Demonetization… The Good, the Bad and the Ugly

Part One: The Basic Background of the Cash Economy

Demonetization:

As per the Investopedia “Demonetization is the act of stripping a currency unit of its status as legal tender. Demonetization is necessary whenever there is a change of national currency. The old unit of currency must be retired and replaced with a new currency unit”.

The demonetization of Rs. 500 and 1000 notes had been the subject of discussions everywhere. Why was is done is the first question… people have opinions like “It will abolish black money”, “it will bring down the corruption”, “It will hurt rich people with huge cash hoards”, “it will hurt politicians and bureaucrats who have hoarded large volumes of cash through corrupt practicesWell, while most of these goals are correct, there are many other aspects of the demonetization move and it needs to be complemented with other measures to achieve all these goals.

Question comesWhat is black money”  is it the money earned from illegal activities like drugs, prostitution, smuggling, etc.  or is it the money someone has but not declared as his/her income in order to avoid tax on it, or is it all that cash that is in circulation without any trace or track of it be its purpose, nature of transaction, origin of it and destination of it.  In my opinion, it is all of the above.

All economies in the world have a Currency and all economies have a large volume of Cash in Circulation. But the difference is, do the Government authorities know where this Cash is coming from and where is it going. Can it be tracked? The answer in most cases is “NO”. Cash cannot be tracked and hence, it becomes very difficult to say what purpose the cash is serving. Is it just the liquidity required to carry out the day to day business and trade or is it that is facilitating illegal activities in the country. When this Cash becomes the larger part of the economy then it is alarming as more and more of trade and activities are happening in the country that has less and less accountability and traceability.

Cash in Indian Economy

Coming to the case of India where the Cash economy forms almost 97% of its transactions volumes (Mind boggling and alarming) and most of it about 84% is done using two largest denominations viz. Rs.1000 and Rs.500 notes. Now, going back to the question, how come such a large economy is so much cash dependent. Why there is an absence of transactions that are digital/electronic or through banking channels using Electronic Funds Transfer (EFT). India has one of the best and most robust banking networks in the world and we have probably the best track record for our banks to be financially solvent. I see two basic reasons for that…

  1. “Checks” in India are unreliable instrument for any financial transactions specially when it is issued by any individual. These checks carry no credibility whatsoever, as getting a check dishonored is not taken seriously either by the issuer, the bank or the authorities. Checks bounce routinely and checks are stopped as a common practice without much accountability. If you have a bounced check, pursuing legal measures would seriously drain you more than you stand to gain from it.
  2. While Banks have a large network of its branches across India, still there are pockets of population that does not have access to Banking Network. The lack of basic infrastructure like reliable availability of Electricity and Communication Infrastructure makes Electronic Funds Transfer very challenging. However, it is getting better and it is now when Indian Economy should start to move to Electronic/Plastic transactions.
  3. Thirdly, it’s easier to transact in cash than to pay charges to the bank for electronic funds transfer. Cash is so much in abundance in our economy that arranging any volumes or amounts in cash is never a problem.

You can get crores of Rupees in large bills any time. If you have money in the bank, you can withdraw it from bank without any questions asked; if you have a credit with a supplier, you can ask him to pay you in cash; if you have a friend you can borrow money from him in cash. It’s so easy to get Cash that you don’t really bother to transact in any other form.

The problem comes only when this Cash needs to go back into the Banking channels or routed through electronic medium. Now, this money coming into your account need to be accounted for, included in your Income statement, maybe taxed as well. So, what is the way out? Keep it in Cash. No Questions asked and no one gets any wiser. You buy Property – pay in Cash, you buy grocery – Paid in cash, you want to buy Gold – Pay in cash. Why bother to use checks, credit/debit cards, electronic funds transfer and pay someone the charges for these transactions and also account for these transactions. You save not just EFT charges, but also the Sales Tax, VAT, Service Tax, etc.

Whom it is hurting… it all looks to be working perfectly then why rock the boat, why to disturb the status quo…!!! Because, It is hurting the Indian Economy… and it is hurting the all the Honest Tax Paying population which again happens to be just a fraction of the total earning population of the country. It is Hurting the Government earnings. Government budget is getting into wider fiscal deficit year on year basis.  What can be done to help this fiscal deficit? Increase taxes, add all kind of cess to the Tax paying people and kill them with the burden of tax while rest of the economy keeps running on Cash without paying a single penny to the Government, Authorities, Banks and Financial institutions. It is so unfair on the Tax Paying population that they have carry the load of 84% of the population who does not believe in paying taxes.

Government introduces Service Tax & VAT hoping it will improve collections, It brings GST hoping it will reform tax collection and increase the top line for the Government but nothing seems to work… where is the flaw…??? Flaw is the Cash. Transactions keep happening in Cash which eliminates any need for Bills and Invoices hence these cash transactions can be avoided to be accounted and hence no Tax to be paid… No VAT, No Service Tax, No GST and not even Income Tax as the establishment is not showing any income.

Root Cause of Fiscal Deficit is the Cash volumes and unaccounted cash transactions which happen without paying any kind of tax. Common to see Shops are full of merchandise & customers, bustling with business, transactions happening at mad volumes but, the there is no accounted revenue for these businesses and consequently no income to show and hence no tax to be collected or paid. Government remains poor, while this Cash Economy balloons up with all the Untaxed money and “Zero” accountability. As a last measure, Government brings FDI, borrows money from IMF, BRICS, World Bank for infrastructure projects and eventually, all this needs to be paid back and hence increases Tax further to maintain the balance of payment.

People are buying more as they have more disposable cash while Banks remain without much liquidity… so Banks increase Interest rates on Deposits to lure people to bank their savings. Higher deposit Interest rates increases Lending rates and hence higher cost of funds and inflation. People still do not go to bank as they have got cash to pay. Depositing their Cash in the bank in these deposit schemes will make the Taxman wiser about their money. The Tax paying community again comes to rescue. They save whatever they can and put their money in banks to earn interests which is then lent to the businesses who in turn show not much of profits or even declare themselves as bankrupt and Bank has to write them off as NPA. It’s the Tax Payer whose money has been lost. Not the businessman, not the person Transacting in cash.

QUESTIONS:

  1. Is it only the responsibility of few Tax Paying Population only to fund the Government while the larger earning population avoid Tax and enjoy the benefits of Government Schemes and social security? I am sure everyone would agree that funding the government is the responsibility of all earning and consumer population of the country and it is Government’s right to impose taxes to run the economy.
  2. Is it that people to blame who don’t want to pay VAT/GST or Service Tax to keep their costs lower for their purchases? Yes, each and every one who has ever purchased any goods or services and did not obtain the receipt/invoice. These transactions have probably gone unaccounted and hence no Tax collection for the Government.
  3. Is it the businessman who is getting the most benefit from the Cash Transactions or is it the consumer who is the bigger beneficiary here?
  4. What is the way out of this Cash
  5. How can this vicious cycle be broken?

Although, we have got few answers, but we will get deeper into these questions in later parts. Breaking the Vicious Cycle in Part-2 keep reading.

 

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About Rajeev

Known as "Guru" the author has a wide and broad interests from Food, Technology, Health, LifeStyle and Spiritual Yoga. As an Energy Professional with extensive Technology Experience specializing in Program Management, Business Transformation and Strategic Management. Likes to simplify Technology that can be used in everyday life without needing to be a whiz.

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