As GDP Growth Falls, Has Demonetization Cost Us Big?

Posted by Damanbir Singh in Business and Economy
June 3, 2017

According to official data, India’s GDP growth in the fourth quarter fell to 6.1%, primarily because of demonetization adversely affecting economic activity.  Additionally, Labour Bureau quarterly report released last week stated that casual workers bore the brunt of demonetization, with 1.52 lakh such workers losing their jobs in the three months to December 2016.

When the ban was announced in early November 2016, the Central government stated the following objectives for taking this decision – eradicating counterfeit currency; fighting tax evasion; eliminating black money; and promoting a cashless economy. However, it is becoming apparent that these objectives are far from being met, while at the same time, the costs of the decision continue to be felt to this day.

On the issue of tackling counterfeit currency, new counterfeit notes of ₹500 and ₹2000 denomination appeared within just two months from the day the scheme was announced. Larger denomination notes make it more economical to print counterfeit currency. Thus, issuing the new ₹2000 note, along with continuing ₹500 notes, has made it feasible for such activities to thrive. Counterfeit notes have now been intercepted crossing the Bangladesh border, presumably to fund terrorist activities, as well as finance other illegal operations such as human trafficking, a point raised by Nobel Laureate Kailash Satyarthi.

Image Credit: Sanjeev Verma/Hindustan Times via Getty Images

One important point worth noting here is that the EU recognized the role larger denomination Euro notes played in funding terrorist activities and subsequently phased them out. Meanwhile, domestically, an even larger denomination note is bound to have the reverse effect.

As far as fighting tax evasion and black money activities is concerned, complex tax laws, under regulated real estate sector, political interference in investigative agencies and expensive and lengthy resolution by tribunals and courts make it feasible to still continue such activities post-ban. Until the cost of participating in black money activities becomes higher than that of transacting by legal means, the economy of black money will continue to thrive.

Thus, the introduction of Goods and Services Tax (GST) is bound to have a bigger impact on tackling tax evasion than a note ban, as it simplifies taxes. Consequently, a better way to move forward on the issue would be to rationalise income tax and corporation tax in the same way, namely, a direct tax code. These steps would have the dual effect of increasing tax compliance and incentivizing economic growth. Note ban, on the other hand, is completely and unequivocally bad for the economy, especially for micro and small enterprises.

Similarly, as far as promoting a cashless economy is concerned, this step has hardly been a success. While deposits held with banks and usage of mobile e-wallet applications experienced a surge post-demonetisation, deposit growth has declined recently, as has the usage of such payment applications.

Here, lack of financial inclusion, meaning the proportion of the population with access to banking services, plays a major role. Only 28% of the population having access to the internet. Lack of these services, coupled with the continued presence of larger denomination notes after the ban, incentivises even higher value transactions to be conducted in cash.

Also, unlike countries like the US, where carrying a large amount of cash can result in its seizure by the police, in India, there is no such rule, even though the role of cash during elections is well known.

Therefore, multiple factors are to blame for raising costs of transactions by legal means. Unlike the note ban, these issues require sound policies and their implementation. Being lengthy and politically costly processes, politicians are unwilling to undertake these, even though they are much more effective in the long run. Thus they resort to shortcuts like the ban.

It showcases the tendency of the government to use its powers in a coercive manner as a shortcut, rather than incentivising citizen behaviour through better laws and their better implementation. Correcting this would require better parliamentary oversight over executive decision making, and better representation of people’s interest in the parliament itself, so as to make executive action accountable.