Costs and benefits of the currency swap, part II

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In his 8 November address announcing the currency swap, Prime Minister Narendra Modi mentioned three goals: corruption, black money and terrorism. People understand the first goal—corruption. It earns rents for its practitioners. Those rents are actually extracted. The income generated is black and the activity performed to earn it is illegal and, in most cases, unethical. Hence, support for the currency exchange remains strong. For most people, it is a case of schadenfreude. That does not guarantee long-term success of the policy or public satisfaction with it. Perverse happiness can give way to a sour and bitter aftertaste.

Further, that nearly 90% of the Specified Bank Notes (SBNs) withdrawn have been deposited into the banking system is not so much an indictment of the government as it is that of Indian society. In fact, the worry is over the implications if more than 100% of SBNs find their way into banks. More than that being very bad news, it will be very sad news and in many ways. It will raise profound questions over the future of the Indian economy and the Indian state. Regardless of whether that risk is realized, the implication of the deposit of nearly 90% of the withdrawn SBNs is that the future generation of black money through corruption will continue. Corrupt Indians, it seems, are able to beat the system because the system lacks credibility.

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While it is welcome that the Prime Minister has demanded that all members of Parliament and state legislatures from the ruling Bharatiya Janata Party declare their bank account details post-currency swap and warned that political parties can get scrutinized too, the root cause of corruption—political patronage for cash—remains untouched by this exercise. Unless the conduct of elections and the running of political parties are subject to the same rules as the rest of the country is, the extinction of the stock of SBNs won’t stop generation of further black money through corruption. Incidentally, the government’s statement and clarification on the question of declaration of old bank notes with political parties reinforces cynicism.

The second goal of the exercise is black money. Most equate black money with corruption. But corruption is a subset. The informal economy too, whether we like it or not, is a subset of black money. Readers should refer to the taxonomy of underground economy developed by professor Friedrich Schneider (Shadow Economies And Corruption All Over The World: What Do We Really Know?, September 2006).

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Regardless of whether the activity pursued is legal or not, if the enterprise is unregistered, unregulated and untaxed, then it generates black money. Of course, if the income so earned is below the tax threshold, it may not be an issue but the non-reporting may be a problem in other aspects. Nonetheless, given that nearly 84% of the total employment in the country is informal employment, unreported tax-liable income earned in cash even in the pursuit of legitimate activity is likely substantial.

Schneider discusses a concept called tax morality. Declining tax morality means that more people are willing to join the shadow economy. That depends on not just tax rates but also tax administration.

In international empirical analysis, indirect taxation has a significant explanatory role. That is why the new goods and services tax (GST) should have focused less on revenue-neutrality (who knows the rate that would ensure it?) and more on ease of administration and compliance. Too many rates and cess on top of that defeat the purpose.

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On direct taxes, the coming budget should be more radical than the previous three budgets of this government. Not only should tax rates be lowered, and tax slabs reduced and simplified, but the taxation threshold amounts should go up substantially. If “Operation Currency Swap” was meant to raise the costs of dishonesty and regardless of whether it achieved that in practice, it is also time to raise the rewards for honesty. The marginal evader should be made to turn marginal compliant.

In his article for Financial Times, Ken Rogoff wrote that Modi was aiming for a mindset change with his currency swap. That is a fourth but unstated goal. Therefore, the success of the exercise with respect to these three goals (corruption, black money and mindset shift) other than terrorism should be measured in the following ways: above-trend increase in the number of income-tax filers and payers, in the ratio of non-corporate income tax to GDP, reduction in employment in the informal sector and rise in employment in the formal sector; an increase in the average size of factories and production units in terms of employment and output.

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In other words, “the missing middle” in India’s production should vanish. Merely using the funds in the banking system to provide loans to the informal sector without enhancing their performance, productivity, formalization and scaling up is a futile exercise, and no different from a “loan mela” of the past.

If the withdrawal of SBNs is deemed a failure, it will have two benefits and one cost. It will hold a mirror to Indian attitudes and state capability. That the reflections are ugly serve as a useful reality check. Second, the government will learn to rely on a wider body of genuine experts and not a narrow circle of advisers with pet ideas for its remaining term in office. The cost will be that the risk of a Third Front government with Congress support (or vice-versa) in 2019, will become very real.