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Monday, November 14, 2016

Trumping black money

by Suyash Rai .

On November 8, the US elected Donald Trump, and our government decided to trump black money. The move to discontinue the higher denomination notes in circulation is bold. However, boldness is not a virtue in and of itself. It needs good company. The decision creates some benefits, but it is also intrusive and disruptive.

In 1978, when the government demonetised high denomination notes (Rs.1000, Rs.5000 and Rs.10000), they were really high denomination notes: Rs.1000 in 1978 is the same as Rs.18000 today. They were a minuscule portion of currency in circulation, and only a handful of people held those notes. In contrast, today, Rs.500 and Rs.1000 are small bills. About 86 percent of currency in circulation is in these denominations. The action has consequences for almost all citizens who have cash in their wallets. How should public policy analysis think about this action? It's useful to break this up into three components:

  1. Ex-ante analysis: Is the decision sound at the time it was taken? This is a forward-looking assessment that may be proven wrong on hindsight.
  2. Concurrent assessment: Is there sound execution? This is a concurrent assessment of all the actions that are undertaken to see the idea through - maximising benefits and minimising costs.
  3. Ex-post evaluation: Did the decision achieve its objectives, and at what cost? Once the dust settles, we should look back and ask the extent to which the objectives were achieved, tote up the costs actually experienced.

In the use of the coercive powers of the State, a sound policy process starts with a good ex-ante analysis, using all the facts and logic available at the time, and then ensures proper execution. The policy process then looks back and introspects, and wonders if things could have been done better. All of us as citizens are part of this three-part thought process.

Ex-ante analysis of costs and benefits


One way to analyse a policy proposal before it is implemented is to compare its expected benefits with its expected costs. The process of doing this thinking often throws up many good ideas for how to improve an initiative, by discovering ways to achieve the same objective at a lower cost.

Expected Benefits


To consider the expected benefits of the cash ban, let us begin with the government's stated objectives. The decision is supposed to be an attack on three problems:

  1. Fake currency: the objective is to eliminate fake currency. This is achievable by this decision, as the notes are to be deposited in bank branches and post offices, and as long as these establishments run a check on those notes being deposited, this objective will be achieved. Losses will be imposed upon those unwittingly holding fake currency. The factories making the fake 500/1000 rupee notes will close down. However, (a) The pressure of work at bank branches and post offices may mean that many bad notes slip through and (b) There is no magic bullet in the fight against counterfeiters, who will now rejig their factories to counterfeit the new designs of notes. It is being reported that the new designs do not have any additional security features, in which case the counterfeiters would soon be back in business.
  2. Black money: It is useful to distinguish between black money creation, and black money storage. Black money may be created through illegal activities (eg. bribery), or through legitimate activities (eg. trading business) where all taxes were not paid. Black money is accumulated over a period of time and stored into a range of financial instruments. We should understand the likely impact on this unaccounted wealth and on future black money creation:
    • Impact on unaccounted wealth: Unaccounted wealth may be stored in many ways: rupee cash, gold, real estate, foreign currency cash, accounts in foreign countries, and other instruments. Of these, rupee cash is relatively unattractive as it earns a negative real rate of return. A 2012 study by an institute of the Ministry of Finance found that cash is the least preferred instrument for storing unaccounted wealth. Reports from raids by enforcement authorities also suggest that cash is only a small part of unaccounted wealth they find; the instruments of choice are benami properties, gold, diamonds, shares, etc. Moreover, part of unaccounted wealth is laundered, and becomes more difficult to identify. As with the white economy, only a small fraction of the total unaccounted wealth is kept as cash.

      The November 8 decision will not result in most of these persons being caught by law enforcement agencies, as they have been forewarned: everyone knows that deposits in banks of above Rs.250,000 will result in an investigation. However, persons holding unaccounted cash may have to quietly and privately bear losses. The extent of these losses depends on the rate charged by the market for laundering cash. Here is an example. Person X has Rs. 100 crore in unaccounted wealth, of which Rs. 10 crore is in cash form. Even if person X loses all the cash, much of the unaccounted wealth would still be with him. Since utility of additional wealth diminishes with increasing wealth, the net impact on his well-being would be small. However, he may sell the cash to person Y for Rs. 6 crore in new notes (to be delivered immediately or later). The person selling has taken a 40 percent loss, but still gets to keep 60 percent of the cash, and more importantly, continues to own the other instruments of unaccounted wealth. The person purchasing the cash would now launder the money through a network of persons willing to deposit it in their accounts (relatively safe for small deposits) or exchange it in banks (up to Rs. 4000) for a commission. In this example, black money only changes hands from one corrupt person to another corrupt person, but is not destroyed. It is a test of the character of many people in our society: whether they will fall for the get-rich-quick temptation to help launder some money in exchange for a cut.

      Some analysts, including the government's Chief Economic Advisor, have argued that this decision would lead to a transfer from black money holders to the central bank and to the government. This assertion raises important questions about what a central bank and government can and should do. If some cash does not return at the end of March, 2017, should the RBI simply decide to reduce its liabilities by that amount, and create a windfall profit? This seems very draconian, and makes many simplistic assumptions about the way the world works. The RBI Governor's promise on the note reads, "I promise to pay the bearer --- rupees." It does not add conditions on this promise. It is alarming to read about people in government and outside talking about consficating private wealth so brazenly. If government and central bank just give up their liability with a 4.5 month notice, it might erode faith in the currency. It would be unwise to do so. RBI should carry the liabilities on its balance sheet for the foreseeable future, and keep limited windows open for people to return their hard-earned cash. They cannot announce this in advance, but in March-end, they should consider modifying the notification to this effect.

    • Impact on black money creation: Is this decision likely to have lasting impact on the working of the black economy? That depends on the deterrence it creates in the minds of participants. Deterrence is created by one's sense of the probability of getting caught and punished. Since this decision is not likely to ensure large-scale identification, prosecution and punishment of those creating black money, it may not have a significant effect on future black money creation. One may argue that this decision creates a deterrence by limiting the opportunities for black money storage. Others may argue that this decision would force people holding black money to move to other instruments that may be easier traced. Neither of these arguments hold much water. Since the decision is expensive (discussed later), the newly issued Rs. 2000 and reintroduced Rs. 500 notes would, for the foreseeable future, serve as reliable stores of unaccounted wealth. Transactions in the black economy may move to other means, such as USD cash, gold or bitcoin, but these transactions will not go away.
  3. Terrorism and criminality: The government has pointed to the use of fake currencies by terrorists. Other commentators have highlighted the use of cash by criminals. For a short time, we may see some drop in terrorism and criminality, to the extent that terrorists and criminal organisations are organised around transactions in cash. However, high denomination notes will be back, and criminals will also change their tactics. We have not created new deterrence against terror and crime.

To summarise, the major direct benefits of this decision are likely to be: eliminating fake currency, and inflicting one-time losses upon black money stored as cash. We will ignore indirect benefits, such as the increased use of digital money, as there are other, vastly less disruptive ways to pursue those objectives.

Expected costs


We now turn to toting up the expected costs to society, where three key elements appear:

  1. Costs of low economic activity during transition period: As the means of exchange, money is the lubricant of economic activity. A sudden monetary shock disrupts the smooth working of the economy.

    Barring big cities, the adoption of electronic payment instruments is slow, and the infrastructure is weak. We have been seeing high growth rates of electronic activities, but in absolute terms, this is still very small. A 2013 survey of 3066 households in rural and urban India found that only 3.6 percent of respondents had ever done a non-cash transaction. In June 2016, there were about 75 crore debit cards, but only 12.9 crore payment transactions, which suggests that most people who are issued a debit card never use it for a purchase. Given the lack of financial development, most transactions in India use cash. The action of the government has given an 86% decline in cash in circulation. Using a broader money supply measure (currency plus demand deposits), this is a 55% shock to money supply.

    As a consequence, in the next few weeks, economic activity is likely to be sluggish, as the main means of exchange would be unavailable. There are many reports on sluggish activity in factor markets and product markets. In informal labour markets, daily laborers are not able to get work. There is a decline in registration of land and other property deals. Many product markets that rely on full or partial cash payment are affected. Anecdotally, we are hearing of a 50 percent decline in sales in many establishments in the last five days. Most of us have heard stories of people not able to pay for weddings, local travel, food, etc. We have also heard about tourists stuck in various destinations with cash they cannot use. Each day this situation persists, the costs will increase. The time spent by individuals in dealing with the crisis of cash is time that could have been used to produce GDP or to obtain utility.

    These costs will show up in the form of lower GDP growth for the affected period. It is important to note that GDP counts all output, whether the production is done with tax evasion or not. The entire impact should be considered as a cost. Money is not black unless tax has already been evaded. So, even losses imposed on black money holders due to their legimitate economic activity must be included as costs and not as benefits. At the time of production, one cannot say whether tax will be evaded on the activity.
  2. Cost of printing and delivering cash: About 22 billion printed notes would be destroyed. These would be partially replaced with new Rs.2000 notes, the redesigned Rs.500 notes, more of the old Rs.100 notes, and digital money. The process of collecting and destroying old notes, and issuing new notes, involves costs:
    • Costs incurred on printing and transporting old notes: The notes that will be destroyed were printed at the cost of about Rs. 7000 crore, and there were certain costs in distributing them all across India. These costs are now written off.
    • Costs incurred on printing and transporting new notes: There will be costs of producing and distributing the new notes. We do not know how large they are.
    • Costs of collecting, exchanging, issuing notes, reconfiguring ATMs: The banking and postal system is swamped with this activity. The man-hours expended here have costs, and could have been used in productive activities. This activity has crowded out other banking services.
  3. Cost of harassment of honest taxpayers: Government announcements seem to indicate that they will use leads from large cash deposits (greater than Rs. 2,50,000) in banks to conduct inquiries and investigations. Many legitimate cash-intensive businesses would be caught in the net, and may now face months and years of harassment. Since cash is neither black nor white, only thorough investigation can reveal its genealogy. This means there may be many fruitless investigations leading to harassment of individuals and businesses, and avoidable costs to exchequer.
  4. Other costs: We are hearing news about increased criminality in many places, as some petty traders and shops are offering to accept the old notes at discounted rates. It is too early to say whether this will have a lasting impact as increased criminality. Second, the decision has placed a large amount of cash in transit. This exposes many people to petty crime, reports of which have been trickling in. In desperation, ordinary people are getting duped in many ways. Third, there are reports of health emergencies and other problems that are getting exacerbated because of lack of money. Fourth, there are social practices that have been disrupted by the decision. For example, some people keep stash of savings hidden from their family members. Now, they have to reveal these savings to other family members, leading to emotional and social costs. Finally, there may be a decline in faith in the Indian currency, and we may see people use other store of value and medium of exchange.

To summarise, we should analyse

Benefits to societyCosts to society
One time purging of fake currencyCosts of low economic activity for some time
Impose losses upon persons holding unaccounted cashCosts of printing and transporting cash
Short-term disruption of cash-intensive terror and criminal activitiesCost of harassment of honest taxpayers
Other costs

 

Comparing benefits with costs


A simple cost benefit analysis would merely quantify all costs and benefits and look at which is larger. But in this situation, there is a crucial factor to be considered - how a rupee of loss inflicted upon those with black money should be compared with a rupee of cost imposed on those with no black money. If Rs. 10 crore is loss incurred by those with black money, and Rs. 10 crore is the aggregate loss incurred by others, should they be treated as same? I think that would be unwise, and it is important to assign different weights to benefits and costs. Here is one way to assign weights to costs and benefits. Suppose someone comes to you and makes a proposition:

Assuming that your giving up some money will lead to a corrupt person losing some money, how many rupees would you be willing to lose to inflict a loss of hundred rupees upon an unknown corrupt persons?

Different individuals may offer different values based on factors such as experience of corruption; opinion about retributive justice; belief in reform by punishment; etc. This trade-off that people are willing to take tells us something about the weights that should be assigned to nominal values of costs and benefits of the decision.

In order to discover numerical values, I obtained 12 data points by posing the above proposition to 12 persons. The answers ranged from Rs. 0 to Rs. 10, and the average was Rs.2.46. The average respondent was willing to pay Rs.2.46 to inflict Rs. 100 of loss on unknown corrupt persons.

This is hardly a precise estimate. The sample was not random (though I did try to maximise the diversity within the 12 persons). Since the respondents knew me, some might be signaling virtue or posturing. We should view this as a very crude estimate. A question using `one hundred rupees' as the hypothetical loss just captures one point. My sense is that the utility function is logarithmic, with people willing to pay progressively lower amounts for each additional rupee of loss inflicted on the corrupt. For example, a person willing to pay Re. 1 to inflict Rs. 100 of loss on the corrupt may not be willing to pay Rs. 1 crore to inflict a loss of Rs. 100 crore. As the loss inflicted increases, the ratio between the cost one is willing to pay and the loss inflicted would increase, and at some point, a person would not be willing to pay any further amount.

It is also important to consider distributional consequences. Most of of the economic lives of the poor are cash-based. Daily wage earners are usually paid in cash and they spend in cash. At the end of the month, they may have no savings, but they do vigorous cash transactions during the month. They will be hard hit: each rupee has high utility value at low income levels; access to bank accounts is low; transport cost and opportunity cost of time is a larger percentage of the cash to be exchanged; and so on. Every rupee of cost imposed upon the poor should get a higher weight than that imposed on the non-poor.

Now, an obvious question is: should citizens' "willingness to pay" be the determinant of what government can ask them to pay? For instance, this is not the basis for setting tax rates. However, I would argue that this method of assigning weights by asking people their willingness to pay for loss inflicted on black money holders is quite relevant here. The cost of this decision is to be incurred over and above the direct and indirect taxes we are paying. Those taxes are meant for, among other things, catching corrupt people and inflicting losses upon them.

Without complicating this unnecessarily, we should know that people can be expected to incur only a small percentage of the losses inflicted upon those holding black money. Taking this into account, and making allowances for an elected government's power to take such decision, I think the cost that honest people can be expected to incur should be weighted up by at least ten times before comparing them with the benefits. So, if the losses inflicted upon those with black money are Rs.2 trillion, the costs for others should not be more than Rs.0.2 trillion. It seems probable that costs of this decision will outweigh its benefits, or will be quite close. What this means is that, the probability of costs outweighing the benefits or being close to the benefits may be larger than the probability of benefits outweighing the costs.

Many people seem to be proudly accepting the costs of the government's decision. They hold the assumption that their sacrifices are leading to huge losses for the corrupt. This makes it all the more important to analyse and report the full benefits and costs of the decision, so that people can understand the consequences of what is happening.

Concurrent assessment of implementation


The cost/benefit analysis is influenced by implementation. If there are a hundred ways of implementing the decision, each would induce a different set of realised benefits and costs. Government has a duty to ensure that a decision is implemented in the best possible way using all the levers available to government, which maximises benefits and minimises costs. Consider just three sets of variables:

  • Timing of the decision: The decision was announced on November 8th, with almost immediate effect (from midnight). The timing is a variable in government's control. No timing is perfect, but this timing seems flawed. First, this is one of the peak wedding seasons of the year, and weddings being cash-intensive events, the ban is causing much misery. Unless there is clear evidence to show that most of the money spent on weddings is black money, this timing is somewhat cruel. Second, one of the ways to launder money is to report it as agriculture income, which being non-taxable is all white money, unless an investigation finds over-reporting. Kharif crops were harvested in October. On the one hand, this opens possibilities for laundering, and on the other hand, it imposes losses on farmers looking to sell their produce. Agriculture wholesale markets use cash and may be unduly affected. Third, this being the festive season, many legitimate businesses are also flush with cash, which means a higher cost imposed on such businesses. If objective was to target those with large accumulated stock of cash, it could have been met even in lean season. Finally, 8 November was the date when there was a possibility that Donald Trump would become President of the US, which is a new set of risks on international scale.
  • Limits on exchange and withdrawal: The government has placed certain limits on exchange of old notes and withdrawal of new high denomination notes and old low denomination notes. These limits are the same for everybody - individuals and businesses. Did these limits need to be so low? Could the government have allowed higher limits to reduce the costs for those not holding black money? For example, if the exchange limit was Rs.10,000 and the withdrawal limit from ATMs was Rs.5000, it may have helped most households with cash required for their day-to-day activities, while still being too low for hoarders of black money. The limits of Rs.4000 and Rs.2000, respectively, have increased the costs for regular households and businesses. Moreover, government should have allowed higher limits for registered businesses on transactions in their current account, to minimise costs to businesses. Some businesses with unusually high transaction volumes could be investigated later, but it would have protected legitimate businesses.
  • Readiness of the banking and postal system: The entire banking and postal system was caught unawares. Government says that it will now take three more weeks to configure ATMs. One can understand that configuring ATMs for the new Rs.500 notes before the decision would have run the risk of giving out information that could be used to predict the government's decision. Perhaps the government could have ensured the ATMs are configured in advance for the newly issued Rs.2000 notes, which were in the works for long, and also ensured greater supply of Rs.100 notes. The situation is so bad that in small towns, most ATMs are still not dispensing cash, and branches easily run out of cash.

These are factors that are substantially in government's control, and it seems that the planning ahead of the event can be faulted.

Considering alternatives


Let us go back to the discussion on benefits and objectives. First, consider the objective of eliminating fake currency. Governments everywhere grapple with counterfeiters, and there is a standard armoury of strategems for dealing with them. Banning notes overnight is not the usual way to fight fake currency. If eliminating fake currency is the main objective, government could have announced a time period (say, 3 months) to exchange old notes for new notes. This would have eliminated fake currency, and avoided most of the costs of an overnight ban. The overnight ban decision cannot be justified by the objective of eliminating fake currency.

On black money, as discussed earlier, the main objective that this decision can reasonably achieve is to inflict losses upon those with black money stored in cash rupees. However, if we do want to solve the problem of black money, it is more important to plug avenues of tax evasion, and to go after more preferred instruments for storing unaccounted wealth (eg. real estate). All said and done, based on what we know, this decision is likely to have only a small impact on those holding black money, and almost no impact on the creation of black money.

Should governments run such experiments: Concerns about high modernism


Governments do not take the Hippocratic oath. They can inflict harm. However, when they do so, we as citizens have a right and a duty to question them. Large actions which impose more harm should elicit more questions. The government has suddenly decided to squeeze out 86 percent of currency in circulation and 55 percent of liquid money. Costs are being imposed on innocent people, and those with black money might lose just a portion of their unaccounted wealth. Is this a good bargain in economic terms? In my view, the costs may outweigh the benefits, especially if you assign proper relative weights to benefits and costs.

When State capacity is limited, we should be mindful of the load that we place upon public administration. The load, of replacing 86% of currency notes with new ones, seems to be a case of premature load bearing, and has given an organisational rout. It is better to cross the river by feeling the stones, with a large number of small moves within an overall strategy.

There are so many known unknowns, and unknown unknowns, that we cannot accurately predict the outcomes, nor can we ensure sound implementation amidst such large scale disruption. It is in the nature of governments to process information that is spread out across the economy, slowly and imperfectly. By the time feedback comes in and leads to change in policy, it is too late. Even the best public policy process will be limited by availability of information and estimation methods. This does not mean that governments shouldn't do anything. It only means that we should internalise these constraints and be modest in our aspirations for government. Complex plans of a certain nature should not be made. This is especially true in a complex, multi-layered society like India.

Governments should build on what they know from experience, and then hand the baton to the next incumbent. Trying to solve the entire problem through shock therapies is too risky. It may have huge unintended consequences. Consider an example: cash that does not come back by March-end. Government will claim that all of it was black money. We cannot assume that. In a country where citizens are generally wary of state, and steer clear of it, even those people who have, over a period of time, tucked away a lakh in cash for rainy day or a future plan might eat some losses due to fear of penal action by the State. Some people living abroad may not consider it worth their while to come back or to get to Indian bank branches in their country to exchange a few thousand rupees they may have. This is an example of known unknowns. The unknown unknowns are the unpredictable conspiracy theories and swindle schemes that might flourish on the fertile soil of ongoing chaos.

Nuclear options should be used only when other options have been tried. Experiments of this scale can be run if there are no alternatives. India still has a long way to go in strengthening the administrative structures that allow and sometimes abet black money creation. Since most of the unaccounted wealth is likely to be with those creating black money, strengthening these structures would not just plug new black money creation, it would also help confiscate unaccounted wealth. To address the problem of black money, we must focus on compliance management to plug creation of black money, and improved enforcement to crack down on unaccounted wealth. Draconian, disruptive decisions seem to admit that reform of the basic institutions of administration has failed. Has the government done all it could on those fronts? For instance, have the recommendations of Tax Administration Reforms Commission been considered and implemented? On black money, as on other issues, the best thing that a government in India can do is to first get the basics right.

Politics of black money


Why did the government take such a drastic step? To understand the answer, we must consider the context in which this decision is being implemented.

In India, there is this mass hysteria about black money. This has been created by a combination of factors: high ticket size corruption scandals; release of information showing nexus between big business and politics; widespread petty corruption; anti-corruption social movements; political mobilisation around the issue of corruption; and so on. The electorate has signaled that this is an issue that they care about. This is the context of this decision. Some have accused the government of taking the decision because of electoral considerations, while supporters of the government say this is a genuine attempt to solve a big problem. Both sides agree on the scale and seriousness of the problem, even while they disagree on intentions and means. One cannot help but wonder whether the issue has been blown out of proportion.

Most of the failures of the Indian State are being blamed on corruption. Capacity is being confused with character. It serves as a simple explanation for all the ills of our governance system. The reality, however, is much more complex.

Estimates of black money in India compare favorably with similar developing countries. In 2010, World Bank had estimated "Shadow Economies" of 162 countries. The weighted average size of the shadow economy of these countries in 2007 was 31 per cent of the official GDP, down from 34 per cent in 1999. For India, it had come down from 23.2 percent to 20.7 per cent. Some would argue that it may have increased since then, but it would still comparable favorably with most comparable countries. Just because we are not doing very badly compared to other countries does not mean that we should be complacent, but this should give us cause to reflect on how big a problem this is, and how we should solve it. This is not an emergency situation, but people perceive it to be so. Where do we go from here?

Black money creation is a problem, although perhaps not as big as it is believed to be. A bigger problem is how India can deliver high GDP growth for at least two decades, before we get into a demographic nightmare scenario. Solving both these problems - black money and sustained high growth - will require considerable improvement in the capacity of the state to perform its basic functions, which includes asserting itself on residents to take its due. If our government thinks that the black money issue is a major justification for doing difficult things, it should use it to take tough decisions that enhance administrative and regulatory capacity. It could be used to justify reforms of tax administration, government expenditure, investigation agencies, regulatory agencies, and even courts (under supervision of Supreme Court). Getting these basics right would serve us better than a large scale disruption that comes at a potentially big economic cost.

These themes are found in many fashionable problems, such as black money, corruption or inequality: they seem to get blown out of proportion and simplistic immediate solutions are then demanded. Statesmanship lies not in pandering to public opinion, but in reshaping it and channeling it towards worthy objectives that strengthen the foundations of our Republic.

Conclusion


The biggest problem in India is the lack of State capacity. State capacity lies in systematic, professional thinking. This article shows the kind of policy thinking that would have been useful in analysing the question of de-notifying the 500/1000 rupee notes. These decisions have far reaching consequences, and it would behoove us to subject them to thorough intellectual analysis, ahead of time. As we are seeing, no amount of frenetic field activity can overcome a bad policy.


The author is a researcher at the National Institute for Public Finance and Policy, New Delhi. I thank Ajay Shah for useful discussions.

41 comments:

  1. Sir, I admire the reasons given by you.it is very rational and informative.
    Sir my question is does rising NPA's of our bank have any role to play with demonitisation? Because none of our bankers and economic advisors are coming forward to explain the situation on behalf of government. We have seen arvind Subramanian writing articles in defence of government but not this time.

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  2. Dear Mr Rai,

    Agree largely with your views. Being a tax professional my suggestion would be that the Govt should come out with an announcement that any cash deposits made by any person for which he is unable to show bonafide source, tax shall be levied at flat 30% plus penalty based on fixed slabs (for eg. cash deposit upto 100 lakhs -Penalty 10lakhs, 100L-500L - 50 lakhs etc) instead of levying 200%, which is a major deterrent for the black money holders to bring the money into the legal system. Intention is to bring the money into the system and not to take venegeance against tax evaders for not complying with Amnesty schemes -Better late than never.
    As rightly mentioned seasoned corruptioners unaccounted money are laundered and lying safe. So if at all there has to be some incentive in this so called surgical strike, the Govt should come out especially the finance ministry on tax administration on the cash deposits thereby incentivize people holding cash to deposit in the bank.

    Further the next step is to take India into an integrated cashless ecosystem. It is tough, but definitely possible. Especially the unorganized sector which is roughly 80%. Appropriate infrastructure to be made and seamless integration should be made. This has to be done immediately as an aftermath to the surgical strike on currency note.

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    1. You above tax proposal are invalid. As government cannot do injustice for people who paid 45% tax in voluntary disclosure schema announce just few months back.

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    2. Further cashless system is not required. IT system are not foolproof against cyberthiefs. Depending on full cashless is not requiredd. Further cash or cashless government should not bother. Government should not have income tax. What ever tax it wants should be raised based on a transactional tax mechanims or withdrawal tax or currency tax. Let people have the money they earned.

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  3. Hi Suyash, Good all round analysis. My observations - Just wonder why RBI cannot extinguish its liabilities by offering a different instrument of equal value. It is not going back on "i promise to pay the bearer....". If someone chooses to decline the offer it is because that person is guilty of misreporting his assets with a different authority viz., the IT department. RBI, as monetary authority is not committing any brazen act. Also, after suggesting that RBI/Govt cannot inflict this loss on the black money holder, you seem to fault that there is not enough punishment/deterrence for future black money creation because the loss is not big enough. I find this contradictory. If the unaccounted money is rendered worthless after 31st march, isn't that sufficient deterrence for at least one generation to think twice before hoarding. Also coupled with other checks in terms of electronic trail on all forms of usage of cash,this could become reasonably effective.

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    1. Another point that has been missed is that even though property is 90% of the black money, with no black money in the system the prices of property are also going to fall. Same with gold and other ways black money is hoarded.

      for e.g if today property costs 10cr(5cr white and 5 cr black) we can expect it to go down to 6cr(5cr white and 1 cr black).

      What people are not realizing is that the the person incurred a notional loss of 4 crs which will deter hoarding black money in future no matter what form.

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  4. Sir any comments on the ensuing "flow" problem? With GST on most goods and services at 18% (against about 15% now) there is no incentive for end customers to demand invoices or use say cards (another 1-2% txn charges)
    In order for the flow to be curbed, there needs to be a set of incentives for the end customers eg something like a pass through on vat bills paid during the year from my tax liability. Clearly a humongous task but there needs to some system designed to ensure things don't revert to cash based BAU once the dust settles

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  5. I think it is the best piece I have read so far on this subject. Congratulations!

    The one thing that I would add is that policy cannot think of market players as binary objects. Either you are honest, or you have stacks of cash, which makes you dishonest. Either you are a good citizen, or anti-national, and so on and so forth. There is always a spectrum and it is harmful to think in 2D space.

    Enough has been said of polarisation in the political space, but not in the economic policy space. You do talk about this in the article especially when you say that cash is neither black nor white, but it might be useful to bring this more centrally, as a pithy phrase, in any ex-ante or ex-post analysis we do.

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  6. One of the better articles, I have read recently on the black money issue. Honestly, it hurts me to see your rationale - it seems correct! I agree with 90% of what you say. Have the same concern as Venkat on RBI not writing down the liabilities.

    I think the primary hit is going to be the hoards of cash (high denominations) that the political parties must have kept for the upcoming state elections.

    It is a scary bet that Modi took. If it is followed by future policies that will actually stop corruption and black money accumulation that will help, otherwise Modi is gonna lose 2019 elections. It is a risky bet given 10% of black money is hoarded in cash.

    Agree with Renuka on 2D thinking we do in policy. The other thing, I came across is that lot of businesses particularly in manufacturing etc. don't prefer to pay taxes because the business requires them to bribe officials for their day to day work. Their concern is - "I am ready to pay all my income tax and other tax liabilities, if I am guaranteed that I don't have to pay any more bribes". Second reason is lot of businesses steal tax on VAT and when their goods cross borders - they bribe sales tax officers etc and NOT pay taxes. Their concern here is if I pay full tax then the cost of my product would become higher than the selling price in the market (assuming others don't pay taxes, their cost will be less) and I lose market share by being an honest citizen.

    Long way to go. But I hope we someday reach cashless economy and can be done with unaccountable income. It is not a small problem when less than 5% of the whole population takes burden of the entire income tax returns.

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  7. The analysis on only three well known angles of thinking, namly,fake currency,terror financing and black money. There are other things which are left out. In banking industry writing of losses quarter after quarter clearly shows that NPA are crippling the banks to function. The public is not privy the seriousness of the banking industry. India had to meet basel 3 normal of capital adequacy not sure how this exercise will benefit basel 3 compliance on Indian banks. India is safe to the extent that banks do not speculate on derivative products. The demonitization exercise introduces banks to most of people. Even to people who are not used to banking. The huge increase in CASA of banks will possible give RBI better moving space to manage the health of banks. It is possible if situation had continued some banks would have collapsed. RBI is already indicating that 10% of the collected money will be left with banks for banking operation.the crr ratio allows for more capital for lending freedom.
    Only 3 percent of indian population are tax payers.
    Out of Indian population wherever tds is possible or tcs is possible government has puts it hands and collected tax. Very miniscule percentage of people can be called as honest tax payer. No one want to share their hard earned money to government. It is only out of fear of tax authorities people pay tax. If tax authorties are lax no one will pay tax. It is okay for financial consultant to look for legal ways and mean to avoid tax. Majority of the traders and people in country who deal with cash convienently avoid tax. The demonitization is like a war level activity in civilian lifes. This whole exercise will enforce upon lot of people who are not tax payer to submit their returns and the tax base will increase. Because government is not able to tax people who are dealing with cash this step will make lot of people shell out unpaid tax. The government even if it does not charge penalty of 200% it will be big amount as it will collect more than 33% of uncollected tax.

    Black money creation is due to attitude of the people of the country it cannot change as people do not want to share their earned money with government. The trust that government is doing good for them is not visibily evident. If government taxes one section of the population and waives of loans to other section of the population for election consideration it is easy money is given off with less effort. Previous governments have done that.

    India should move toward transaction tax and currency tax and get rid of income tax this will make people wil be happy that their income is not taxed both transaction tax and currency tax will be considered cost of business and yet government can estimate it revenue collection based on scale of economy.

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    1. transaction taxes are the worst kind of taxes. GST is a much superior tax. income taxes are somewhere in between. transaction taxes are like reducing the grease in a machine that needs to be well oiled. it simply shrinks the whole economy.those who advocate transaction taxes havent thought it through. transaction taxes dont raise much money at all, but reduce the overall number of transactions. if you dont believe it, look at STT numbers by chidambaram or the effect of 5 pence on plastic bags -transactions reduce by 85%!

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    2. Yeah agreed. It is a friction. If applied for currency dealings it is a deterrent for people to use bank transactions. As well advertized Indian people look for mileage of vehicle even if vehicle is costly. Hence if cash transaction thro banks are taxed people will go for cheques and cashless methods

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  8. Very nice post... But I have a question on your assertion over GDP calculations including black transactions. You write - "...It is important to note that GDP counts all output, whether the production is done with tax evasion or not. The entire impact should be considered as a cost. Money is not black unless tax has already been evaded..."

    Are you sure? From what I understand, GVA is calculated from the value-added of the corporates reporting under MCA21 - alternatively GDP by expenditure is calculated as sum total of final cons. expenditure (I doubt if a business will report turnover unless it wants to pay tax on it).

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  9. Till now there has been no formal articulation about the benefit of currency ban. We have only one speech by PM which was centred about fulfilling his promise about black money. His supporters or would be supporter have added many benefits ranging from cashless economy to price correction in real estate. Whether these fancy benefits were pre thought by the government or is an output of sycophancy is equally probable.

    it is hard to be convinced about any economic benefit as of now. However, the political ramifications are clear. This move will surely kill regional parties who get a good share of their donation from informal sector in cash. Hence, every regional party will some one Amar Singh now to get access to super rich who can pay in formal ways.

    Most probably, it has nothing to do with economics. It is surely a very smart political move to kill regional parties. Such an outcome is surely better than any economic benefit for atleast the ruling party

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  10. What's preventing the 2000 rupee note being counterfeited? They have the same security features as the earlier ones -- http://www.thehindu.com/news/national/demonetisation-of-rupee-notes-no-time-to-add-new-security-features-in-notes-says-official/article9335159.ece

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  11. An interesting aspect of the question is whether there exists state capacity to scrutinise all deposits or deposits above a threshold for tax evasion. In itself it creates immense opportunity for rent seeking by tax officials, whose track record in this space is well established. Even if we assume that all assessment will be done with good intentions, the sheer volume of these is something that the tax department or even the courts (decisions will certainly be appealed) may not be able to deal with.

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    1. This is interesting aspect of the exercise. IT department is now intelligent than before going by notice they are sending to common citizens based on past years it returns. With the technology support of big data and machine learning they teach the computer to identify potential scenarios or pattern of bank credits which can be likely candidates for tax evasion. The technology call supervised machine learning can help it department without much effort in identifiying tax evasion scenarios. As regards to capacity I they will thro the burden on the citizen to explain the sources if it does not match with it returns. There IT department are kind of free for other work. The difficult part is enforcement this can go long as apppeal and reappeal can lengthen realizing the tax collection from the defaulter.
      Ther core part is IT department reliance on Digital technology which PM is often mentioning will be used to automated most of IT work.
      When I spoke to bank offical they said that when credit above 2.5l happens automatically the message is sent to IT department the bank need not compile the data. If bank balance rises suddenly for 0 to 2.5l a message will be send to IT department. These records which IT department sends are available as critical information in database which will scanned using computer algorithms to help IT officials to pick and choose the depositor and ask him to submit IT return if he has not submitted. If a return is already submitted it will matched with return and reason judgment about black money will be arrived at

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    2. flagging an account for deposit over 'x' amount, does not need any sophisticated algorithms, big data or "machine learning". it can be done in a few lines of code in a few minutes.

      the question is what then? what if it is flagged? what if they find that somebody deposited 10 crores but didn't explain it in their returns? what then? right.. then they pay the guy a visit or send him a notice. at the point, what is preventing the offender from paying a bribe to the IT dept with his newly minted Rs. 2000 notes and getting away with it. THAT, right there is the crux of the issue and how black money is generated and tax evaded in the first place. And this stupid "surgical strike" does nothing to address that.

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    3. Rightly said. Big Data machine learning is not to flag, it is pick the likely offender.
      On the second part , that depends on what the objective of PM is on the exercise. And what control and monitoring PM has on IT department and it's officer it also depends on moral of the officers with respect to the exercise. Enforcement is the grey area but still 100 compliance cannot be expected but yet uncollected tax will get collected and RBI will be benefited as RBI does not have to keep its promise for lot of notes which has not been returned.
      Black money is due to attitude of people it cannot be changed. This exercise will cause a shift in people's mind how they should deal with cash. In February budget withdrawal tax is for sure. When you withdraw cash from bank gov will tax.

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    4. >Rightly said. Big Data machine learning is not to flag, it is pick the likely offender.

      >On the second part , that depends on what the objective of PM is on the exercise.

      The "objective" of the PM is not his private business. He needs to spell it out clearly. And if those "objectives" are not met or can provably not be met with the action he has taken, he should be raked over the coals and thrown out of office. Unfortunately, even throwing him out of office may not undo the damage that has already been done and all the damage that is being inflicted as we speak.

      >Black money is due to attitude of people it cannot be changed.

      Then you have to live with it. You have to live with black money and corruption being a way of life. Furthermore, it is utter nonsense to say that black money is "attitude of people". It is not.

      Greed is a human trait... but greed alone cannot create black money. Black money is created wherever and whenever there is scope for human discretion. The real way to combat black money is to strangle it at the points of creation. And the way to strangle it is extensive digitization, computerization, decentralization of government and massive reductions in size of government. Any and all elements of personal human discretion should be removed. Only then will corruption be alleviated (not 100% eliminated). But this action of Modi, as catastrophically far fetching as it is, does NOTHING to address any of the root causes. It has foolishly gone after symptoms and is unraveling as we speak.

      If this ends as badly as I'm fearing it might, Modi will need to be tried for treason and waging war against the state. And history will remember all his cheerleading acolytes as active accomplices. This is like a doctor prescribing chemotherapy to fight a cold.

      aside:
      >Rightly said. Big Data machine learning is not to flag, it is pick the likely offender.
      Wrong for several reasons, but I don't want to go into that discussion now. It is a separate debate.







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    5. My comments are not be glorify PM or what is done by him. PM objective is spelled out clearly in public domain. Our is a representative democracy not participative democracy. People do not decide on everything gov does. What PM decides and what he does is privy to him and his cabinet. There is secrecy which cabinet enjoys everything need not be told in public domain. If certain actions of him are not correct are leading to damages only way it can be remedied is by voting him out. Damage is a relative term, PM has multivaried responsbilities, he has responsiblities to government finances and also well being of his fellow citizens and the nation.
      On the second paragraph I would not strong defend the statement I have mentioned. People are not ready to factor the cost of tax into their calculations. They want to pocket the tax. Government is also a factor why people do like that. When government extends it reach and collects tds or tcs it is doing so forcefully creating and applying law. On areas where government does not have a reach black money is created. There are many people in the so called well of category who despite having enough have a attitude of not returning back to the government what is due by mean such as making it invisible. The word called benami fits here. What do you call such action greed or attitude. Greed everybody has attitude some have.
      You have strong words for PM, time will tell what is the result. Damages on the people at large it is visible for the government the benefits are visible. But one thing is for sure this decision is heartless. Government is trying to act retrospectively which it had said that it will not bring retrospective laws. Trying to tax retrospectively for the past actions is very harsh. Government is trying to snatch from the people its due thro enforcement and is similiar to what you said (strangle) by digital means at point of creation. The demonitization is also strangle at point of creation as cash is where black money originates in India. Question also arise if not now when should we tackle the issue of black money. The problem is the expectation that people should be pay income tax. If that expectation is removed then work black money vanishes.Government taxation should not depend on taxing individuals income it should raise raise tax thro other means which are easily measurable and not dependent on individual disclosure or assessment.
      On third paragraph, Their are numerous data being collected. deposit above 2.5l and deposit above 50k. This has to be combined w;ith data from other sources lt returns. It is not possible by human supervision in reasonable time to determine who has not paid tax. Only 3 to 5% of people are assesses now it may be more. To determine who among the depositors are having large dues the big data technique may be used. If I believe the data is real huge not possible to be manually processed.
      There is another clarification which I like to make their is difference between corruption and blackmoney. Blackmoney is not paying tax, corruption seeking favour to do a work. Corruption applies to official work and by large applies to government officials and employees in public context. Corruption in private place is limited impact mostly controlled by respective enterprises. So when someone say people are corrupt it invariably means government officials and employees and does not apply to people who have not paid taxes.

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  12. "Power is power."

    The author points out that 'As with the white economy, only a small fraction of the total unaccounted wealth is kept as cash.' This is quite likely true, although we should think about how much of the unaccounted wealth is simply appreciation, increase in value of gold and property bought with illegal cash.

    In any case, we are missing a trick here by not recognizing the critical importance of cash black money in the Indian political economy, especially for corrupt government officials. We have ample evidence that nearly every government official caught with disproportionate assets, has large stocks of cash stowed away. Cash is the preferred medium for bribery, for obvious reasons.

    There are of course, deep socio-political reasons that allow corrupt officials to thrive and, by and large, live free from the fear of prosecution. Colonial legacy, the imperatives of caste/patronage politics, low levels of literacy and the continuing dominance of the public sector in formal employment mean that our babus continue to wield disproportionate power. And years of this status quo, have allowed many of them to translate this excess political power into real economic power. The hordes of cash in possession of corrupt government officials, even if a fraction of the 'overall' unaccounted wealth remain an important aspect of this translation.

    This move not only disrupts the smooth translation of such power, but shows abusive officials that the leadership of the country and the public can still hurt ALL of them substantially.

    It is premature to say that this action will shift the balance of power, and change the administrative culture. But if this does work, it adds a potent in the armory of the government. Today its Rs. 500 and Rs. 1000, tomorrow it maybe some other denomination. This has the potential to greatly disrupt the collection of bribes.

    If such a power shift does occur, one can imagine the boost to the morale of the honest officials and the public. You have correctly pointed out that a lot of the problem with the Indian state is about capacity, not character. But character does effect capacity.

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  13. Very well written.. loved it. Economic loss and impact of this decision can still be handled, dealt with. But, social turmoil it has created in incomparable. Govt can not simply say that I told you so... I told you to open bank account.. what good does it do to a labor, farmers and small businessmen, hawkers, rickshaw walas and so many people who do not use bank for day today transactions. You can't force them to be standing in bank for hours to deposit their earnings of lifetime. Someone rightly pointed that BJP might loose 2019 election and I would hate it.

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  14. Point made in this comment is very true. Government can't make people dependent on daily cash suffer.

    BJP has been doing clever thinking. It's thought process will have backup plan to benefit the same people it is troubling now. There significant cash coming to government disposal. RBI dividend plus tax penalties. This amount PM might use to make a major section of citizen happy. Like housing, or other benefit or welfare schemes. Modi mania is still on even after 2 years. Do not rule out Modi in 2019 yet.

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  15. Hi Suyash, nice post.

    I just wanted to add one point to the benefits - wouldn't alteration of behaviour, say people shifting to digital payments, as a result of the measure, be a benefit? To give an idea on some initial leading evidence, some articles are suggesting that people who used to use the Cash On Delivery option on e-commerce have moved to e-wallets, etc. Similarly, I know people who are using their ATM cards for the first time to avoid standing in bank queues. I suspect these people will continue using ATM cards (as adopting to technology involves an initial inertia, and then people find it difficult to go back). Not that this will change the outcome of your CBA, but doesn't a change in behavioural norms factor in, in a CBA?

    Also, since it is so easy to track consumer behaviour in the digital space, it would be an interesting exercise to identify whether consumers really ended up shifting to digital payments, using this as an event study. This will allow one to measure the "effectiveness" of the measure to the extent it has had an impact on behaviour of citizens.

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  16. I think you've overlooked the biggest benefit of this exercise.

    1) Money coming into the formal banking system (more than compensating for the "unproductive hours" bank employees are spending in this exercise). This will improve transmission of monetary policy, reduce borrowing rates due to reduction in bank CoF and potentially kickstart the domestic investment cycle.

    2) While an overall deflationary impact would be negative for growth, over the medium term falling interest rates will increase the real rate of return for savers and in real estate specifically, price corrections will leave more money in the hands of home loan borrowers and boost discretionary spending (of course, this could get offset by reduced property prices for existing real estate investors - but the former, over the medium to long term, will far outnumber the former).

    This is not an exercise of today's or tomorrow's benefits vs immediate costs - this will without doubt add value to the Indian economy.

    Appreciate the rigor and depth of your analysis and insight though.

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  17. What will happen to real estate is question mark. Real estate has strong association. There might be difference in price between organised and unorganised. Currently speculation is how will real estate deals be done with cash component.
    The temptation to go back to old way is there as another demonetization is many years away.

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  18. "Assuming that your giving up some money will lead to a corrupt person losing some money, how many rupees would you be willing to lose to inflict a loss of hundred rupees upon an unknown corrupt persons?" Your premise is not correct at this point, the 100 rs lost by the black money holder is being redistributed in the system, which you did not consider.

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  19. Very well written arrticle. Congratulations.
    Let us add one more dimension - collateral impact. The world now knows that the Indian PM can take bold decisions based on his instincts and impulse without bothering about the consequences. He is probably advised by people who think similarly or unable to present him a coherent alternate view. Couple it with the facts that our Defence minister has an alternate view on the "Nuclear no first use".

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  20. I was thinking of how #Demonetisation could have been done better. Here are my thoughts.

    Govt could have clubbed #Demonetisation with Jan-Dhan account opening earlier or now in second and decisive round. They could have announced first / second round with incentive of Rs. X (how to arrive at it later) be deposited [not credited through Direct Benefit Transfer (DBT)] in new and existing accounts.

    Once account is opened, the beneficiary could have been given Rs. X cash with a credit & debit entry as a practice exercise (a disguise) in simple banking operation of withdrawing money with usual form-filling or otherwise. For this, massive preparation like staff augmentation, availability of Rs. X notes in denomination 100 in all parts of the country could have been done in anticipation of huge rush. Infact, they could have done excess by exaggerating the foot-falls expected per branch.

    Many people from poor economic background who would've not understood or skipped opening the account or for second, third member of the family would have queued up for Jan Dhan not just for DBT & other benefits but for free Rs. X/- in cash!

    There are 210+ million Jan-Dhan opened till now. Assuming this could have gone upto 3/400 million, the cost of this operation could have been around Rs. 3/40 billion (assuming Rs. 100 given out) which could have been absorbed by freeing up of RBI's liability from 500/1000 Rs which is not going to return to its balance sheet. This would have really meant wealth distribution, paying the poor with black money!

    Coming to X. It could be Rs 100 or some multiple of it related to daily wage. Assuming half-day wage is paid (time spent for opening account) it could be Rs 200 based on average Rs 400 daily wage).

    How could this be fool-proof? This would've prepared the banking system for massive foot-falls and availability of Rs. 100 notes across the nation which would have brought down the desperation and need to rush to banks.

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  21. I do not agree with your point that
    'If government and central bank just give up their liability with a 4.5 month notice, it might erode faith in the currency.'

    Inflation is the ultimate test to check faith of population in the domestic currency and post demonetization inflation is likely to come down.

    Chances of Indians storing black money in USD are less. We have seen discontinuation $100 bill by USA worth of $1.2 trillions and launch of new $100 bill in 2013. More than 50% of old $100 bills were stored outside US and are worth of just a paper now. Even Europe is mulling discontinuation of €500 bill.

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  22. Excellent piece by Suyash. Permit me to add my two cents.

    In your point on "Readiness of the banking and postal system", there's one aspect that you seem to have overlooked. What on earth prevented the authorities from ensuring that ATMs could handle the new currency notes without the need for reconfiguring all the machines? It is widely reported that the new Rs.500 and Rs.2000 notes are longer than the width of ATM dispensers. The FM himself announced that it will take an additional 3 weeks to recalibrate/reconfigure/modify over 2 lakh ATMs in the country. What kind of inept bunglers would miss something so obvious? I mean, even a person with "ordinary" common sense would make sure that he has space in his house before buying a new piece of furniture, right?

    It is this kind of blunder, which is now being callously dismissed as inevitable pain, which has raised so many hackles, and rightly so. Even fence-sitters (like me) who are willing to give the government a long rope for this largely symbolic tokenism are completely disillusioned with such fundamental flaws of execution.

    Last but not least, Ajay, congratulations on your tight moderation policy - I have not seen a single abusive or derogatory comment, unlike almost all other discussion fora.

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    1. The PM should have had two team Team A a private team comprising of
      1. His cabinet
      2.All Bank chiefs and bank officers
      3.Essential staff related to the ATM operation across the country
      4. Necessary technical guys
      5. Necessary logistics guys.
      6. The suppliers of the recalibration kit
      7. The PMO officers and his finance secretaries.
      8. RBI and key personnal from RBI
      9. The mint and key personnel from it.
      Take secrecy oath from all of the above. Declare a private date for all of the above to surrender their 500 and 1000 notes.
      The count of above people would definitely be about greater than few thousands.
      Then a have team B after announcement which the entire country and bank official and RBI.

      Even without doing this opposition is finding fault of preference treatment within BJP, what would they say if a Team A was formed.
      What would have happened to the secrecy if team A was formed.
      What strategy would the PM adopt to keep this away from the media.

      It is evident it cannot be preplanned if equality of citizen has to be kept in mind.
      This exercise is similar to a earthquake when it is time to hits its shakes.
      A financial quake.

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  23. I always love a bayesian method to decision making (brownie points even for merely attempting). The article is quite comprehensive, albeit not complete :-). Kudos for a good analysis (even if done with certain predilections for the outcome).This article belabors on the purported costs and risks, but seems to overlook a very fundamental benefit!
    The article seems to suggest that the only benefit of the entire exercise is retribution and nothing else; it calculates the numerical cost for inflicting this retribution - the loss of someone else black money. While I cannot underestimate this benefit of retribution (more on this later), the primary (and 'almost' direct) benefit is the TRANSFERENCE of the (extinguished) black money as funds available to the government for spending. The article debates about the morality of RBI writing off the 'un-deposited' money, but churlishly avoids to talk about the effect of such a write off. That money can be used to increase expenditure on social projects (infrastructure, education etc.) without increasing inflation, deficit or external borrowing!
    Coming back to retribution (I haven't forgotten about this - isn't that the nature of that beast?). Firstly, the math seems a little wonky; how did a 2% cost (via the author's anecdotal data) that reduces logarithmically become a 10% cost? Am I missing something here?
    Sometimes the analysts and policy wonks get lost in complicated while overlooking glaring evidences! The author polled a minuscule sample (who have admittedly have large biases) with a hypothetical question and then weighted and extrapolated the incorrect data to come up with another large number. All this when you have so many people directly telling the reporters on TV that they are more than willing to bear the cost (in terms of discomfort etc.). QED!!! Perhaps, the superfluous exercise is required as an ex-ante analysis (which unfortunately has a direct bearing on his conclusion!!).
    Demonetization is like fumigating the entire country where 'honesty' is the antidote to the poison in the air. The honest person will breathe well and survive, even if inconvenienced for a few hours due by reduced visibility due to the 'mist' in the air; but the dishonest will choke and die in this fumigation!!
    Some other random observations:
    - 'Cost to honest taxpayers' is what will exist (in much larger proportions) with author's alternate solution of better 'Investigation and tax administration'. The fundamental problem is that a large number of people in the country, who appear as poor on paper are actually rich in black money. That is the nature of the informal economy. The only way to better 'investigate' is to multiply the size of IT and ED manifold, so they can raid a large sample of people; rip open their mattresses and smash their cupboards/shelves to look for black money. Firstly, it's uneconomical to raid that many folks; secondly, we don't want a Gestapo in the country!!
    It is a mistake to think that black money always exists in of 100s or 1000s of crores! I am willing to hazard a guess that the vast amount of black money is actually less than 1 crore per instance. Such is the nature of statistics (most natural distributions will fall under a normal curve!). The elite commandos from IT and ED can raid the big fish (or the long tail from the statistical curve metaphor). This would be the 'economical' use of such a department!
    - The issue with a parallel economy is that the government cannot implement an effective 'monetary' policy. The result is that the government will have no levers at all to shape/grow the economy effectively!
    - The compliant seems to be that it doesn’t eradicate the future creation of black money. If you have pneumonia, the first step is to take antibiotics to get cured; vaccination against future occurrences is the NEXT step.

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    1. Responding to the following point made by you: "It is a mistake to think that black money always exists in of 100s or 1000s of crores! I am willing to hazard a guess that the vast amount of black money is actually less than 1 crore per instance. Such is the nature of statistics (most natural distributions will fall under a normal curve!). The elite commandos from IT and ED can raid the big fish (or the long tail from the statistical curve metaphor). This would be the 'economical' use of such a department!"

      Your hypothesis is correct only if you confine the analysis to the CASH component of black money. But the reality is that hard cash forms only about 6% of total unaccounted/untaxed wealth (to use a more formal term). The bulk of it is in the form of real estate (especially land), gold, foreign currency and overseas bank accounts.

      Once you take this fact into account, your theory of the "long tail" doesn't hold. The average ticket size for these kinds of assets is far higher than 1 crore.

      The elite commandos from IT and ED have ALWAYS had the option of going after these big fish, but have not done so, especially with the kind of seriousness and focus demonstrated during this demonetisation exercise. This is not a criticism of the BJP, because every single regime in the past also had this option, but deliberately and consciously chose not to exercise it. Why? I don't think I really need to spell it out, do I? Instead, let me just quote an old African proverb that makes it amply clear: "The mosquito that bites the testicles does not get swatted" (pardon the biological reference).

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    2. I appreciate your response.

      I think few clarifications may be in order.

      If you look at the income distribution in the country, not everyone either earns less than 2.5 lac or more than 1 (or say even 5) crores. There is a vast number of people earning between 2.5 lac and 1 (or 5) crores, who are non-salaried and a greedy enough to evade taxes (these are folks owing a small store etc). Since this number is so large, the cumulative losses in tax collection from this segment is probably much LARGER than that from the smaller group of people earning 10s or 100s of crores.

      It's only 'economical' for the IT staff to investigate the folks possessing 10s or 100s of crores of black money (simply because it has better hit rate and better recovery to effort ratio). Demonetization is an effective tool to extinguish the black money possessed by the small/medium sized crooks.

      Coming to the notion of 6% as cash component in all of black money: It is firstly important to understand where this number comes from. This is the percentage as cash recovered in the raids that IT had previously conducted. As I had already explained above, IT would have primarily targeted the folks with 10s or 100s of crores. It is only logical and logistical (due to available physical space for storage) for someone with that much black money to keep only a small portion in cash. However, the small/medium sized crook would probably hold much higher percentage (20%, 30%, 40% or much more) of his/her black money in cash.

      There is always a penchant in the country to catch the big fish; important point to remember is that all big fish start out as small!! Most of the small/medium crooks rationalize their own crookedness by saying that there's a bigger crook out there and hence he/she is fully justified in their lawlessness until ALL of the big offenders are caught. People in the country need to be cleansed from this notion!!

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  24. Interesting to note that you even suggested better alternatives to this move for eliminating fake currency. But what about black money sir? I see that that is being tackled to some extent by this move.

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  25. The point made here is valid. Drops create a ocean. Many small trader and big trader and doctors(they have the maximum black money entirely cash) would be impacted.
    The enormity of the effort required to bring normalcy is large. Similar would be the enormity of effort of Income tax department as a user mentioned about the capacity of the government to process all in finite time. Sure technolgy would help.
    Would be interesting to observe what announcemnet before UP election would pacify the commoner who have suffered both monetarily because of loss of earning and difficulty due to the project as PM calls it.

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  26. I like this Ex-Ante cost benefit analysis.

    Will this exercise alone in isolation (assuming no more steps to plug avenues of tax evasion) bring black money to GDP ratio considerably below 20% permanently? There are different estimates by different analysts. While Govt. is expecting INR 3 Trillion, some analysts are even expecting INR 4-5 Trillions.

    The immediate benefit claimed is boost in the banking sector especially in public sector banks. But this comes along with assumptions like retention ratio i.e. money that will be held with banks after mass withdrawals, interest rates, spread margins etc.

    Anyway, as of now, as you said, there are so many known unknowns, and unknown unknowns. So, I would also like to read ex-post evaluation from you, may be after 3 to 4 Quarters.

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  27. This exercise is like someone going on a severe fast (that includes going without water) for a month (with its attendant short term discomfort, short term health risks and longer term health problems) to solve severe health problems of over-weight, high cholestrol levels, high sugar levels, etc. Hoping that some sacrifice like this should somehow make the body healthier.

    The tough decision, resolve required to see the fast through, sense of sacrifice, a hope of resolving health problems are all feelings that give a temp high. The first few days of fasting also makes the body feel lighter and better. And then the real test of resolve and if the resolve is there then the test of the physical and mental body kicks in.

    The only way to get healthier is to have the 'will power' and 'resolve' to make longer term corrections in lifestyle, diet and exercise routine. One day, one week and one month fasts and diets might help if done right, might harm if done wrong, might kill if done stupidly but definitely do not leave any longer term benefits.

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  28. What are the other ways Government could have achieved the same demonitisation objectives without cause public pain.
    1. What if government had declared 6 month period by which all 500 and 1000 rupee notes would be replace by its new variants without declaring that it would not be legal the same night.
    2. what if government had banned all cash related transactions with other asset classes(real estate,gold, bonds,forex) such transcation with cash as invalid.
    3.What if government stamps, property registry to closed for the period.
    4.Banks are open for depositing as well as withdrawing cash without affecting economy.
    5.And all purchase above say above 25000 in old currency need to thro bank transaction.

    How would such an arrangement work.

    Currency changing rush would not be there.
    Currency change would happen smoothly
    exchange of old currency with other assets would be blocked
    exchange of old currency with raw material and goods above a certain amount would be thro bank account.
    Poor would not suffer.
    Large queues would not be there.
    And the objective of black money and as well as currency replacement would be achieved

    ReplyDelete

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