Where Demonetisation Falls Very Short Of Tackling Black Money

There has been a huge spike in interest about India's unaccounted economy (popularly referred to as the "black economy") since PM Modi's move on November 8 to withdraw 500- and 1,000-rupee notes from circulation. Many proponents have argued that such a move will wipe out all unaccounted income in the country, while other have maintained that the consequences on the economy will be disastrous. While economic activity will surely be depressed in the short run, frankly, the magnitude of the effects on the economy in the medium-to-long run are uncertain at the time being. The observable facts tell us that it is a major inconvenience to a large majority of Indians, many businesses have reported a significant reduction in commercial activity, and hoarders of unaccounted income are scampering to salvage whatever they can. 

Objectively speaking, one of the few certainties of this currency reform is that it will not be able to eliminate unaccounted money from India. It is an attempt at a one-time reduction in the stock of unaccounted wealth, but will have an insignificant effect on the generation and flow of unaccounted income. Targeting only the stock of domestic unaccounted money will be incomplete as fresh generation in different sectors will take us back to the starting point in a few years. 

If the objective of the government was to punish holders of unaccounted income in India, this move can be deemed to have partially achieved its targets. Partially, because most holders of unaccounted money do not store it in the form of physical cash, but would have converted it into other assets such as real estate, gold, luxury cars, etc. However, if the objective of the government, as touted by many commentators, is to eliminate unaccounted money in the country, this move will barely scratch the surface. (Read this brief set of slides which analyses the objectives and outcomes of the currency reform.)

In order to tackle the unaccounted economy, it is essential to first understand the true extent and reach of it and to gain an understanding of the sources of generation and avenues of utilisation of unaccounted income. (The detailed report published by the Takshashila Institution can be accessed here.) At the outset, it is important to understand that the unaccounted economy comprises of a combination of illegal economy, unreported economy, unrecorded economy and finally, the informal economy. While there may be some overlap between these different categories, any policy that aims to tackle all of this at once is bound to fail. The informal economy, for example, is completely legal and is legally deemed to be exempt from taxation, while the unreported economy consists of legal activities on which taxes have not been paid. The demonetisation move unfairly hurts the informal economy, which is dependent on cash, but will not have any effect on tax evasion, which is a clever manipulation of the account books. 

Estimates of the unaccounted economy vary greatly with different estimation methods and there seems to be no consensus on the estimate. The range is from 25% of the GDP to even 75% of GDP. A reliable estimate by the National Institute of Public Finance and Policy (NIPFP) pegs this figure at 40% of India's GDP in 2010-11. 

Further, analysing the sources and utilisation of unaccounted income in different sectors of the economy would give a far more realistic picture about the extent of influence of the demonetisation move on the unaccounted economy. Real estate alone accounts for over 40% of the total domestic unaccounted income. In 2010-11, the amount of unaccounted money generated in the real estate sector is close to Rs. 4.5 lakh crores. Though real estate prices will dip in the near future due to reduced demand as a result of liquidity crunch, the demonetisation move will not change any of the incentives for people to make transparent transactions. 

The size of trade misinvoicing and illicit financial flows out of India is also staggering. Businesses often misreport their imports and exports in order to avoid taxation and then move the money out of India to tax havens. Global Financial Integrity estimated that $332 billion was illicitly moved out of India's borders between 2010 and 2013 through trade misinvoicing. The hawala market is also a notorious source for generation of unaccounted income. In 2010, $6 billion worth of foreign exchange transactions was done through the hawala market. 

The education sector in India is another important source for generation of unaccounted income. According to an investigative report, the education sector generates around Rs. 48,400 crores of unaccounted income each year for the past several years. This is through donations, high capitation fees, and the bribes paid by several institutions in order to get approvals and the lack of accountability (many education institutions are exempt from filing annual returns) in this sector makes it extremely easy for these processes to continue. 

Agricultural income poses a massive problem in the attempt to reduce the size of the unaccounted economy. Since agricultural income is exempt from taxation, there is the issue of revenue foregone for states. More importantly, though, the exemption is an open invitation for tax evasion and money laundering. Many corporations who are remotely involved in the agricultural sector report their revenue as agricultural income to escape taxes. This amounted to Rs. 31,300 crores in 2009-10. A sensational response by the IT officials given to an RTI revealed that in 2011, agricultural income declared was about 2,000 lakh crores. This might have been an exceptional year and the figure might well be exaggerated, yet, it is symptomatic of the problem of money laundering in agricultural income. 

Then, there is the generation of unaccounted income through corruption within the government and through government schemes. Offering 10 to 20 percent of the contract value as kickbacks to officials is a widely known and accepted practice to win government contracts. Defence procurement, irrigation projects, road construction, public works, national highways and other infrastructure projects are all prone to massive kickbacks. The same applies to government auctions of natural resources such as mining rights and spectrum sale. Only a fraction of these come under the CBI and gets highlighted in the media. 

Given here is a small sample of the extent of unaccounted economy in India. The currency reform is an extremely small step in the larger journey of reducing the size of the unaccouned economy. To truly tackle this "menace", the Modi government needs to make good of its promise of reforming each of these sectors to curb the generation of black money. Some of these reforms will necessarily be sector-specific, such as decreasing stamp duty and putting in place a regulatory structure for real estate, bringing agricultural income into the IT department's purview, disallowing cash donations to political parties, cracking down on capitation fees in the education sector, etc. Much of it can also be achieved by pushing through structural liberalising reforms in the country. The data shows that the size of the unaccounted economy in the country has been steadily decreasing with the increasing liberalisation of the economy. Removing the need for unnecessary licenses and permits, reducing transaction costs, improving transparency and accountability in government procurements, simpler and reduced tax laws, improving ease of doing business and other such measures are desperately required to reduce the generation of unaccounted income in India. 

With inputs from Manasa Venkataraman, who co-authored the Takshashila Discussion Document on Unaccounted Money in India, which forms the basis for this article.

(Anupam Manur is a Research Fellow at the Takshashila Institution, an independent and non-partisan think tank and a school of public policy.)

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