Trouble ahead for the economy

People of the country are elated at the bold step of demonetisation taken by the government. However, there is a need to take a dispassionate look at the deeper impacts of this move. Finance Minister Arun Jaitley has said that demonetisation will lead to an increase in tax collection because of higher tax compliance. That is correct. But higher tax compliance means that people will have to pay more taxes.

The shopkeeper was selling cloth till now at Rs 30 per metre because he was buying the cloth in cash from the power loom owner who was not paying taxes. Now, he will buy the same cloth at Rs 35 per metre because the power loom owner will have to pay tax. This will lead to a reduction in the purchasing power of the consumer and a corresponding decline in his standard of living.

The final impact of demonetisation though will depend upon the direction in which the increased revenues are used. Say, the government uses the additional revenues for improving the sewage system in the villages and slums. That will lead to less sickness. The consumer will spend less on medicines. He will pay Rs 50 in additional taxes on the purchase of 10 metres of cloth but will save Rs 100 per month on the expenditures on medicines. Or the government uses the additional taxes for making roads. People will then save petrol and repair expenditures incurred by them.

The loss of purchasing power due to higher taxes on cloth will be more than compensated by lower expenditures on health care or on repairs of the motorcycle. Now consider a different scenario. Say, the government uses the additional revenues to pay higher salaries to the government servants. The services provided by the government to the people will remain as they were previously. The consumer will pay an additional Rs 50 as tax on the purchase of cloth but will get nothing in return.

The final impact of demonetisation, therefore, will depend upon the direction of the government expenditures. The impact will be positive if the government uses the revenues to provide additional facilities to the people. In this case, the loss of purchasing power in hands of the consumer will be compensated by savings in heath care and increased incomes from better roads. The impact will be negative if the revenues are used for increasing government consumption. In that case, the loss of purchasing power in hands of the consumer will become loss proposition. The additional burden will not be compensated.

The present direction of government expenditures does not give much hope. Reports indicate that there has been a reduction in the capital expenditure of the Central government. Recently, international rating agencies Standard and Poor and Fitch had to downgrade India’s rating citing poor state of public finances. Other agencies have lowered the expected rate of growth in the coming year. Demonetisation and the consequent the increase in tax collection is likely to have a negative impact on the people in this situation.

The second positive impact mentioned by government is that public sector banks have become flush with funds. This is correct. However, the impact of this will depend upon the direction that the money is deployed. One possibility is that the banks may deploy these deposits in giving loans to businesses. They can lower the interest rates. Businesses would then find it profitable to put up new factories because they can borrow at lower rates of interest. Unfortunately, such a beneficial impact is not likely to take place.

The Reserve Bank of India has directed the banks that they must place the additional deposits got by them with the Reserve Bank. Therefore, liquidity of the banks is not likely to improve, interest rates will not come down and bank will not lend more to the businesses. The decline in economic activity is likely to take place for another reason. Industries will be willing to borrow from the banks if there is demand in the market.

However, as explained above, the purchasing power in hands of the consumer is likely to reduce because of increased taxes paid by him. The cost of cloth in the market will increase. The consumer will buy 9 metres of cloth now instead of 10 metres of cloth he brought previously. The demand for cloth in the market will be less. Power loom owners will not be able to sell their cloth and they will employ fewer workers.

This will lead to further reduction in demand in the market. Consequently, it is less likely that industries will borrow or banks will lend to industries. On the other hand, the banks will make more purchases of government bonds. That will make more money available to the government for meeting its unproductive expenditures such as paying higher salaries to government servants.

The beneficial impact on businesses from a reduction of black money, therefore, is not likely to take place. Moreover, black money and corruption in the country may get dollarised. This happened in Russia. People lost their lifetime savings when Soviet Russia collapsed. Since then they have been keeping their savings in euros or dollars. Officials in that country routinely demand bribes in dollars rather than roubles.

We may see a similar tendency in India. The corrupt officials may lose faith in the rupee and start demanding that bribes be paid in dollars. Politicians, bureaucrats and businessmen may start stashing their hidden incomes in foreign countries. One knowledgeable person has told me that a former chief minister has stashed away Rs 8,000 crores in a single bank in Australia.

The recent decline in the value of the rupee indicates that the demand for dollars has increased. People are afraid of keeping their savings—white or black—in the country. They are finding ways of sending money abroad. This tendency will increase and this will further deflate the Indian economy.

Demonetisation will be a boon for the economy only if steps are taken quickly to prevent the above mentioned negative impacts. First step required is to reduce the rate of taxes so that the incentive to evade taxes is reduced. Then the incentive to evade taxes will be less. The rate of income tax too should be reduced. That will reduce the incentive for people to send their income out of the country.

Second step required is to take strict measures to control corruption at the lower levels. Indian economy will be in trouble due to demonetisation if these steps are not taken immediately. Author was formerly Professor of Economics at IIM Bengaluru

By Dr Bharat Jhunjhunwala