Demonetization: Impact on GDP, Inflation, Tax Revenues and Black Money

M. Ramya Krishna
MBA II Year
Department of Business Management
Stanley College of Engineering & Technology for Women
Abids, Hyderabad-1
Mobile: 9490349418
Email: ramyamittapalli1234@gmail.com

Abstract

Demonetization is the mechanism by which the government states to withdraw the money which
is current legal tender. The government being sovereign can take such decision. The effect of this
announcement is that the currency notes in circulation will now cease to be valid tender and can
only be exchanged at the banks. Demonetization of higher denomination notes as an idea has
been around. This paper will study the probable effects of present demonetization drive by the
government. The paper specifically studies the effect of demonetization on GDP, Inflation, Tax
revenues and black money. This study also suggests the approaches to tackle the menace of black
money.

Keywords: Demonetization Economy, GDP, Inflation, India, and Tax Revenues

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Introduction

Demonetization is the mechanism by which the government states to withdraw the money which
is current legal tender. The government being sovereign can take such decision. The effect of this
announcement is that the currency notes in circulation will now cease to be valid tender and can
only be exchanged at the banks. Demonetization of higher denomination notes as an idea has
been around.

There are two important issues with respect to the present demonetization. First, That the notes
ceased to be legal tender from midnight of 8th November just 4 hours after announcement. So in
effect the only places where they will be accepted will be banks. Second, even the banks have
been given time until when they can accept the notes 30th December. Third, the cash swap
carries restriction. Thus, in effect the announcement forces these notes into the banks deposits
within a short period of time.
As per RBI estimates9, 15billion notes of 500 denomination (approx. Rs. 7853.75 billion) and 6
billion notes of 1000 denominations (approx. Rs. 6325.68 billion) exist. In addition, RBI
estimates that fake 0.2 million notes of Rs. 500 and 0.15million notes of Rs. 1000 were
discovered. The actual number of fake notes in circulation will be higher. These will be worthless
from 09 November 2016 but you can get the credit for the money held as these notes in the form
of bank deposit. Naturally, those who can disclose deposits equal to the amount they
hold in cash will have no problem. RBI earlier removed pre-2005 notes of all denominations
from circulation as they have fewer security features compared with subsequent notes. The
process of removing the older notes from circulation continued for nearly one year. The deadline
was extended till December 2015 and those notes continued to remain legal tender till
November. This was not exactly Demonetization but removing from circulation and has now
subsumed into the present Demonetization .

There are questions which are pertinent in this back drop. Will it be effective if people can still
create new black money thereafter? Will it increase the GDP? Will it increase inflation? What
about tax revenues? We look for answers.

Literature Review

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The issue of black money has been well-explored. The National Institute of Public Finance and
Policy has been active in research about black money. Their 1983 survey of estimates of Black
Money1 led to a report on Aspects of Black Money in 1985. The Report of 2012 titled Measures
to tackle Black Money in India and Abroad3 and the 2012 White Paper on Black Money by
Ministry of Finance covers the various research studies and updates them. These studies however
have not been able to determine a consistent estimation of the black economy. The estimates,
including from other sources, vary from 15% to 45% of the total economy. The papers, however,
give a broad spectrum of mechanisms to deal with black money.

Apart from the above Indian initiatives, there have been global initiatives to tackle underground
economy or shadow economy. Primarily, the principles remain the same. Internationally, I
find, they focus more on facilitating voluntary compliance than enforcement. Maintaining trust
and confidence in tax system takes precedence5. They also recommend risk based monitoring
mechanisms, coordination amongst revenue departments and education among other things.
Need for Demonetization

Demonetization is necessary, whenever there is a change of national currency. The old unit of
currency must he retired and replaced with a new currency unit.

History of Demonetization

Indeed, it has. The first demonetization took place in 1946 and Rs 1000 and Rs.10,000 notes
were demonetized to curb the unaccounted money. Later in 1978, Rs. 1000, Rs. 5000 and Rs.
10,000 were demonetized. The higher denomination banknotes in Rs.1,000/- , Rs.5,000/- and
Rs,.10,000/- were reintroduced in the year 1954 and these banknotes were again demonetized in
January 1978. Therefore this is the third time demonetization has taken place. The critical
difference is in the quantum however. The first and second Demonetization s effected really high
value notes which formed a small part of notes in circulation. We can arrive at the estimates by
comparing the denomination of the note with the annual per capital GDP. In 1960, Indias
percapita GDP was Rs. 400 (then currency), in 1978 per capita GDP was Rs. 1722/- whereas
today it is Rs. 103,000/- (todays currency). 10Thus in 1960, a 1000 Rupee note was 2.5X and in
1978 it was 0.5X per capita GDP, considerably easy to withdraw. The second aspect is that today
the 500/- and 1000/- currency notes represents ~85% of physical money in circulation. At that
time, it was considerable less

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Earlier, Rs.1, 000 and Rs.10, 000/- banknotes which were in circulation, were demonetized in
January 1946, primarily to curb unaccounted money. The higher denomination banknotes in
Rs.1,000/- , Rs.5,000/- and Rs,.10,000/- were reintroduced in the year 1954 and these banknotes
were again demonetized in January 1978. So that makes in the last time demonetization was
done in India, almost 36 years ago.

Repercussions

Though, result of the above will come in due course of time but it is sure that all developed
countries are moving towards cash- less transactions. No doubt control of currency needs a huge
expenses like printing, preserving, security etc.

In our country there are so many unorganized sectors, which are mostly live in the cash
economy. Indias 263 million farmers got shocked from this news.

Online transactions and net banking. Card swapping has also increased with the surge in first
time users creating bottlenecks initially.

Towards Cashless Economy

Total 371 million mobile internet user base in India is the highest in the world and is
growing fast, can gear up this mission very speedy. Applicants and prepaid instruments
such as wallets have been actively targeting this segment. The National Payments
Corporation of India (NPCI) has built the Unified Payment Interface (UPI) which has
now become operational with seamless network.

Indias cash transaction value as percentage of total transactions is pretty high at 68% in
comparison to other developed countries as it is 20% in US, 14% in USA, 11% in UK
and 8% in France.

Now, government is going to notify a panel to rill out cash less economy. Some of the
Chief- Ministers are primarily agreed to it and they may declare their state cashless in
forthcoming year, after looking the present position after demonetization in their states.

Now, question is how to increase cashless transactions in an economy like India where
23% people are below poverty line, literacy rate is nearly 46% and so many regional
languages are being used. Farmers have important role in the economy and most of them
are illiterate. Further, their most of the business is run through cash only.
Since ultimate transactions are being done through banks only, hence, banks can play a
vital role in the cash less economy of every country.

Approaches for Eradication of Black Money

The following are the approaches to deal with black money menace:

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1. Establish identity of persons (through PAN Card, Aadhar Card etc.) operating in the country
citizens and foreigners.
2. Enable low the cost direct bank transfers (Implementation of NEFT/IMPS/RTGS and other
formats) including direct transfers of subsidies to the beneficiaries under the Aadhar scheme.
3. Enable electronic register of assets (Underway through electronic land records, digitisation of
revenue records)
4. Reform tax system so that cost of compliance is lower than cost of tax evasion. (through
initiatives such as Saral forms, e-filing, self-declaration etc.) Indirect tax system through
simplification (GST).
5. Widen the net for disclosure by filing Income Tax return. (auto-processing returns for tax
refunds)
6. Regulations that increase costs for black money creating activities. (Prevention of Corruption
Act etc.)
7. Create attribution chain for funds entering and exiting the country (such as through P-Notes,
FDI, Prevention of Money Laundering Act etc.)
8. Create e-trails of both incomes and expenditure.
9. Control on holding of cash and physical money including Indian and foreign money. (FEMA,
recent Demonetization )

Conclusion
One argument goes that if a certain portion of the cash does not get deposited
then RBI will no longer have to be liable for those notes. That reduced liability
will be transferred to Government. If you estimate that about 30% of the
currency notes will not come back, Government could be receiving about 30% of
Rs. 14 Trillion is more than Rs. 4 Trillion. Such gains will be a game changer. Such
arguments are nave as they come from misunderstanding of how central bank
balance sheet works12 and also how money is created.
One must remember that Balance sheet is an accounting construct to understand
the capital deployment. Destruction of soiled notes, removal of older notes and
other activities also do not create any income for government. Such activities
merely adjust the balance-sheet on the liability side only. Simply put, there will
be no gain to the government if RBIs liabilities are written off.
The issue in present case is the quantum of readjustment. If RBI balance sheet
shrinks by 30% one fine day, there will be panic. But this effect can also be muted
by writing down in phased manner while keeping the liability alive on paper. If

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this was possible you could have seen demonetization every 5 years. The only
effect is that it will improve the quality of RBI balance sheet but no further.
The second part of the argument is that such a windfall need not wait for
demonetization. The windfall is nothing but quantitative easing. That has
consequences and is a well debated concept.

Still, following demonetization on November, 8, 2016, online monetary transactions have gone
up by 250% compared to what the month was witnesses in recent years. This shows that there is
scope for e-banking in our country.

We need a specially trained cyber police, forensic labs with state of the art evidence gathering tools, public
prosecutors who understand technology and cyber courts to punish cyber criminals.