Demonetisation update 29 – glimpsing the benefits

A searching email followed up by phone call from a former policymaker as to whether the Finance Minister has any fiscal payoffs to show from the demonetisation exercise made me go back and pore over the speech. When we do our write-ups on the budgets, they are within a few hours of the budget documents being released. One has an eye on the clock. Hence, making sense of the documents and connecting disparate threads is almost impossible.

Although I have read many commentaries on the budget, so far, I had not found much that would make me revise my assessment that it could have been bolder in streamlining and rationalising direct taxes. Banking reforms are suffering from neglect – benign or malign.

There are many interesting initiatives on the education front – a system for measuring learning outcomes (paragraph 48), promise of reforming UGC, on making institutions more autonomous (paragraph 50),  MOOC through ‘Swayam’ (paragraph 51), a national testing agency for exams (paragraph 52), streamlining procedures of government recruitment, two-tier system of examination for government jobs (paragraph 127), etc.

But, those are not fiscal in nature.

Public investment is seen as a counterbalance to private investment slack. Yes but it can never be adequate. Public investment proposals suffer from many lacuna. They may not start on time or finish on time or both. There could be several objections and court petitions that bog down the investment. There are other – non-pecuniary – considerations that render them unviable, etc.

On fiscal considerations, the numbers in the budget are not unrealistic. The nominal GDP growth assumption is not unrealistic. Market borrowings have been kept in check thanks to reliance on savings collected under various small savings schemes. The explanation on that is quite clear and transparent. That is nice.

4. Securities against Small Savings:.Small Savings Schemes: The small savings schemes currently in force are: Post Office Savings Account, Post Office Time Deposits ( 1,2,3 & 5 years), Post Office Recurring Deposits, Post Office Monthly Income Scheme Account, Senior Citizens Savings Scheme, National Savings Certificate ( VIII-Issue), Public Provident Fund, Kisan Vikas Patra and Sukanya Samriddhi Account. The rate of interest on small savings schemes has been aligned with G-Sec rates of similar maturity, with a certain amount of spread on certain small savings schemes. The spread on Post Office Time Deposit (5 years), Post Office Monthly Income Scheme Account, 5 years NSC (VIII Issue), Public Provident Fund is 25 bps, on Sukanya Samriddhi Account 75 bps and on Senior Citizens Savings Scheme, 100 bps over the rate of G-Sec of comparable maturity. The interest rates will be notified on quarterly basis.

Securities issued against Small Savings: Collections under various small saving schemes, net of withdrawals, during the financial year, form the sources of fund for National Small Savings Fund (NSSF). The net collection is invested in Central and State Government Securities, which forms the application of funds under NSSF. Presently the term of Central and State Government Securities is 10 years, with no moratorium at 9.5 per cent interest rate. The State can opt for a share of 50 per cent or 100 per cent of net collection within that State. Redemption of these securities into NSSF is reinvested in Central and State Government Securities in ratio of 50:50 at the prevailing rate of interest. Interest payment to subscribers and cost of management constitute the expenditure under the fund and interest on Central and State Government Securities forms the income of the fund.

The sources and applications of NSSF are shown in Annexure 6A and details of various components of NSSF are shown in Annexure 6B. [Link]

The Finance Minister had mentioned the impact of demonetisation on tax receipts in three places in his speech: Paragraphs 12, 138 and 142. He is looking to incorporate it in 2018-19, it appears. That is what I understand from these three paragraphs.

Paragraph 12 is general in nature. Hence, I am not repeating it. But, paragraph 138 gives a hint:

It will be our endeavour to improve upon these fiscal numbers, especially the fiscal deficit, in the next year, through greater focus on quality of expenditure and higher tax realisation from the huge cash deposits in Banks, triggered by demonetisation.  [Link]

Paragraph 142:

After the demonetisation, the preliminary analysis of data received in respect of deposits made by people in old currency presents a revealing picture.  During the period 8thNovember to 30thDecember 2016, deposits between ` 2 lakh and ` 80 lakh were made in about 1.09 crore accounts with an average deposit size of ` 5.03 lakh.  Deposits of more than 80 lakh were made in 1.48 lakh accounts with average deposit size of ` 3.31 crores.  This data mining will help us immensely in expanding the tax net as well as increasing the revenues, which was one of the objectives of demonetisation. [Link]

In fact, T.N. Ninan concedes, somewhat grudgingly, in my view this in his Op.-Ed. this morning:

If anything remotely near this order of black cash has indeed been unearthed, most observers would say that it validates the idea of notebandi. If its execution had not been botched up on the monumental scale that it was—causing enormous hardship to millions, many of whom lost their livelihood while some even lost their lives—this would have been seen by most people as a gamble worth taking. [Link]

Mr. Ninan mentions that ‘economic growth foregone’ could be of the order of 1.0% to 1.5% of GDP but he estimates that the extent of black money unearthed at Rupees 6.0 trillion and that is 4% of GDP. The benefit/cost ratio is in government’s favour. Even if it is not 6.0 trillion but only half of it, the benefit cost ratio (on top of other non-monetary benefits) is in government’s favour.

Mr. Ninan’s numbers are not out of line with the estimate provided in the Economic Survey. One of the more interesting chapters in the Economic Survey is the chapter (chapter 3) on the demonetisation exercise:

3.20 Perhaps the most conclusive evidence on the extent to which Rs 500 and Rs 1000 notes are used for transactions comes from data on “soil rates,” that is the rate at which  notes are considered to be too damaged to use and have been returned to the central bank. RBI data show that in India low denomination notes have a soil rate of 33 percent per year. In contrast, the soil rate for the Rs 500 note is 22 percent, and the Rs 1000 just 11 percent. One way to estimate black money is to assume that all these notes should soil at the same rate, if they were really being used for transactions. This would yield an estimate of money that is not used for transactions at Rs. 7.3 lakh crores.

3.21 But this assumption would be extreme since the lower soil rates for the high denomination notes could arise if they are used in the same way, but just less frequently because there are fewer high value transactions.

3.22 There is a way, albeit not perfect, to differentiate between these two hypotheses, by comparing Indian data to soil rates in other countries. In principle, if a rupee-denomination note and a foreign denomination note fulfill a similar transaction function, then their soil rates should be similar (all else equal). If the Indian soil rate is instead lower, this suggests that a fraction of the notes are not being used for transactions, but rather for storing black money.

3.23 Using relative soil rates for the US $50 and $20 notes and applying them to comparable Indian high denomination notes, yields an estimate of the amount not used for transactions, and hence potentially black, of about Rs. 3 lakh crore. This is substantial, as it represents about 2 percent of GDP. [Link]

So, the Economic Survey puts the store of value estimate of the Specified Bank Notes (Rupees 500 and Rupees 1000) at between 2% and almost 5% of GDP. Mr. Ninan puts it at 4% of GDP.

For the sake of completeness, I must mention a story by Roshan Kishore for the MINT which takes a different line from that of Mr. Ninan and the Economic Survey on the extent of black money in the deposits made into the banking system.

Having read all the three, I must now mention that Roshan Kishore’ story looks somewhat extremely pessimistic (too low an estimate, that is) on the proportion of black money in the bank deposits. That said, if he is correct, then attempt to squeeze out the black money from the bank deposits would risk unleashing either tax terrorism or inspector Raj. The government needs to be mindful of that and observers have to be on the lookout for signs of that.

In addition, Mr. Ninan does mention those non-monetary benefits:

Since a large part of the money that has come back to banks may not have been money in circulation but cash stored away, there will be no need to print notes to the full extent of demonetised notes. This would reduce the ratio of cash to GDP, and act as a drag (for a while at least) on fresh black transactions. The digitisation drive that the government has launched will make the system more transparent, and less prone to tax evasion, while facilitating greater financial inclusion. These and other benefits will depend on the quality of the government’s follow-up measures. In short, while people have paid the price for the disruption caused by demonetisation, now is the time to ensure its benefits. [Link]

I analysed the data on personal income taxes that the IT Department had released last April. I used the recent number for 2015-16 included in the budget figures. That is 287637.12 crores (Rupees 2876.371 billion) instead of the figure of 286801 (Rupees2868.01 billion) crores in the IT dept. document released last April.

So, over the 15 year from the year ending March 2001 to year ending March 2016, the CAGR of personal direct taxes is 15.82%. In fact, the growth rate has been much lower for the two years ending March 2015 and March 2016 at 9.4% and 8.2% respectively (CAGR: 8.8% over the NDA two years)

Against that, the growth rate expected in 2016-17 is 22.8%, rising further to 24.9% (as per budget estimate) in 2017-18. So, there is an implicit acknowledgement of the demonetisation effect. Explicit recognition has been deferred to 2018-19, as per the speech. So, there is the demonetisation effect after all!

Some think that the Finance Minister has held himself back from taking full account of the expected higher direct tax realisation from the information gathered through the cash deposits into bank accounts. Quite likely.

Does all this mean that I have been unduly harsh on the Finance Minister in my assessment of his budget for 2017-18?

Not quite. In a way, a fiscal bonanza (either in the coming fiscal year or next or next two years) is similar to availability of credit for borrowers. What one does with it is more important. On that, there are fewer positive signals.

Finally, since these are impressive numbers (2% to 5% of GDP) and impressive potential benefits over a much longer period, one is curious to know why the government has not beaten the drum louder and harder on the demonetisation success. What gives?

[Tailpiece: Ministry of Finance has set up a separate page called ‘Budget for better India’. Intresting and smart initiative.]

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