In EcoSurvey, demonetisation defense is a misleading half-truth

A key theme of the Economic Survey presented to Parliament today is demonetisation. The survey seeks to discuss “complexities of the analytics, empirics and potential impacts of demonetisation”. It has focused on the three sets of issues in this regard: (a) broader aspects of management of demonetisation, as reflected in the design and implementation of the initiative, (b)   economic impact of demonetisation in the short and medium run and (c) implications of demonetisation for the broader vision underlying the future conduct of economic policy.

The poor and inefficient technological readiness made such a massive operation ineffective. It is a pity that money supply figures are not recorded properly and the RBI’s hesitancy to report the remonetisation figure is a clear evidence of this.

The Survey refrains from discussing the broader aspects, steering away from what is the most critical aspect of the entire exercise of demonetisation. It is the ill-conceived and poorly timed design and implementation of demonetisation that is at the crux of the many adverse consequences that have impacted the common citizen, besides hurting the economy.  The exercise was based on a false perception that cash transactions breed corruption and less cash means that the level of corruption is reduced. The poor and inefficient technological readiness made such a massive operation ineffective. It is a pity that money supply figures are not recorded properly and the RBI’s hesitancy to report the remonetisation figure is a clear evidence of this.

The survey maintains that there have been short term costs but potentially long term benefits. To prove this point it has carried out an impact analysis using ten  variables which include: (1) Money/interest rates, (2) Financial system Savings, (3) Corruption (underlying illicit activities), (4)Private wealth, (5)Public Sector Wealth, (6) Formalisation/Digitisation, (6)Real estate, (7)Broader economy, (8)GDP, (9) Tax collection, (10) Uncertainty/ credibility.

A perusal of the long term impact on the above heads leads one to conclude that there is no definiteness and that the so-called impact analysis is highly conditional. For an example, the survey comments that loan rates could fall further, if much of the deposit increases prove durable; that the financial sector system savings will increase, to the extent that the cash-deposit ratio falls permanently; that corruption could decline, if incentives for compliance improve.

It goes on to argue, without providing any basis for such assumptions, that private wealth could fall further, if real estate prices continue to decline and that government/RBI’s wealth will increase when unreturned cash is extinguished, reducing liabilities. Further, it claims that real estate prices could fall as investing undeclared income in real estate becomes more difficult and that the tax component could rise, especially if GST is imposed on real estate.

The survey claims that indirect and corporate taxes could decline, to the extent growth slows. Over the long run, taxes should increase as formalisation expands and compliance improves. This is again a very simplistic and an erroneous view.

This is more of a wish list rather than any analysis. The long term impacts of demonetisation are sugarcoated with many ifs here. Such an analysis, claims and statements are neither expected nor appropriate in a prestigious document like the Economic Survey.

More importantly, the impact of GDP analysis lacks analytical rigour and is misleading. The Survey, to defend demonetisation, takes the shelter of nominal growth. The survey mentioned that “an even better counterfactual for comparison would be the level of nominal rather than real GDP growth. After all, demonetisation is mostly a nominal demand shock, so its effect in the first instance will be on nominal magnitudes.”  This is not only an analytical blunder and but also a classic case of creative accounting to defend and justify a wrong. For all analytical purposes, the real GDP represents truly the performance of the economy and certainly not the nominal GDP.

Furthermore, the survey to prove the point of minimum adverse impact of GDP has gone into the technicalities and concluded that when one is comparing the GDP growth estimates by IMF, CSO and others, it would be more appropriate to make a comparison based on the changes in the forecasts rather than their levels. This suggestion has the potential of inconsistent approach to make any comparison.

Another important issue is tax collection. The survey claims that indirect and corporate taxes could decline, to the extent growth slows. Over the long run, taxes should increase as formalisation expands and compliance improves. This is again a very simplistic and an erroneous view. It is important to recognise that less cash in the economy does not mean formalisation in the economy is automatic. There are structural rigidities in the form of bankable habits and stricter KYC norms. Even in the much- discussed ‘jandhan’ accounts, as the demonetisation experience suggested, there are ample cases of misuse.

The increase in tax – GDP ratio is a sustainable answer to prudent fiscal management. But moving to a formal economy has no direct relation with increase in tax compliance.  Tax compliance is one issue but more important is enhancement of tax base along with rationalisation in tax rates and withdrawal of many tax exemptions.

With regard to credibility, the survey has mentioned credibility will be strengthened if demonetisation is accompanied by “complementary” measures. However, these complementary measures have not been defined in the survey. There seems to be some inconsistency in the Survey; on the one hand, there is an argument that full remonetisation will not happen but while discussing the credibility there is a mention that  early and full remonetisation  is essential.

It is difficult to resist the conclusion that the Economic Survey has been used to justify the erroneous decision on demonetiaation and related issues. Counterfeit notes are the result of deficiencies in the currency management architecture of the RBI. At the end of the day, it is important for the RBI to improve the currency management architecture. Similarly, black money or unaccounted money is the result of deficiencies in the tax administration of the government. In a longer term perspective it is important to strengthen the currency management architecture and tax administration without harassment.

(R K Pattnaik is Professor, SPJIMR. Jagdish Rattanani is Editor, SPJIMR. Views are personal)

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