Different Dimensions of Scrapping of High Denomination Currency Notes

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TOPIC: General Studies 2

• Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

The government took a drastic step of demonetisation on 8^th November 2016 by scrapping currency notes of Rs. 500 and Rs. 1000 where it was nearly made a non-legal tender since the next day.

Why demonetisation?

The main motto of demonetisation by PM was:

1. To tackle black money in the economy
2. To eliminate fake currency and dodgy funds which have been used by terror groups to fund terrorism in India.

Black money

There is a difference between black money and black economy.

Black money is the money that’s not taxed in system. So it is basically unaccounted money.

Black economy includes in its purview the income derived from illegal activities like smuggling, money laundering, criminal activity.

Though black money is generated through legitimate activity, it still forms part of black economy as the result of legitimate activities is not offered for taxation.

Will the purpose be achieved?

The demonetisation step by government is going to have limited success because it may neutralise the efforts of counterfeiting and terror money but not eliminate generation of black money.

Black money is never because of the high currency note. It is highly present in real estate which is ploughed back into the country through tax havens, FDIs and FIIs, hoarded in jewellery and other precious materials. It cannot be eliminated just through demonetisation as its generation is not technical but because of system flaws.

Another concern has been counterfeit currency which was smuggled into country with objective of affecting Indian economy as well as terror funding.

Hence, it could be effective measure against these which have been flowing from across the border.

Indian economy has some strength because of cash economy. Cash economy has faster transaction rate and lower default rate and thus there is no need to chase anybody to recover money. However, there do exist chances of leakages as well as evasion. Hence, there has to be a perfect mechanism and balance between cash and bank economy given the nature of Indian economy. Instead of demonetisation, currency notes with better security mechanisms could have been introduced.

Previous instances

Demonetisation of higher currency notes happened in 1946 and 1978.

Rs 1,000 and Rs 10,000 bank notes were in circulation prior to January 1946. Higher denomination banknotes of Rs 1,000, Rs 5,000 and Rs 10,000 were reintroduced in 1954 and all of them were demonetized in January 1978. However the impact was not felt so much by common man as the size of economy was small compared to today. Also, the black money was 4% of GDP in 1955 which is now more than 60% of GDP.

This happened not only because of evasion but because there is systematic effort by the drivers of black economy that there could be nexus between politics and business, corporate and other houses in the society.

Hence, elimination of high currency notes will not lead to liquidation of black money. This requires systematic dismantling of structure which are basically creating black economy in system.

Effect of demonetisation

There was chaos in the market as daily wagers, vegetable vendors, retailers were not accepting old notes. The new higher denomination notes were also not easily available. Notes of denominations Rs. 100 and Rs. 50 were so much in demand that there was a potential crisis in their supply also within society. As a result, the economic activity at retail level and micro level was stopped virtually.

The banks had to face most critical situation as they were not logistically equipped to deal with this kind of a situation. So there was equivalent chaos in banks as in markets.

Though it is said that instead of dismantling the currency, there could have been smooth transition to have these transferred or exchanged by the people. This would have enabled them to understand and embrace the change to digital modes of transactions. But it is very well known that even if 5 months were given to people to accept the change from cash to non-cash, it would not have been possible as mindset was set. So time period was not a matter of concern. More important was to understand if the mechanism shall work for which it was intended — to root out the black money.

80% of India’s economy is cash economy. It is difficult for the rural economy to be entirely transformed into plastic money with one single policy decision.

Tax administration reforms

In pre 1990s, the marginal tax rate was very high at around 93.5%, which deterred compliance. Post 1991 reforms, there were concessions and liberal measures which increased the tax to GDP ratio. Even Kelkar Committee gave suggestions on moderate tax rates, expansion of tax base etc. Now even the marginal tax rate is 30.9%, yet the compliance rate has not really gone up. This shows that compliance has nothing to do with lowering of tax rates. Tax rates changes affects the middle level people more than the propertied class or corporate class which are really not affected by it.

The average income of the people in the country is not high. Thus, widening of tax net cannot sufficiently give desired results unless people have higher income. In addition to it, there are many who don’t pay income tax inspite of having taxable income. Such tax evaders need to be first identified and made to pay penalties over and above taxes.

Recently, the strict nature of government helped in collection of Rs. 65000 crore as taxes. Thus, if there is need to increase the tax base or tax payers, there must be a strong enforcement mechanism. The IT department should be logistically equipped in more effective way to deal with tax evasion so as to limit the gradual dilution of process of enforcement as always observed.

Key word:

Marginal Tax Rate: it is the tax rate that is applicable for each tax bracket of a taxpayer’s income or other taxable income for which he or she qualifies. It is the percentage taken from the taxpayer’s next rupee of taxable income over and above a set income threshold. As an individual’s income rises so will his or her marginal tax rate.

The main objective of marginal tax rates is to tax individuals on the basis of what they earn, where people with lower income are taxed at lower rates as compared to people with higher income.

Connecting the dots:

• Demonetisation has impacted the societal canvass of inequality and unaffordability. Do you agree? Discuss.