has many kinds of errors in it.
• One of the principal errors is the black economy itself.
• Therefore, even for accuracy in the estimation of the
white economy, the black economy needs to be
analysed.
• Finally, if the black economy is large, it cannot be
ignored.
• Measuring the size of the black economy is important.
 Definition of Black Economy
• An economy generates factor and transfer incomes. In the
national accounts, the former are counted but not the
latter.
• Transfer incomes are not linked to production.
• Unfortunately, a lot of illegal incomes are transfer incomes
such as bribes or undeclared capital gains in the sale of real
estate.
• But several experts count these illegal income in estimating
the size of the black economy.
• Ideally it should not be counted.
 Definition of Black Economy

• The generation takes place elsewhere and the money is

circulated via real estate transactions.

• To avoid multiple counting in measuring the size of the

black economy, only factor incomes should be counted.

• For these reasons, in Kumar (1999), black incomes

generated in legal activities in India are defined as “factor
incomes, property incomes here that are not reported to
direct tax authorities. The entire income produced in
illegal activities is counted as black incomes.”
 Black Money, Black Economy and Black Wealth

• Three terminologies are used as synonyms but

they are not.
• Black Money: Portion of unreported income or
wealth held in currency notes.
• Black Economy: Unreported portion of annual
national income.
• Black Wealth: Total amount of unreported
income accumulated over the years.
 Crucial Factors Determining the Size of the Black Economy

• The black economy, like the white economy, is dependent

on many economic and institutional factors, and they
determine its size.
• Kumar (1988) argued that the black economy, surplus
income, and the services sector in India are mutually
interlinked.
• Using a set of coupled differential equations, it was shown
that they move together, and this was confirmed by the
data.
 Crucial Factors Determining the Size of the Black Economy

• Kumar (1999) argued that black income generation requires

committing an illegality in a legal activity.
• Further, the entire income from illegal activities is black
income.
• Thus, the size of the black economy would depend on the
extent of illegality in the country, and a proxy for that could
be annual crime data.
• Crony capitalism increased after 1991, leading to greater
manipulation of policies and generation of black incomes.
Determinants of the size of the black economy as a share of
GDP

• The share of the services sector (S/Y),

• The share of the private sector’s property

incomes in GDP (Op /Y),

• The extent of mispricing in foreign trade captured

by the share of trade in GDP (T/Y)

• The extent of registered crime per person (C/P).

Determinants of the size of the black economy as a share of
GDP

• So, B/Y may be written as

• (B/Y) = f (S/Y, C/P, T/Y, Op/Y).

• Assuming a linear function, we may write

• B/Y = a0 + a1 (S/Y) + a2 (C/P) + a3 (T/Y) + a4 (Op/Y)

• It is expected that ai for i = 1, 2, 3, 4 will be positive.

• The equation taken for testing is

• B/Y = a0 + a1 (S/Y) + a2 (C/P) + a3 (T/Y).

 Regression Results

• B/Y = 2.01593 S/Y + 0.01994 C/P + 17.4183 T/Y

- 102.13

• t= 5.44 5.92 0.81 –8.16837,

• R square= 0.8730 Adj. R square = 0.8627

Demonetization

Government’s Version
 Demonetization
• On November 8, 2016, the government announced a
historic measure, with profound implications for the
economy.
• The two largest denomination notes, Rs 500 and Rs
1000, were “demonetized” with immediate effect,
ceasing to be legal tender except for a few specified
purposes.
• At one stroke, 86 percent of the cash in circulation was
thereby rendered invalid.
 The aim of Demonetization
• The aim of the action was fourfold:
1. To curb corruption
2. To curb counterfeiting
3. To curb the use of high denomination notes for
terrorist activities
4. To curb the accumulation of “black money”,
generated by income that has not been declared to
the tax authorities.
 The Impact of Demonetization
• The public debate on demonetization has raised three
sets of questions.
• First, broader aspects of management, as reflected in
the design and implementation of the initiative.
• Second, its economic impact in the short and medium
run.
• Third, its implications for the broader vision underlying
the future conduct of economic policy.
Cash and GDP Growth
 Purpose of Cash Use
• All cash holdings may not have been used for legitimate
transactions, but perhaps for other activities such as
corruption.

• 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.

• In this sense, attempts to reduce the cash in an economy

could have important long-term benefits in terms of
reducing levels of corruption.
 Purpose of Cash Use Contd..

• But even if high levels of cash are needed this doesn’t

mean high denominations are needed.
• It is usually the case that 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.
• However, this argument is counter intuitive because
new currency issued is of Rs. 2000 face value.
 Impact of Demonetization
Impact

Sector Short Run Long Run

Money/interest rates Cash declined sharply Cash will recover but settle at a
lower level.
Bank deposits increased sharply Deposits will decline, but probably
settle at a slightly higher level

Financial System Savings Increased Increase, to the extent that the

cash deposit ratio falls permanently

Corruption (underlying illicit Decline due to non availability of Could decline, if incentives for
activities) cash. compliance improve.

Unaccounted income/ black money Stock of black money fell, as some Formalization should reduce the
holders came into the tax net flow of unaccounted income

Private Wealth Private sector wealth declined, Wealth could fall further, if real
since some notes were not estate prices continue to decline
returned and real estate prices fell
 Impact of Demonetization Contd..
Impact

Sector Short Run Long Run

Public Sector No effect. Government/RBI’s wealth will increase when
Wealth some cash is extinguished, reducing liabilities
Formalization/ Digital transactions amongst new users Some return to cash as supply normalizes, but
digitalization increased sharply the now-launched digital revolution will continue

Real estate Prices declined, as wealth fell while Prices could fall further as investing undeclared
cash shortages impeded transactions income in real estate becomes more difficult

Broader economy Job losses, decline in farm incomes, Should gradually stabilize as the economy is
disruption in cash-intensive sectors remonetized.

GDP Growth slowed, as it reduced demand, Could be beneficial in the long run if
supply, and increased uncertainty formalization increases and corruption falls

Tax collection Income taxes rose because of increased Indirect and corporate taxes could decline, to the
disclosure extent growth slows
 Benefits
• The most important way to view demonetization is as a
tax administration measure, one designed to tax
holdings of black money.
• Demonetization could also aid tax administration in
another way, by shifting transactions out of the cash
economy and into the formal payments system.
• Once the tax department identifies the people who
deposited large amount, they may be tracked in future.
• It will channel savings into the formal financial system
 Early evidence for potential long-term benefits
• Cash accounts for about 78 percent of all consumer payments.

• Cash has many advantages: it is convenient, accepted everywhere,

and its use is costless for ordinary people.

• In Contract, digital transactions require special equipment which

will only work if there is internet connectivity.

• They are also costly to users, since e-payment firms charge both
customers and merchants. (2% to 3% of transaction value)

• 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.
 A Brief History of Demonetization
• India’s previous experience with demonetisation was on 16
January 1978, with regard to Rs. 1,000, 5,000 and 10,000
currency notes.
• The objective was to eliminate the possible use of such
notes in illegal transactions.
• High denomination notes demonetised then, formed about
0.6% of the total currency in circulation.
• After the 1978 demonetisation, `100 notes remained the
highest denomination currency.
• In October 1987, Rs. 500 banknotes were issued.
• November 2000, Rs. 1000 banknotes were issued.
 Curbing the Black Economy
• Government announced an “Income Disclosure Scheme
(IDS)” under which black money holders could declare
black wealth by paying 45% tax in February 2016.

• Voluntary disclosure schemes announced six times till 1997

led to more black income generation.

• These schemes lead to the expectation that the

government will announce more such ones in the future so
one could generate more black incomes today and whiten
them in the next amnesty scheme (Kumar 1999)
 Identification of Black Money
• The only time black incomes and wealth held abroad have
been identified when stolen or hacked data has come to
light in the case of HSBC or the Panama Papers.
• Most recently, in the case of HSBC
• No convictions happened due to the fact that the data is
stolen and the person who supplied the information is not
accessible to the government.
• As soon as the information is public, such deposits will
disappear and may be moved to another bank.
 Impact of International Agreements
• In spite of numerous DTAAs signed in the last 25 years,
no one has been brought to book under this provision.
• In reality, DTAA provided the route for “round-tripping”
from Mauritius so that black money spirited out could
return via that country (Thakurta 2002).
• At one point 40% of foreign investment was coming via
this jurisdiction.
• In the context of the latest scheme (IDS), if one can
round-trip the money by paying 5% why would anyone
pay 45% tax under the new scheme?
 Impact of Demonetization on Black Money
• If India is to come out of its backwardness and impoverishment, fighting
black money and corruption is essential.

• But can demonetisation achieve this?

• Cash Stock: Tip of the Iceberg

• At 62% of GDP, black money generated is around 80 Lakh crores annually.

• Compare this with the figure of 14.6 lakh crore existing in `500/`1,000
notes, the main component of the black money stock.

• Even if we assume 50% of these notes comprise black money, that would
mean a mere `7–`8 lakh crore, that is, under 10% of the total black income
being generated.

• Now the fear is that almost entire amount is back in the banking system.
 Counterfeit Currency
• As for fake notes, the amount of counterfeit currency seized
between 2012 and 2015 was mearly 147 crore, that is, 37 crore per
year.

• A 2015 study by the Indian Statistical Institute, Kolkata on behalf of

the National Investigation Agency estimated the fake currency in
circulation to be just `400 crore,

• This amounts to a mere 0.022% of the total notes in circulation.

• Even the new currency is not foolproof, notes seized near

Bangladesh border copies almost 50% of security features.

• Did demonetization stop terrorist and Maoist attacks on military?

 Cashless Economy
1. Less than 50% of our households have access to a bank, over 60%
of our economy is in the informal sector and 78% of transactions
happen in cash.

2. India has one of the highest cash to GDP ratios in the world, 12%
compared to a world average of 4%.

3. Nearly 6 crores debit cards and 3 crores credit cards are in use.
(without excluding multiple cards by same person)

• Therefore, the move towards a cashless economy, calling on people

to switch to internet banking only indicates how far our decision-
makers are from the lives of the people.
 What demonetization could do
• Demonetization may destroy a tiny part of the black wealth held in
currency but neither reduces the black wealth in other forms nor
black income generation in future.
• This expectation may not be fulfilled since the money being
deposited in accounts is being put mostly in small parcels which will
be below the taxable limit.
• Any gain due to bringing a small part of the black economy in the
tax net could be more than annulled by the big decline in the white
economy and the loss of tax collection there.
• Further, issuing Rs. 2000 notes makes it even more easier to hoard
and transport money.
 Measures needed
• Cashless political funding: Reducing the cap on anonymous funding
from Rs. 20,000 to 2,000 is not sufficient.
• Removing corporate funding of elections and ideally state funding
of elections in the long run.
• Incentivising digital transactions and dis-incentivising cash
transactions. For e.g. tax relief from income tax for digital
transactions.
• Blanket ban on round tripping of investments like Mauritius route
and greater disclosure in P- Note transactions.
• Reducing the registration charges on real- estate transactions.
• Capping cash transactions to Rs. 3 lakh is good start, however fixing
an annual withdrawal limit on the savings accounts is necessary.