Demonetisation: Mr Modi Can Still Salvage a Terrible Decision

After the audacious move of demonetisation, PM Modi should now go for bold tax reforms, writes Sanjiv Bhatia.

PM Modi’s decision to demonetise the currency was a bold move, but not the right one. (Photo: Hardeep Singh/The Quint)

When people start losing faith in the currency, it marks the start of a nation’s decline…

Thomas Jefferson, former US President

Mr Modi’s decision to demonetise the currency was a bold move, but not the right one. And bold moves can boomerang in a big way if improperly conceived. This decision will have major repercussions for the economy and is a huge overreach by the government.

There is virtual unanimity among economists that demonetisation, except in rare cases of hyperinflation, is really counterproductive. In the annals of economic history, demonetisation as a tool to curb either corruption or black money, is unheard of. No developed country has ever used demonetisation as a tool to either fight corruption or eradicate black money.

People wait outside banks to exchange currency notes in New Delhi on 11 November 2016. (Photo: IANS)

Focus on Minimum Government

Tax evasion and corruption are criminal issues that are best handled by the criminal justice system and not by messing around with the lifeline viz., the currency of a nation. Surely there are better ways to address both corruption and black money without the unintended economic consequences of demonetisation.

Corruption stems from the ability of someone in a position of authority and power to extract rent from those requiring benefits that such authority can bestow. As a result, large-scale corruption happens in transactions which involve the government. So if PM Modi wants to reduce corruption he doesn’t have to look far. The institution he heads is broken and changing the colour of the currency will do nothing to abate this systemic corruption.

Corruption will be effectively addressed only by reducing the size, scope, and power of the government, developing a strong criminal justice system, and applying laws fairly and equally to all citizens. Mrs Gandhi demonetised the currency in 1971, as did Morarji Desai in 1978, and we all know what has happened to corruption since.

Rs 500 and Rs 1,000 notes were discontinued from the midnight of 8 November as a step to curb black money. (Photo: PTI)

Rooting Out the Evil of Black Money

The other issue is that of black money. It is doubtful that PM Modi sought advice from economists on this. In fact, it now appears quite likely that Raghuram Rajan’s abrupt resignation might have been brought about by his disagreement with Modi on this drastic and unnecessary step. Did the PM, or his advisers ever consider other more effective and less draconian ways to address the issue of black money? Did they ever try to understand the root cause of this black money and develop strategies to address that?

By demonetising the currency PM Modi has effectively removed more than half the capital from the economy without addressing the root cause of black money. Black money is real money made by real people using real labour. It is not stolen money; it is money hard workiPMng people earn, but on which the government has not gotten its pound of flesh in taxes.

So while demonetisation might have reduced the stock of black money from the system, how will it address the flow of new black money? (Photo: Rhythum Seth/ The Quint)

Stopping the Flow of New Black Money

More than 97 percent of Indians don’t pay any taxes. Many have incomes that fall below the threshold, but most don’t pay taxes because they see how inefficiently the government uses their hard earned tax money, how that money is openly stolen by politicians in one scam or another, or how generously politicians use that money to buy favour with voters.

In addition, a complicated tax code, bizarre tax regulations, high tax rates, and corrupt enforcement encourage the creation of black money. So while demonetisation might have reduced the stock of black money from the system, how will it address the flow of new black money which is being created as we read this article?

A simpler tax code, with low tax rates, coupled with heavy penalties and jail times for tax evasion, would do more to curb black money than destroying a nation’s currency, stalling its economy, and creating untold hardship for millions.

Can the PM somehow salvage the situation and possibly make a positive out of a huge negative. There are two thingsModi must do immediately.

Modi should soon introduce a big bang tax reform that will make the concept of black money obsolete. (Photo: Reuters)

What Can PM Modi Do?

Firstly, he must announce that the tax immunity that expired on 31 September will be extended to 31 December. The black money component of the stocked cash is only about 30 percent. The rest of it is real money which unfortunately is also getting destroyed with demonetisation. And middlemen are already coming up with creative ways to convert the black to white and extract premium. A tax immunity would at least ensure that this premium would instead go to the public exchequer.

Secondly, he should declare an end to all taxation the way it exists today, and replace all existing taxes ( with the exception of import duties) with a simple 15 percent value added tax on consumption. 

That way people automatically pay their taxes when they consume goods and services, so there would be no black money. The poor would get an offsetting credit, based on their income, deposited directly in their accounts.

The value added tax is similar to the GST reform currently underway but would include all taxes not just the indirect taxes currently contemplated. Imagine the huge boost to an economy if income taxes and corporate taxes were abolished and replaced by a simple 15 percent value added tax applied uniformly across all industries.

This rate would be revenue-neutral and would greatly simplify tax policy, increase compliance, get rid of black money, broaden the tax base, increase tax revenue, and provide a huge boost to the economy.

It would be a real game changer for India.

(The writer is Managing Director, Centre for Environmental and Economic Policy. He can be reached @SanjivbDr. This is a personal blog and the views expressed above are the author’s own. The Quint neither endorses nor is responsible for the same.)