Demonetization and Digital Economy

This is an attempt to critically analyze demonetization and the recent push for digital economy.

Why it was needed? PM Modi in that 8 November speech had at least three objectives which were corruption, counterfeit notes and terrorism. More importantly, it was another step in the right direction- making India a digital economy.

Why now?  Many people argue that demonetization ruined our growth perspectives. India was the fastest growing machine in world economy and in their opinion demonetization will hamper its growth perspective for the decades to come.

But nobody is against the concept of digital economy.  Then the question arises – when should an economy become digital? Digitization is a long process and if a slowing economy implements it in a hasty manner, there is no doubt that it will increase its wounds.

In our case, the time is right because right now Indian economy is going through an economic “sweet spot” arising from a combination of a strong political mandate and a favourable external environment.

According to our PM, India has got 3-D advantages, which are Democracy, Demand and Demography. If we consider the views of critiques first, then these three advantages were sabotaged by the process of demonetization.

1)     Forcing citizens to change notes in a fixed time period, reducing their purchasing power by reducing withdrawal limits, changing restrictions and rules in between... yes the complaint list goes on. In no democracy this should happen, that too, withdrawing 85% of currency and replacing it in a short span of time. It’s against the morals of democracy because a citizen has the freedom to decide in which form he should keep his money, where to invest, when to invest… Even many challenged the legality of decision and autonomy of central bank  became a question mark because it’s RBI’s duty to ensure the supply of currency notes (except that of coins which is Government of India’s (GoI) job).

2)     The demand has decreased tremendously, job lose in informal sector was rampant, migrant labourers returned and the credit rating agencies  now predicting GDP growth rate of 6.5-7% compared to earlier 7.5%.

3)     Demonetisation affected the whole population, and the ‘forcible digitisation’ can cause more troubles to elder population and illiterates because of the digital divide exist.

Even a hard core supporter of demonetisation can’t deny each and every one of these as baseless allegations. Yes, there were flaws, the implementation could have been better. But we need to look at both sides of the coin.

1)     Talking about democracy, the honourable court didn’t invalidate the centre’s move. Even the Constitution of India gives more powers to centre in financial matters. The power of centre to make laws retrospectively in financial matters is the epitome of this.

The move also strengthens democracy. There is no doubt that black money, terrorism, parallel economy, secessionist tendencies and corruption are against democracy.

2)     It is true that demand has fallen for some time. But it will rise again because the GoI announced its objective of making India a digital economy. It’s going to hurt those who are having disproportional assets because, even if they somehow managed to get new currency, in a digital economy the transactions are monitored. As of now PAN is compulsory for all transactions above two lakhs and government is planning to decrease the limit. So the one of the limited main options available is spend this disproportional income as soon as possible before digitisation become a reality. This will in turn increase the short term demand.

3)     Demographically it’s the right time for digitisation.  By 2019 India will be the nation with maximum young workforce. We need to reap the benefits of this ‘demographic dividend’ as it won’t last forever.

A behavioural change is needed from old currency system to digital transaction. A young population adapts very fast and it necessitated a now or never condition which resulted in the current course of action.

Now let’s talk about digital economy. In simpler terms, in a digital economy almost all transactions happen digitally and presence of physical currency is reduced (not completely removed (as smaller denominations exist), which will happen when the digital divide is zero, a distant dream for India). 

Now the question arises whether the GoI’s digital push was a well prepared move?

The GoI added momentum to previous government’s financial inclusion programs by its flagship Jan-Dhan Yojana. It created bank accounts for over 200 million people within months. It also ensured every household has at least one bank account by just producing Aadhaar card and brought even poorest of the poor to formal financial system, reducing dependency on money lenders in rural areas by ensuring credit to certain limits in its phase three.  

Only 27 per cent of villages had a bank within 5 km. To help address this last mile connectivity problem, the RBI in 2015 licensed 23 new banks – 2 universal banks, 11 payment banks and 10 small finance banks and continues banking correspondent model.

Advancing the game-changing JAM (Jan Dhan Aadhaar Mobile) agenda then a series of measures has been taken by GoI like the PAHAL scheme of transferring LPG subsidies via direct benefit transfer (DBT), payment to MGNREGA workers from Apr 1, 2016 through DBT, scholarships to the Aadhaar linked accounts of applicants, the three insurance schemes for common man -Pradhan Mantri Suraksha Bima Yojana (PMSBY), the Pradhan Mantri Jeevan Jyoti Bima Yojana (PMJJBY) and the Atal Pension Yojana (APY), providing bank accounts for girl children under Sukanya Samriddhi Yojana.... Many of these schemes were for the poorest section of society and they got familiarised to the formal financial system. Yes, GoI had done the background work for the transition to digital economy.

GoI’s digital drive was based on both push and pull factors. Economic sweet spot, demographic advantage, reduction of leakage (for eg, PAHAL scheme eliminated ghost households and reduced leakages by 24 per cent), NPA burden of banks, parallel economy, black money, left wing extremism, terrorism etc can be categorised under push factors.

The pull factors or the advantages of digitisation are many. Joseph Schumpeter’s idea of “creative destruction” (changing the economic structure from within, incessantly destroying the old one, and incessantly creating a new one) sounds valid here. By digitisation we are changing the old way of doing things by the adoption of technology.

Technology can help in two ways. First, it brings down human discretion and the layers of intermediaries. And, second, it breaks the old shackles and old ways of doing business. In the domain of fiscal policy tax administration will benefit maximum. Govt. can track each transaction in a digital economy. Also better targeting of subsidies can be done, leakages can be minimized. Monetary policy will be more effective and inflation targeting will be more efficient in the demand side because central bank knows the money in circulation. Inflation acts like an indirect tax, so efficient control of inflation helps the poor more.

Also as economic survey 2016-17 points out: “Mobiles can not only transfer money quickly and securely, but also improve the quality and convenience of service delivery. For example, they can inform beneficiaries that food supplies have arrived at the ration shop or fertiliser at the local retail outlet.” GoI also established an e-NAM (national agricultural market) which will further push the digitisation drive.

Unlawful activities can easily be prevented by cracking down the bank accounts involved. Digitisation will also help GoI’s landmark initiatives like Make in India, Ease of Doing Business, Start Up India, Digital India, and Smart Cities.

Problems of banking sector needs special mention. Given the deterioration in asset quality and gradual implementation of BASEL-III, banks will have to improve their capital positions to meet unforeseen losses in future.  An important step taken is the merger of banks which will bring efficiency. Demonetisation has resulted increase in returning loans, which shows that their existed a large number of willful defaulters.

The surge in deposits allowed banks to reduce interest rate, which will result in cheap loans and more growth.  What India lacks is the funds for its infrastructure projects, and internal borrowing is far better than external borrowing considering the currency risks involved. Over the years only savings in physical assets shown improvement, (like in the form of gold) and GoI’s measures to restrict physical gold holding, new gold bond schemes and promoting bond markets tries to change this trend. Also it’s noteworthy to mention that GoI used banks as the front end in its three new insurance schemes (already mentioned) to increase the insurance penetration and density. 

If everything was perfect, then why is so much sound and fury against this decision?

Other than the messy implementation which affected everybody, one reason was the fault existing in the system. Agricultural income is not taxable and how can you expect a farmer to produce transaction details for his life-time savings which he kept as liquid money? Majority of farmers didn’t have savings more than 2.5 lakh, so many were ‘lucky’.

Tax exemption exists for religious donations and political donations also. How can Govt reduce corruption if exemptions are continued considering the fact that these three sectors are very sensitive in India. GoI has clarified that only recognised parties’  fund are tax free, and donations above Rs.20,000 should contain details of provider, but most of the time these rules are discarded. AAP is the only major party which maintained transparency in funding. Though PM spoke about peoples’ right to know where funds of political parties come from, its implementation remained as a castle in air.

Giving immunity to political parties from Right to Information Act was another stroke, and GoI’s recent decision to exempt demonetisation deposits by political parties from tax was the last nail. Tax exemption implies that political parities’ as the only entities whose accounts are exempt from any scrutiny. Since all political parties are benefitting by this, we are not listening much about it in public domain, but there is no doubt that this move should be withdrawn.

Good work is not rewarded and bad work is not punished is the cliche situation in India. In demonetisation also this trend continued. Many bankers have been corrupted since 8 November. Corrupt bank officials, apart from a whole array of brokers, gold merchants, hawala operatives, increased the pain of common man, and economy became a standstill for quite some time. GoI came up with alternative methods like BHIM app very late. Media also created a panic whose role we will deal later. If we consider earlier schemes and financial inclusion drives of GoI as carrot, because of the aforesaid reasons demonetisation acted as a stick and no doubt, in a democracy people don’t like sticks.

One challenge which needs special attention is cyber security. As digitisation increases there is threat both from inside and outside of the country, for both customer and the economy. Customers need to be educated about secure banking practices and banks should have the infrastructure to withstand cyber attacks.

Many argue that, demonetisation made a large chunk of black money to white. It is evident from the fact that the old currency returned crossed the GoI’s and central bank’s expectation. Also GoI came up with penalty schemes for very late. Still there is good thing to say. Central bank can estimate the actual money in circulation. Also high amount of black money can’t be spent again in bulk. Also accounts can be scrutinised for any irregularities any time.

Many argue this fight to black money was a failure because majority of black money had been invested in real estate or as gold. The answer to this is to wait and see. In a Govt. report, real estate is identified as one of the top eight sectors where black money is generated and stored. Economic survey 2016-17 suggests to introduce “property tax” and this if implemented will no doubt hurt such benami properties.

According to Alvin Toffler the illiterate of the 21st century will not be those who cannot read and write, but those who cannot learn, unlearn, and relearn. The resistance to change was another reason for opposing demonetisation. The adaptability to ‘new normal’ can be improved via making people familiarise with digitisation. It can be done via carrots like removing transaction tax from bank than the sudden stick like demonetisation. Also incorporation of regional languages in mobile phones needed to increase adaptability.

Media could have played a pro-active role in this behavioral change. But what media done is sensationalising news and creating panic and even propagating fake news. For example there was fake news like GoI will increase tax slab to appease people.

Economic survey 2016-17 talks about “missing tax payers”: “Only 4% of the population pays direct tax in India. Missing taxpayers are not those who are evading taxes altogether or under-reporting taxes but those who have legitimately gone under the tax radar due to “generous” government policy. We ask how many taxpayers there would have been in 2012-13 if the threshold had been maintained at Rs. 1,50,000 (the threshold limit in 2008-09). We find that there would have been an additional 1.65 crore units incorporated within the taxation system (an addition of about 39.5 percent)”

The important feature of direct tax is, it is progressive ie as income increases tax rate increases. Thus increasing direct tax base gives Govt. room to rationalise indirect tax, which is not progressive in nature. Both poor and rich pays equal tax for 1 kg apple, thus it hurts the poor more. Thus by this digitisation drive, GoI tries to avoid tax evasion and increase tax base and promote a culture of tax-paying.

Economic survey 2016-17 provides another interesting observation: “The history of Europe and the US suggests that typically, states first provide essential services (physical security, health, education, infrastructure, etc.) before they take on their redistribution role. A corollary is that if the state's role is predominantly redistribution, the middle class will seek - in Professor Albert Hirschman's famous terminology - to exit from the state. They will avoid or minimise paying taxes; they will cocoon themselves in gated communities; they will use diesel generators to obtain power; they will go to private hospitals and send their children to private education institutions. By reducing the pressure on the state, middle class exit will shrink it, eroding its legitimacy further, leading to more exit and so on. All these pathologies are evident in India.” Thus paying tax can also be seen as measure of accountability of state.

French economist Thomas Piketty (the author of “ Capital in 21^st Century”) reiterated these by saying that Indian middle class need to contribute more like their European counterparts had done. Thus a digital economy drive is the step in this right direction where Govt. can provide services with minimum leakage and ensure citizens paying the tax which will ensure long term growth and make India a developed nation.