This year’s survey is out and has a full chapter dedicated to on the aspect of “Demonetization”, which is summarized in this article.
Survey describes Demonetization as
“A radical governance-cum-social engineering measure, radical and unprecedented step with short term costs and long term benefits where the aim of the action was:
to curb corruption,
the use of high denomination notes for terrorist activities, and
The accumulation of “black money”, generated by income that has not been declared to the tax authorities.
To signal a regime change, emphasizing the government’s determination to penalize illicit activities and the associated wealth.
Survey also describes ‘Demonetization’ as unique and unprecedented in international economic history, as it combines secrecy and suddenness amidst normal political and economic conditions. All other steps in the world were under the conditions of hyperinflation, wars and political upheavals.
Survey also called this move as unconventional monetary policy because, in the wake of Global Financial crisis (GFC) advanced economies used monetary policy to stimulate growth like negative interest rates and “helicopter drops” (referring to expansion of money supply) of money. This move was reverse of it, it has reduced the cash supply, hence it could be considered “helicopter hoover”
The survey says that the action was taken as follow-up step to a series of earlier efforts to curb such illicit activities.
Creation of the Special Investigation Team (SIT) in the 2014 budget;
The Black Money Act, 2015;
The Benami Transactions Act of 2016;
The information exchange agreement with Switzerland;
Changes in the tax treaties with Mauritius and Cyprus; and
The Income Disclosure Scheme.
Short-term costs of Demonetization
Inconvenience and hardships- especially of those in the informal sectors and cash intensive sectors of the economy who may have lost income and unemployment.
Reduction in consumption there by Growth slowed, as demonetisation reduced demand (cash, private wealth), supply (reduced liquidity and working capital, and disrupted supply chains), and increased uncertainty
Job losses, decline in farm incomes, social disruption, especially in cash-intensive sectors
Uncertainty increased, as firms and households were unsure of the economic impact and implications for future policy Investment decisions and durable goods purchases postponed.
Demonetization affects the economy through three different channels
Aggregate demand shock- because it reduces the supply of money in the form of cash and affects the private wealth i.e., unaccounted money
Aggregate supply shock- for ex, agricultural production might be affected since sowing requires laborers to be paid in cash, and also make it difficult for them to buy inputs.
Uncertainty shock- because agents of the economy face confusion related to the magnitude and duration of the cash shortage and policy response.
Macroeconomic consequences of Demonetization
After the demonetization move, bond yields have increased in almost all major economies, but it decreases in India by 32 basis points. (for ex, US bonds increased by 58 basis points.)
The Macro assessment is made on five broad factors.
Agriculture (rabi) sowing
Indirect Tax revenues – as a measure of production and sales
Auto Sales-as a measure discretionary consumer spending
Real Credit growth
Real estate prices.
Agriculture sowing has increased for wheat and pulses when compared to last year by 7% and 10.7% contrary to fears, probably because of good monsoon and favorable weather conditions.
Indirect tax revenues have increased, probable because the dues were allowed to be paid in demonetized notes.
Passenger cars and two wheeler sales have decreased.
Credit growth has weakened
Real estate prices have seen a drop in all the major cities.
Benefits of Demonetization
It can be viewed as a tax administration measure, a mode to separate white incomes from black. The black money thus retrieved could be used in productive ways – to recapitalize banks, to retire government debt, or to redistribute to the private sector, increase welfare spending. Aids tax administration by also shifting the transactions out of cash economy to formal payments.
Tax Compliance: Indicating the regime shift on the part of government- demonstrating state’s resolve to crackdown on illicit ways of tax evasion, leading to financial penalty and social condemnation, which can bring about lasting effects on behaviour to comply with the tax laws.
It will formalize savings, by bringing them into banks, which will provide a base for banks to give out more loans at lower interest rates.
Digitalization: Demonetization has forced economy to move less cash or cash-lite transactions which reduces the anonymity in transaction which has been misused to do illegal transactions. Digital transactions will help
Bring people into wired era and thereby increasing financial inclusion.
Reduce tax evasion by leaving trials easy to track.
Bring level playing fields between tax evading and tax compliant people.
Reduce the charges of maintenance and costs of handling cash for banks.
Indirect and corporate taxes could over long run, increase as formalization expands and compliance improves.
Informal output could decline but recorded GDP would increase as the economy becomes more formalized.
Demonetisation could have particularly profound impact on the real estate sector. In the past, much of the black
money accumulated was ultimately used to evade taxes on property sales. To the extent that black money is reduced and financial transactions increasingly take place through electronic means, this type of tax evasion will also diminish.
On the whole demonetization can be very beneficial in the long run, if the follow up actions required for the minimizing the costs and maximizing the benefits are taken.
The follow up action suggestions as made by economic survey are
Fast and demand driven re-monetization
furthering of tax reforms (DTC)
Bringing land and real estate into GST
Reducing the tax rates and stamp duties
Acting to reduce anxieties of the investors and tax-payers about over-zealous tax administration.