No relief from black money

The stated purpose of demonetisation was to rid the country of the menace of black money. Presumption was that politicians, bureaucrats and businessmen holding large amounts of black money will not be able to convert it into white and they will suffer huge losses.

They will not dare to indulge in black activities henceforth. This expectation has, however, been belied. Black money holders have found various ways of managing around demonetisation. Perhaps the most popular method is to work through the banking system. People have told me that bank managers are charging 10 to 40 percent to convert old notes into new.

Chartered accountants are depositing black money in the accounts of shell companies. Businesses are recycling black money through temple trusts. It is possible that the government may hunt these transactions and take punitive action subsequently. Such is not likely though. I spoke with two newspaper editors from Gujarat.

Both said in one voice that black money increased in Gujarat during the tenure of Narendra Modi as chief minister. Modi may have implemented projects like bus lanes and may have weeded out corruption at lower levels such as in making drivers license, but he utterly failed to control black money. As such it is even less probable that he will be able to weed out black money at the national level.

The government has already admitted the failure of demonetisation. It became clear to the Finance Minister that holders were able to convert black money into white. In the process, the government was left high and dry. The government had expected that people will pay taxes of 85 per cent to convert black money into white. But this did not happen.

As a result the Finance Minister opened a new window for the conversion black money into white. One can deposit black money in old notes in Prime Minister Garib Kalyan Kosh and pay 50 per cent tax, and keep 25 per cent of the money in interest-free deposit for 4 years. The interest lost on this money works out to about 12 per cent. Thus, the effective cost of conversion of black money under the scheme comes to 62 per cent.

The government was dangling a carrot in front of the black money holders to pay 62 per cent instead of 85 per cent. However, is still too steep to be attractive. The rate for conversion of old into new notes varies between 10 per cent in Bengaluru and 40 per cent in Mumbai according to information available with me. It appears that large amounts of old notes were being surreptitiously converted by these players.

The government was not able to prevent this illegal conversion. Therefore, it decided to ease the conversion legally by reducing the tax. Thus, while introducing the above Income Tax Amendment Bill, the Finance Minister said that it came to the government's notice that some people were trying to illegally exchange the demonetised Rs 1000 and Rs 500 currency notes hence this new window was opened.

It is unlikely that much black money will be unearthed due to demonetisation because it is possible to convert in the grey market at rates much less than 62 per cent offered in the new window. In any event, big players do not keep large stocks of currency notes. Experts estimate that only 3-4 per cent of black money is held in currency notes. Reason is that keeping black money in currency notes runs the risk of a raid by Income Tax officials. The money also does not earn interest. Its value declines with inflation.

Therefore, they place black money in other storehouses. The first preferred storehouse is foreign banks. A knowledgeable person said that a former chief minister of UP used to stack currency notes like bales of cotton in a godown. However, the money was deposited in a foreign bank before the person demitted office. Businessmen regularly send their black money abroad by under-invoicing exports and over-invoicing imports.

Say a businessman exports a container of electrical parts for Rs 1 crore. He raises a bill of only Rs 70 lacs and collects Rs 30 lacs from the importer in the United States and deposits it in a bank there. Similarly, a businessman may import goods of Rs 70 lacs but ask the opposite party to raise a bill for Rs 1 crore. He pays Rs 1 crore for the import and collects Rs 30 lacs in the United States.

Such movement of back money out of India has increased after demonetisation as indicated in the decline of the rupee in the last 3 weeks. The decline means there is high demand for dollars. People are buying dollars to send money abroad in large quantities. The second mode of storing black money is to invest in property, gold or business. A businessman evaded taxes and generated crores of black money every month.

He would invest this amount in the construction of a new factory. The black money was used to buy cement and steel and ‘disappeared’. Government officials and politicians regularly invest in property and gold. All these storehouses remain unaffected. Businesses generate black money to avoid paying taxes. It was necessary to reduce the rates of tax so that the incentive to evade tax is less.

This has not been done hence generation of black money will continue as previously. Therefore, demonetisation is not likely to help reduce the menace of black money. The government has made it known that it will next make a surgical strike against benami property and undeclared stocks of gold. Such measures will only push the black money abroad. People fear that the government may demonetise the new notes of Rs 2000 again.

Some fear that notes of Rs 100 too may be demonetised. Such a fear will be immensely harmful for the economy. It will encourage the players to remit their black money abroad so as to remain out of the reach of the Indian government. You cannot train a wild horse in an open field. Trainers erect borders around a field before they start whipping a wild horse.

The government must similarly erect impermeable financial borders before it starts attacking black money. The present measures will only make money flee from the country just as a young lad runs away from home if subjected to too much strictness. Author was formerly Professor of Economics at IIM Bengaluru

By Dr Bharat Jhunjhunwala