Black in a new hue

THE underlying assumption of the Narendra Modi government that the flushing out of high-value denomination notes will wipe out the scourge of black money is not only misplaced but positively and dangerously misleading. The two denominations that were outlawed on November 8 account for about Rs.14 lakh crore circulating as cash in the Indian currency system. By the government’s own admission, it is expected to flush out a maximum of Rs.2 to 3 lakh crore as a result of the exercise that has paralysed the entire economy. Given that the GDP (at current prices) in 2015-16 was about Rs.136 lakh crore, the share of black money that would be impounded after the massive exercise would be a minuscule 2.2 per cent (assuming a haul of Rs.3 lakh crore from the ongoing exercise). That does not sit well with all other studies that have estimated the size of the Indian black economy.

A study by the National Institute of Public Finance and Policy in 2014 estimated the black economy to be about 70 per cent of national GDP. Prof Arun Kumar, who taught at Jawaharlal Nehru University and did a pioneering study in 1999 ( The Black Economy in India ), reckons that black money in cash form accounts for a mere 3 per cent of the black income generated annually.

Black money basically arises from two kinds of activity. Activities such as gun-running, smuggling, and child- and drug-trafficking fall in a category of crimes that are illegal by the very nature of the enterprise. This implies that gains made from them are categorically illegal. Money made from such activities is black because the activities they result from are beyond the pale of the law. But this is a relatively minor part of the problem of the black economy. As the former Chief Statistician Pronab Sen observed recently, the black money generated from such activities constitutes a tiny fraction of the black economy.

The much bigger problem arises from activities that may in themselves be perfectly legal but that generate incomes at least a part of which is hidden from the eyes of the state. Incomes arising from any activity that is beyond the cognisance of the state would thus be recognised as black money. This notion arises from the fact that any economic activity, or a portion of activity, that is not reported to the state constitutes evasion. In fact, if the state were to abolish all taxes without exception such a scourge would simply cease to exist, except in the form of political corruption.

Tax evasion is the prime source of black money. But it is not as if black and white are in two separate compartments. Tax evasion can assume myriad forms. It could arise from under-declaration of production, as is known to be widespread in the case of the pharmaceutical industry. Thus, if a company produces 100 units of a medicine but declares that it produced only 80, it would conceal the income arising from the undeclared output, pay lower taxes and thus evade taxes. Note that in this case its entire operation is not generating black money and that black and white money is generated by the same activity. Another widespread method adopted by companies, including many large ones, is by understating incomes and overstating costs. They benefit at both ends because lower incomes means lower taxes and overstating costs enables them to set off a higher portion of their operating income in order to boost their profits. In fact, this is rampant in international trading operations and generates other pernicious effects. A company that imports from overseas can overstate the cost of imports and/or understate the price of its exports so that it paves the way for capital flight in the guise of a genuine transaction.

Protagonists of economic liberalisation, who claim to be in the fight against the pernicious influence of black money, do not realise that the “hands off business” liberal logic does not sit well with a no-nonsense regime that brooks no evasion. In fact, rules governing the terms on which Foreign Direct Investment (FDI) enter the country have been continuously eased. FDI has been a major conduit for the re-entry of funds that have flown out of the country but return masquerading as foreign investment. This is termed as round-tripping. The fact that Mauritius and Singapore are the primary sources of FDI gives credence to this method of recycling black money, which, ironically, enjoys a double-benefit—first because it arises from evasion and therefore involves unpaid taxes and, secondly, because when such funds re-enter they enjoy the special concessions and privileges that a liberal regime extends to “foreign” investment. Seen from this perspective, the notion that black money is a pot of cash stashed away somewhere appears wooden-headed. As the eminent economist Prabhat Patnaik explained recently, it is not a stock but a flow that is constantly circulating, seeking returns and expanding in scale and size, just as capital anywhere would do. It is for this reason that black money does not sit as unproductive cash but is invested in other assets such as gold, foreign exchange assets such as dollars or moves into other lines of business (for instance, educational institutions, increasingly privatised, offer a lucrative rate of return).

One of the most pernicious effects of black money is the fact that it depresses the tax-GDP ratio which is the basis of the state’s claim that it does not have the money to bear its share of the responsibility in meeting social sector expenditures—education, health, pensions and a host of other welfare measures. It is obvious that a more efficient tax administration, one that combines punitive action with hard-nosed investigation, would plug the loopholes. While it is true that the IT revolution has hastened the speed with which money travels great distances at a fraction of the time it used to take a few decades ago, the very same technologies also enable tracking of these flows. The problem is not the lack of technology, but ideological. If investments are, as a matter of state policy, placed on a pedestal, it also indicates to investors that the state is ever willing to accommodate their interests. Far from attacking the scourge of black money and the liquidation of high-value denomination notes and their replacement by at least one that has an even higher value, those engaged in the generation of black wealth can breathe easy even as the vast majority of the country bears the brunt of demonetisation.