The right sequencing of economic policies, while exceptionally important for the success of economic reform, is relatively neglected in popular discussion. For example, macroeconomic stabilisation of a country with high inflation, sluggish output growth and an overvalued exchange rate would require that the correction to the exchange rate precede stabilisation policy. Reversing this sequence would not yield the desired results. Former US Fed governor Ben Bernanke, in a lucid review of the interaction between exchange rate policy and monetary policy argues that floating (or at least flexible) exchange rates can function as automatic stabilisers and shock absorbers leaving monetary policy free to concentrate on its core responsibility of inflation and output stabilisation.

A similar argument is relevant to the current debate in India on demonetisation and GST. Many seem to agree that GST is a good policy (although some might say that it was implemented too soon and that GST rates have yet to find their optimal levels) but some criticise demonetisation. An important point to understand here is that without demonetisation GST could not be a success.

These two policies together and their sequencing has drastically reduced the size of the informal economy in India. As M Shahe Emran and Nobel laureate Joseph Stiglitz show in an important paper “On selective indirect tax reform in developing countries”, VAT (GST’s predecessor applied to goods only) in an economy with a large informal sector (like India’s) introduces a strong distortion between formal and informal sectors of the economy and hence reduces welfare.

Apart from this, transactions could move into the informal economy whence tax collections would be sluggish. This has been borne out by Indian experience. VAT was introduced into India on April 1, 2005 and indirect tax revenues were stagnant in response. According to the ministry of finance’s Indian Public Finance Statistics 2014-15 Centre and state indirect tax revenue was 11.37% of GDP in 2005-06, 11.77% in 2006-07, 11.06% in 2007-08, 10.43% in 2008-09, 9.63% in 2009-10, and hovered between 10.53% (2010-11) and 11.57% (2014-15).

It follows that it was essential to sharply reduce the size of India’s informal economy to make GST a success. By this logic, demonetisation should have occurred before the implementation of VAT in 2005. There is no gainsaying the fact that prior to November 2016 India had a very large informal economy. A key indicator of this was the overwhelmingly large proportion of transactions carried out using cash (the 2015 currency to GDP ratio was 12.51% for India compared to 9.34% for China, 7.38% for the US and 2.45% for Norway).

According to a recent Bloomberg report India unearthed more than a billion dollars in illegal cash holdings from more than 2,00,000 shell companies post-demonetisation. This Bloomberg report also cites McKinsey & Co to suggest that in 2013 India’s black economy was nearly 30% of GDP. Clearly, the situation was unsustainable and had to be addressed.

Gains from moving towards electronic modes of payment are compelling. Electronic payments and transfers provide an easy audit trail for governments to tax individuals and businesses and track illegal transactions such as money laundering, financing of crime, terrorism and drug smuggling. No wonder, some governments (eg Denmark), routinely discourage the use of currency notes. Businesses, too, benefit from a move from cash to e-transactions as there is evidence (from Australia) that people spend more when paying electronically.

Electronic means of payment provide greater security of transactions despite the threat of cybercrime. Carrying large amounts of cash involves large risks of its own and fuels government inefficiency and corruption. A Time magazine report suggests that carrying out transactions by cash actually hurts the poor more than the rich, since it is harder to protect cash against theft, decay and natural disasters.

Some have argued that since of the Rs 15.44 lakh crore worth of currency denotified all but Rs 16,000 crore came back into the banking system demonetisation was a failure. This argument is wrong. All bank deposits have enough information to identify the depositor. Large depositors can be pursued to check their legitimacy. According to an ET report, the CBDT has discovered unexplained cash worth Rs 3 lakh crore in bank accounts.

Although the demonetisation programme was kept a well-guarded secret, the government had prepared the population well. Opening of a large number of Jan Dhan and other bank accounts ensured that ordinary people had an avenue to deposit their invalid Rs 500 and Rs 1,000 notes. Thus, a welcome byproduct was the sharp growth in financial inclusion, something that was talked about for decades but had remained elusive. By announcing a generous amnesty scheme for tax dodgers well before November 2016 the government ensured that those who wanted to come clean on their financial affairs had an opportunity to do so.

Indian tax/GDP ratio is lower than that of many countries with comparable per capita GDP in PPP terms. Another major spinoff from the dual policies of demonetisation and GST has been the sharp increase in tax revenue and number of taxpayers (both direct and indirect taxes). Many areas urgently need public expenditure and the higher tax revenue will facilitate this.

To conclude, demonetisation and GST have been momentous structural reforms in India. Although their implementation caused temporary hardships to many, faster, more transparent and inclusive economic growth lasting well into the future is now imminent.