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Demonetization and Gst in India

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The Initiative:

On November 8, India’s Prime Minister Narendra Modi announced that 86% of the country’s currency would be rendered null and void in 50 days. It was posited as a move to crackdown on corruption and the country’s booming under-regulated and virtually untaxed grassroots economy, but is also being used as a driver to get millions of Indians onto the country’s official economic grid — many for the first time.

The Objective:

  • Demonetization of high currency notes has a two-fold objective – first, choking the funding channels of militancy and terrorism from across the border.  In the last few years large number of counterfeit notes were regularly discovered in states infested with terror activities. Thus, demonetization will certainly paralyze financing channel of terrorist activities.
  • The other objective, to fight corruption, is rather complex and needs to be addressed persistently through different ways..

The Impact:

  1. Lending Rate Cut: An interesting and welcome macroeconomic effect is the possible reduction of interest rates by the banks.
  1. According to SBI Chief Arundhati Bhattacharya since the demand for credit has slowed down. Therefore, lending rates too will fall but after a gap.
  2. Lower interest rates should, all else being equal, produce a stimulus to the economy.
  1. Reduce Inflation: There's also another interesting macroeconomic effect here, the money supply will be smaller as well. The total cash in circulation in the Indian economy is some 18 trillion Rs, meaning that the demonetization will reduce that money supply, the base money supply, by 16 or 17 % or so
  1. Reducing the base money supply will lower inflation.
  2. Of course, it's possible that the shock to the economy will lead to a reduction in production. If the destabilization reduces production by more than that fall in the money supply then we'll have more inflation. But it would be extraordinary to believe that production is going to fall that much.

  1. The Taxation effect: Any deposit that is significantly in excess of Rs 2.5 lakh and reflects an "abnormal" rise in income is likely to be scrutinized and subjected to a 200% penalty+ as it may not be seen as eligible for the current year's tax assessment, tax authorities have said.
  1. Demonetization has operationalized the Jan-Dhan bank accounts, with around 210 billion rupees ($3 billion) in deposits, based on recent statistics. The Pradhan Mantri Jan-Dhan Yojana (PMJDY) was launched in 2014 to achieve greater financial inclusion, and increased bank account penetration from 35 percent to 53 percent during last three years. But around 74 percent of these new accounts remained non-operational with zero balances.  
  2. At least some of these money will indeed be taxed and it would not have been taxed without the demonetization program. This means that the budget deficit will be smaller than it otherwise would have been. This will have knock on effects upon interest rates and inflation once again.
  3. The additional inflow of large amount of cash in the banking system will enable capital investment in sectors such as roads, ports, and railways. 
  1. It would inspire confidence of international community that India is serious about its commitment to fight corruption. This will enhance India’s ranking in ease of doing business as well as in various global indices of corruption.
  2. Negative-Shock strike at unaccounted economy could lead to shrinkage in production, especially in informal sector including micro, medium and small enterprises.
  3. Negative- Demonetization will lead to lower conspicuous consumption and real estate activity. Thus, residential investment could suffer and impact 300 industries which provide inputs in housing sector. Therefore, India’s growth rate in short run could be a matter of concern unless government uses the fiscal multiplier to boost growth.

Will demonetization push India to a Digital economy?

  • This move has is a quantum leap towards a cash-less economy and is probably the single biggest public policy innovation since liberalization in 1991, jolting the economy towards a digital future.
  • The demonetization will nudge a larger number of individuals to lessen their dependence on cash transactions and resort to digital payments. Downloads of Paytm wallet (a mobile e-commerce company with a user base of over 150 million) has tripled since November 9. 
  • However a number of factors need to be taken into consideration. India is a very diverse country in terms of languages and scripts. Also, the country has low level of literacy of about 70%, and English literacy of not more than 10% of the population. Given the fact that all electronic devices have English numerals and all communication on digital banking is also in English, there is natural barrier to completely digitalize Indian economy during immediate period.
  • India continues to have 30% of population or nearly 40 crore people below poverty line. These people could also be slow in embracing digital economy.
  • 90 % of the Indian population operates in informal sector. Illustratively, the transport sector including taxis, auto/cycle rickshaws, horse carriages and bullock carts are all on cash payment as also most of local markets/shops/dhabas and similar business outlets, especially in rural areas.
  • For a populous country like India, any future strategy for financial inclusion will call for technology to reach the bottom of the pyramid. To facilitate use of Internet and digital transactions, the government can consider forming a Digital Sevak Dal – a network of young people to educate and support the Indian public in cities and rural areas to transition to a cashless economy. The Student Police Cadet scheme in Kerala is an example where schoolchildren visit the homes of poor and the elderly and help with e-literacy and digital transactions. Given the large number of unemployed, and that it requires minimal investment in education, the initiative can create major positive spin-offs.

Indirect Taxes



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