How Demonetisation Increased Tax Compliance And Tax Base 

‘Demonetization continues to generate considerable debate amongst economists and policymakers. By now, there is enough evidence that the negative economic impact was sharp but temporary.’

These are the opening lines of a new paper on demonetisation titled, ‘Evaluating the impact of Demonetization on the Indian Economy’, by Srinivas Thiruvadanthai and Karan Bhasin.

In their own words, in the paper, the authors explore what prompted demonetisation, whether it was successful in curbing black money, and whether it had other spill over effects. In the end, they summarise that while the costs of demonetisation were significant they were short-lived while the benefits have been gradually accruing.

‘Rising usage of cash, exploding real estate prices, and surging gold demand in the decade leading up to demonetisation suggest that black money generation was growing. The increase in personal income tax buoyancy and the growth in tax filers post demonetisation indicate improving tax compliance’.

In the excerpt below, it is the improved tax compliance part of demonetisation benefits that has been explained:

(You can read the full paper here).

Two of the most important stated objectives of the demonetisation were to reduce corruption and black money. In that context, it is important to view the impact of demonetisation on these two objectives that are intricately related.

A major source (and reason too) behind generation of black money has been corruption and illegal activities. In that context, demonetisation by design forced old currency notes to be deposited into bank accounts with the view of scrutinising these deposits for identification of illegitimate money in future. Consequentially demonetisation removed anonymity of money and this made identification of black money easy.

Moreover, India’s historically high rates of taxation had a detrimental impact on its tax compliance. A direct consequence of this was that direct tax to GDP ratio for India was lower than other similar income countries. The low tax compliance could be a major factor behind the extensive dependence of cash in the economy.

Therefore, intuitively one would expect direct tax compliance to improve post demonetisation.

In chart 7 we show personal income tax (PIT) buoyancy, corporate income tax (CIT) buoyancy and total direct tax buoyancy (these have been computed using nominal GDP at factor cost). As evident from the graph, personal income tax buoyancy did improve (compared to pre-demonetisation levels) significantly in FY2016-17 and this increase continued till FY 2017-18. However, it is interesting to note that for total direct tax buoyancy and corporate income tax buoyancy, there is only a marginal improvement in FY2016-17. A major reason behind this could be the fact that profit cycle didn’t recover in FY2016-17.

Another factor worth mentioning is the reduction in the corporate income tax rate from Budget 2015-16 onwards which could have had an impact on the CIT buoyancy.

Another important indicator is the direct tax as a percentage of GDP. In chart 8 we look at the revenue from total direct tax and corporate tax as a per cent of GDP. As evident, there has been a consistent increase in the revenue realisation, however, the increase was subdued in FY2016-17. A major reason behind this was the decline in the revenue realisation from corporate direct taxes as a share of GDP.

The impact of demonetisation was bound to be on the personal income tax as most of the cash would be held by individuals. Therefore, the correct indicator to see the impact of demonetisation on tax compliance would be revenue realisation from personal income tax. In chart 8 we can clearly see that revenue realisation from personal income tax (as a per cent of GDP) has improved significantly post demonetisation. In fact, revenue realisation from personal income tax as a percentage of GDP is at an all-time high post demonetisation.

This improved revenue realisation from personal income tax has compensated for the fall in revenue from corporate profits. From charts 8 and 9 we can clearly see that 2016 onwards there has been an increase in direct tax compliance and given that demonetisation occurred in November 2016, we can safely argue that this increased tax compliance has occurred due to demonetisation.

We further looked at the growth rate of revenue realisation from personal income tax and total direct taxes. To see the impact of demonetisation on revenue realisation, we calculate the average annual growth rate from 2010-2015. We then use this growth rate to generate the predicted revenue realisation from these taxes for the years 2016 and 2017. The reason why we take an average for only six years is because we want it to reflect the general short-term trend in the growth rates of revenue mobilisation from direct taxes. Any divergence between the actual revenue realisation and the predicted revenue realisation can be attributed to demonetisation.

As discussed above, chart 10 reiterates the point that impact of demonetisation is subdued on the revenue from total direct taxes. This holds true particularly for the year FY2016-17 as we see only a small divergence, however, this divergence increases for FY 2017-18. A major reason behind this has been that corporate profit have been subdued in this cycle. Consequentially, corporate income tax collections have not risen and that is exerting a downward bias on the impact of demonetisation on the revenue from direct taxes.

It is interesting to note the divergence for revenue realisation from personal income tax (chart 11). The divergence is stark for both the years and it is worth highlighting that this divergence increases for 2017.

Given that the only exogenous factor in 2016 was demonetisation, it could be concluded that demonetisation has led to a significant increase in revenue realisation from direct taxes, specifically from personal income taxes. It is also important to stress the fact that this divergence is only increasing, which suggests that demonetisation could have a long-term positive impact on tax compliance.

Next, consider the trends in tax filers. There has been a steep acceleration in the number of personal income tax returns post demonetisation, and this indicates a significant broadening of the tax base.

The drastic increase in the growth rate of both the number of total returns filed and individual returns filed strengthens the case that demonetisation improved tax compliance. Additionally, the simultaneous broadening of the tax base with improved revenue realisation further reinforces the argument that the positive impact of demonetisation on tax compliance would be long-term in nature.

You can read Srinivas Thiruvadanthai’s articles for Swarajya here, and Karan Bhasin’s here.