Arun Kumar
The economic aspects of demonetization have been debated for the last six years. The government has maintained that it has been beneficial to the economy, while critics have argued that it has been a disaster. The government’s affidavit submitted to the Supreme Court on November 16, 2022, presents a justification of the government’s position.

The principal argument is in para 3, that demonetization “…was not a standalone or isolated economic policy action. As such, the withdrawal of the legal tender character should not be seen or scrutinized in isolation from the rest of all connected economic policy measures”. This is repeated in para 25. Clearly, the attempt is to divert attention from demonetization’s failure to achieve its then-stated goals by claiming that this step was a part of a wider policy framework. The attempt is to shift the goalpost once again.

Trend of growth reversed

While a few statements in the affidavit are supported by some data, most of the statements are of a general nature without concrete data supporting them. The veracity of the data presented can also be questioned. By any reckoning GDP fell during 2016-17 as a large number of businesses, especially small ones, could not work during that period. The official data did not take this into account.

Even going by the official data, the affidavit mentions in para 28 that the GDP grew by an astounding 8.2% in 2016-17. For 2017-18, it gives the figure as 6.8%. So, even going by these figures, the rate of growth of the economy fell after demonetization. It fell further to 4% by 2019-20. Whereas, before demonetization, the rate of growth had risen from 5.2% in 2011-12 to 8% in 2015-16. So, the rising trend was reversed, even if one accepts the controversial official data – but the affidavit does not mention that.

Supporting data missing

Para 27 mentions, apart from other things, that there was less fake currency, a significant amount of black income was detected and there was better tax compliance. No data is given to support these statements. Since how much fake currency is circulating in the economy is not known, how can it be claimed that there is less fake currency? Data is only for annual seizures but that is not the same as how much is circulating in the economy. So, to prove the point, data should have been given on both these aspects.

Regarding detection of black incomes, data should have been presented – how much of it has been detected since 2016. It takes time to prove that some income thought to be black is actually black. The income tax department sending notices to assessees that they have undeclared income, does not make that income black. Legal wrangling delays the finalization of the case declaring some income as black. To settle the point, the affidavit should have presented data on the size of the black economy in 2016-17 and how much of it was unearthed.

For about six crore assessees, about 2,000 prosecutions were launched and there were about 50 convictions in 2017 (according to a PIB release). The prime minister said last year that the number of effective tax payers is about 1.5 crore, about 1.1% of the population. This number should have shot up if demonetization had helped detect the large number of black income generators. If that has not happened, it implies that either demonetization failed to catch black income generators or very few generate black incomes and the sledge hammer of demonetization was needlessly used.

Long-run implications

There are short-run and long-run aspects to the arguments in the affidavit. What happened immediately – while the process of demonetization was on and within a few months of the policy’s announcement? Further, given that none of the immediate goals were achieved, one can focus on analysis of the longer term impact.

Any impact on the black economy should have become apparent by now, six years later. If black incomes had been substantially unearthed, the direct tax to GDP ratio should have increased after demonetization. Since black incomes are generated by those earning high incomes and they fall in the highest tax slab, when they declare more of their incomes, the percent tax collection goes up more than the GDP. So, the ratio of direct tax to GDP should rise. But it has hardly budged from around 6% since 2010-11.

While the number of assessees has gone up, if the increased number was on account of tax evaders coming into the tax net, the tax GDP ratio should have gone up. But most declare nil income or very low incomes so the increase in their numbers does not lead to an increase in the ratio of direct tax to GDP.

In brief, tax to GDP ratio remaining unchanged or being slightly less than earlier suggests that neither more black income generators are in the tax net nor more black incomes have come into the tax net post-demonetisation.

Other issues

There are many other issues in the affidavit, but two are important. First, that the amount of high-denomination currency notes was rising fast (para 13), and the second, that formalization of the informal sector will help the economy (paras 4 to 7 and 26).

The affidavit says, growth of high-denomination notes between 2010-11 and 2015-16 was 76.4% for Rs 500 and 109% for Rs 1,000 denomination notes. The demand for money depends crucially on the nominal growth of the economy and the demand for high-denomination notes grows faster since it is easier to transact in bigger notes.

A comparison of the annual growth in nominal GDP with growth of high-denomination currency shows that they moved in tandem. In 2010-11, the growth was 20.2% and 24.1%. In 2013-14, the numbers were 13% and 11.7%. In 2016-17 till the time of demonetization, the numbers were 11% and 8.9%. Actually, currency in circulation (including the high-denomination notes) was a little less than the increase in the nominal GDP. Thus, there was nothing unusual about the growth of cash or high-denomination notes.

Formalisation of the informal economy is a non-starter. The formal economy is highly capital-intensive and generates few jobs. So, a vast majority of people entering the labor force are forced to work in the unorganized sector. Given that the incomes in the latter are much lower than the former, if there was a choice, everyone would want to work in the formal economy. So, digitization, banking and EPFO change little for those in the unorganized sector.

They continue to work at low wages and incomes, and remain insecure. Formalization is just a change in nomenclature. Given that those in the unorganized sector have low incomes, they remain outside the direct tax net. So, formalization will not lead to higher tax collections. Actually, most of the black incomes are generated in the organized sectors, not in the low paid unorganized sector.

In brief, the affidavit filed in the Supreme Court by the government hides more than it clarifies. Either it does not support its arguments with data or presents limited data. So, the affidavit’s attempt to shift the goalpost from the analysis of benefits of demonetization to the larger perspective of the good done to the economy does not succeed.

This article was first published on The Wire as Union Government’s Affidavit On Demonetisation Shifts Economic Goalposts, Again on Nov 24, 2022.

About the Author

Arun Kumar

Arun KumarMalcolm S Adiseshiah Chair Professor, Institute of Social Sciences, New Delhi and author of ‘Indian Economy’s Greatest Crisis: Impact of the Coronavirus and the Road Ahead‘.

Read more articles by the author at IMPRI Insights

Authored By: