On 8th November demonetization was announced with the aim of the action was fourfold: to curb corruption; counterfeiting; the use of high denomination notes for terrorist activities; and especially the accumulation of “black money”, generated by income that has not been declared to the tax authorities.
It followed a series of earlier efforts to curb such illicit activities, including:
• The creation of the Special Investigative Team (SIT) in the 2014 budget;
• The Black Money and Imposition of Tax Act 2015;
• Benami Transactions Act 2016;
• The information exchange agreement with Switzerland;
• Changes in the tax treaties with Mauritius, Cyprus and Singapore; and
• The Income Disclosure Scheme.
Demonetisation was aimed at signalling and emphasizing the government’s determination to penalize illicit activities and the associated wealth. India’s demonetization was unprecedented in international economic history because:
• It was highly secretive and sudden.
• It was carried out in normal economic and political condition exemplified by macro-economic stability and fastest GDP growth rate. All other sudden demonetisations have occurred in the context of hyperinflation, wars, political upheavals, or other extreme circumstances.
In India there were two previous instances of demonetisation, in 1946 and 1978, the latter not having any significant effect on cash, but the recent action had large, albeit temporary, currency consequences.
Globally new monetary policy tools like negative interest rates policy and ‘helicopter drops’ of money have been employed to stimulate growth and increase money supply. India on the other hand instead of expanding money supply has squeezed it and it can be called as ‘reverse helicopter drop’ or ‘helicopter hoover’.
Benefits of demonetization
A. Tax on black money: Demonetization offered three options for black money holders:
• Declare their income, deposit it and pay tax rate with penalty.
• Continue to hide and suffer 100% tax rate.
• Launder their money.
Anecdotal evidence says that there was money laundering through various methods like:
• Retime the accrual of money and then depositing in account.
• Paying intermediaries to convert black money into white (as commission, payment for standing in queue, depositing in others account).
Despite these demonetization provided following benefits:
• In all these cases, black money holders still suffered a substantial loss, in taxes or “conversion fees”.
• Laundering run the risk of punitive taxes and prosecution, in addition to the fees or taxes already paid because of continuous surveillance and data mining by government on spooky deposits.
• The December 30, 2016 Ordinance has declared the unreturned notes as no longer constituting legal tender and this will extinguish RBI liability and increase its net worth.
In this sense, demonetisation has affected a transfer of wealth from holders of illicit black money to the public sector, which can then be redeployed in various productive ways – to retire government debt, recapitalize banks, or even redistribute back to the private sector.
B. Tax compliance
• Demonetization has shown state’s resolve to crack down on black money.
• Social condemnation: Since this action has commanded support amongst the population, demonetisation shows that black money will no longer be tolerated by the wider public.
These two effects if combined with other incentive measures can result into behavioural change among people and greater tax compliance.
• Demonetisation could also aid tax administration in another way, 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.
• It will channel more savings into financial system. It will help banks in providing more loans at lower rates.
• In the longer-term, if demonetisation is successful, it will reduce the equilibrium cash-GDP and cash-deposits ratio in the economy. This will increase financial savings which could have a positive impact on long run growth.
Potential long term benefits
Though it will take several years to see the impact of demonetization on illicit transactions, on black money, and on financial savings, there are some signs pointing to change.
A. Impact on Digitization: One intermediate objective of demonetisation is to create a less-cash or cash-lite economy, as this is a key to channelling more saving 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.And there are many reasons for this situation. Cash has many advantages:
• It is convenient, accepted everywhere, and
• Its use is costless for ordinary people, though not of course for society at large.
• Cash transactions are also anonymous, helping to preserve privacy, which is a virtue as long as the transactions are not illicit or designed to evade taxation.
In contrast, digital transactions face significant impediments:
• They require special equipment, cell phones 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.
At the same time, these disadvantages are counter balanced by two cardinal virtues.
• 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 levelling the playing field between tax-compliant and tax-evading firms (and individuals).
In the wake of the demonetisation, the government has taken a number of steps to facilitate and incentivize the move to a digital economy. These include:
• Launch of the BHIM (Bharat Interface for Money) app for smart-phones based on the new Unified Payments Interface (UPI) which has created inter-operability of digital transactions.
• Launch of BHIM USSD 2.0, a product that allows the 350 million feature phone users to take advantage of the UPI.
• Launch of Aadhar Merchant Pay, aimed at the 350 million who do not have phones. This enables anyone with just an Aadhar number and a bank account to make a merchant payment using his biometric identification.
• Reductions in fees (Merchant Discount Rate) paid on digital transactions and transactions that use the UPI.
• There have also been relaxations of limits on the use of payment wallets.
• Tax benefits have also been provided for to incentivizedigital transactions.
• Encouraging the adoption of POS devices beyond the current 1.5 million, through tariff reductions.
As a result of all these number of digital transactions has increased considerably. Data from the National Payments Corporation of India (NPCI) show that RuPay-based electronic transactions increased by about Rs. 13,000 crore in case of POS transactions and about Rs. 2,000 crore in e-commerce, an increase of over 300-400 percent. Same has been the case with debit card, credit card and AEPS (Aadhar-Enabled Payments System) transactions.
The success of digitalization will depend considerably on:
• The inter-operability of the payments system. The Unified Payments Interface (UPI) created by the NPCI is the technology platform that will be the basis for ensuring interoperability. But to ensure this, individual banks should facilitate not thwart inter-operability.
• As digital payments increase the security features of these e-payment systems will need to inspire trust, to ensure this trend continues.
B. Impact on Real estate sector
• Demonetization can have profound impact on real estate prices as black money was used evade taxes on property sale and have resulted into inflated prices. According to Knight Frank and Survey calculations real estate prices in eight major cities has
started declining post demonetization.
• 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.
Short term impacts
A. Impact on GDP: Demonetisation is potentially:
• 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);
• And an uncertainty shock because economic agents face imponderables related to the impact and duration of the liquidity shock as well as further policy responses
To analyze the impact of demonetization on GDP in a macro-assessment on five broad indicators are focused:
• Agricultural (rabi) sowing;
• Indirect tax revenue, as a broad gauge of production and sales;
• Auto sales generally, as a measure of discretionary consumer spending, and two-wheelers in particular as it is the best available indicator of rural and demand of the less affluent;
• Real estate prices; and
• Real credit growth
The high frequency indicators present a mixed picture.
• Agricultural sowing, passenger car sales, and overall excise taxes bear little imprint of demonetisation;
• Sales of twowheelers show a marked decline after demonetisation;
• Credit numbers were already looking weak before demonetisation, and those pre-existing trends were further reinforced after November 8.
Impact of Demonetization (Tabular Format)
A. Experience of demonetization around world
1. Ghana 1982 -
• Measures: Demonetisation of 50 cedi notes in 1982; no exchange facility for long; freeze on bank deposits
• Rationale: Excess liquidity and inflation
• Effect: Loss of confidence in the banking system
2. Brazil 1990
• Measures: Collor Plan: monetary contraction by freezing all deposits above certain limit .Deposits upto a ceiling denominated in the old currency (cruzado novo) were converted to the new currency (cruzeiro) at parity.
• Rationale: To fight hyperinflation
• Effect: Contraction of output; price moderation only very gradual due to uncontrolled re- injection of liquidity
3. Australia (1988, 2015)
• Measures: Introduction of next generation notes with tactile features.
• Rationale: Prevent counterfeit
• Impact: The first country to have a full series of circulating polymer bank notes
4. Singapore (1999, 2004)
• Measures: The Portrait notes, the fourth series of currency notes, were launched in September 1999 with sophisticated security features (1999). Discontinued issuance of S$10,000note and instructed banks to stop re- circulating it since October 2014; but still remained legal tender (2004).
• Rationale: Mitigate higher money- laundering risks associated with large-value cash transactions.