Repairing The Demonetisation Damage: Dos and Don’ts For Government Post-30 December

by R Jagannathan - Dec 23, 2016 11:04 AM +05:30 IST
Repairing The Demonetisation Damage: Dos and Don’ts For Government Post-30 DecemberCustomers at a bank counter exchanging old notes for new. (GettyImages) 
Snapshot
  • Demonetisation – to be followed by GST – sets the stage for both tax and subsidy reforms, by expanding the ambit of the formal financial system and the taxpayer base.

    This gain should not be blown up mindlessly, but nurtured to yield huge economic and tax efficiency for the future.

An early end to the pain of demonetisation is not in sight, but the end of the deadline for the deposit of old Rs 500 and Rs 1,000 notes (30 December) is barely a week away. This is, therefore, the right time to dust up plans to combat and counter the short-, medium- and long-term negative impact of demonetisation, even while sealing in the gains.

The scenario as of now is this: the bulk of the Rs 15.44 lakh crore outstanding with the public in old notes will come into the banking system, but the cash outflows to compensate for this immobilisation are too slow to revive economic activity quickly. While most economists are writing off this quarter (January-December) for growth, it would be a fair bet that even the next quarter will be impacted. The aim must be to prevent any further extension of the pain, and stop the negative consumer psychology from becoming longer-lasting.

The first order impact of demonetisation has been a severe constriction of cash-based transactions and loss of irregular or informal jobs in several sectors ranging from trade to real estate to small businesses. The second order impact of this demand compression will probably hit us in the next three months. Prices will probably stay muted for a while.

Given this reality, the chances of a huge tax revenue spike in the short run can also be ruled out. It will happen, but in the next fiscal year, assuming the government gets its act right.

The government’s priorities should be to revive consumer sentiment, inject cash as fast as possible, provide a fiscal stimulus, increase public investment in infrastructure, and create an accommodative structure for handling an expanded tax base as more transactions come into the formal banking system. It is also clear that the government cannot provide any cash bonanza for the poor as there may be no immediate tax gains to be made from demonetised currency not coming in. The gain in bank deposits will pay off more slowly, as tax officials may have to spend years chasing their dues in courts.

Here are some dos and don’ts for the Narendra Modi government.

First, an economic stimulus as in 2008. Tax cuts for corporations and individuals are a must to revive sentiment in the consumption sector, the corporate sector and in the markets. Finance Minister Arun Jaitley would do well to cut the top corporate tax rate to 25 per cent in one go (making up some of the losses by eliminating the big tax breaks), while the tax-free limit for individuals should go up to Rs 5 lakh. An alternative is to raise the limit to Rs 3 lakh, and expand the 80C limit to Rs 3 lakh, which could include the housing loan interest deductions now limited to Rs 2 lakh. Some leeway on the fiscal deficit is warranted given the demand compression. A range of 3.5-3.8 per cent would not be unconscionable in 2017-18.

Second, tax administration reform. With lakhs, if not millions, of new assessees now likely to enter the tax net, disputes will spike, as those claiming sudden surges in incomes (and hence bank deposits) will be tempted to delay payments by resorting to courts. The government must prepare for this by setting up quick-settlement tax and arbitration courts, so that the legal system is not clogged for years with tax cases, and also to prevent tax terrorism.

Third, digital speedup. The self-created demonetisation crisis would have been wasted if digital and non-cash payments are not speeded up. When cash returns, there will be a tendency to revert back to the old ways, but this must be disincentivised, both by taxing cash usage and privileging digital cash (ie, debit cards, e-wallets and net and mobile banking). Formal sector wage payments should be shifted to cheque and electronic transfers, and the first priority must be to minimise cash in urban transactions, starting with the metros, going to the smaller cities, etc. It is only the rural sector that needs more leeway with cash, and not urban centres.

Fourth, bad loan recognition forbearance. The Reserve Bank of India has already extended recognition of loan defaults by 60 days, and this should be extended till 31 March, but only for small accounts. The forbearance should not be allowed to benefit the formal sector, especially in cases that were already in default before 8 November. Normal loan recovery procedures should be continued, barring in some special cases. Big companies can anyway opt for restructuring loans, and this can continue with higher capital being provided by banks against such loan restructuring.

Fifth, Goods and Services Tax (GST) must be fast-forwarded rather than slowed down. The disruption brought forth by demonetisation will have facilitated the expansion of the tax base and the entry of smaller traders into the formal banking system. This disruption can be minimised if GST is fast-forwarded, since GST is about forcing the informal vendor systems of companies to start paying tax. Leaving a gap between one disruption and another will mean two disruptions, when by combining the two we could manage with one-and-a-half disruptions.

But there are things the government must not do in the post-30 December scenario.

#1: There should be no farm loan waivers. At best, small farmers should be given an interest write-off or extended repayment terms. The credit system in the rural sector is being systematically eroded by repeated write-offs, and we have now created an expectation that farm waivers will have to be given before every election. This cannot but do long-term damage, for it will ensure that no one will be foolish enough to repay loans when they are anyway going to be written off.

#2: No cash freebies without a gameplan. The Modi government does not have any access to easy cash, and so the temptation to put money in Jan Dhan accounts should be resisted. It would be fiscally irresponsible to dole out cash when tax revenues are uncertain and the bulk of fiscal resources have to be made available for revitalising the economy.

However, cash doleouts can be done if they are part of a larger subsidy revamp plan, where the government starts moving towards a universal (or targeted) minimum basic income or cash subsidy. For example, the Rs 40,000-50,000 crore now spent annually on boondoggles like MNREGA can be shifted to fund this targeted income plan for rural areas. Also, currently subsidised products (fertilisers, food) can be partly shifted to cash, with states offering farmers and consumers the option of either receiving their subsidies in cash or kind (through ration shops). By ending MNREGA and using disclosures under the Pradhan Mantri Garib Kalyan Yojana, a basic corpus can be created for a universal or targeted basic cash subsidy in rural areas. This can morph into a wider social safety net called the universal basic income if GST turns out to be a revenue gusher for both states and the centre. It is something that can wait till 2018-19 or even for 2019-20.

Demonetisation (to be followed by GST) sets the stage for both tax and subsidy reforms, by expanding the ambit of the formal financial system and the taxpayer base. This gain should not be blown up mindlessly, but nurtured to yield huge economic and tax efficiencies for the future.

Jagannathan is Editorial Director, Swarajya. He tweets at @TheJaggi.
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