Two steps, demonetisation of Rs 500 and Rs 1,000 notes, and limiting the amount of cash anyone can hold, will significantly reduce domestic black money transactions

By R Vaidyanathan

The white paper on black money produced by the ministry of Finance and presented to parliament during the last session has evoked a mixed response (See here).

One of the major criticisms it has faced is that it has mixed up domestic black money and illicit money kept in tax havens abroad by Indians. These two need to be dealt with in different ways. Some part of the domestic black money is used in productive activities like real estate, trade, construction, mining, transport, restaurants and other businesses. The illicit money kept in tax havens abroad is, by and large, not used for domestic purposes unless it is round-tripped through share markets or foreign direct investment (FDI) to domestic operations.

Domestic black money is a no-confidence motion on the government of India while illicit money kept abroad is a no-confidence vote on India itself - its stability and its people.

Domestic black money is primarily dependent on the cash economy and tries to avoid formal transactions through banks due to fear of being captured by electronic systems and the tax authorities. So the holding of black money is usually in the form of cash and transactions undertaken in cash. This implies that substantial portions have to be kept in high denominational currency, since storing or carrying huge quantities of cash in small denominations is relatively difficult.

In India, if we take only currency notes (and coins), we have the lowest denomination at Re 1 (of course, the Rs 1 currency note has been replaced with coins) and the highest at Rs 1,000 - which implies that the differential is 1,000 times between lowest and highest pieces if currency. In the US, the most popular highest denomination is $100 - and the differential is 100 only.

Not only that, we find from Table 1 below that the Reserve Bank of India (RBI) seems to favour printing higher denominations currency even though the mass of poor people may transact only in lower denominations. We find that in 2005-06, around 57 percent of the total amount of Rs 43 lakh crore of coins and notes introduced in circulation comprised Rs 500 and Rs 1,000 notes. But by 2010-11, the share of the higher notes had become 79 percent of the total value of Rs 95 lakh crore.

This implies that more and more of the denominations in circulation are skewed to higher value notes when the mass of people may need lower value denominations. The very high denominations also facilitate transactions in black money.

If the government wants to reduce domestic black money, it should withdraw Rs 500 and Rs 1,000 notes from circulation, and replace them with lower denominations such as Rs 100 and Rs 50. This can be undertaken in an orderly fashion over a period of say three to four months and all those who possess the higher denominations can exchange it with banking channels for lower denominations. It will automatically bring a huge amount of the funds kept in these denominations into the banking channels.

When this happens, the government can decide the nature of penalties to be levied if the amount has not been declared earlier for tax purposes. For instance, for the year 2010-11, nearly Rs 75 lakh crore would be converted from Rs 500-1,000 notes to new Rs 100s, etc. Of course, an adequate number of new Rs 50-100 notes should be made available from the operational point of view for this conversion.

Another issue about holding cash in our context is this. The black money report says: "As of now there are no legal restrictions to keeping very large amounts of cash with oneself or transporting it from one place to another. One is neither required to report it nor provide any explanation for it. There have been suggestions that the government may consider amending existing laws, including the Coinage Act, 2011, the Reserve Bank of India Act, 1934, FEMA, and the Indian Penal Code, or enacting an entirely new statute aimed at regulating the possession and transportation of cash above a particular threshold limit. This may include creating a limitation on cash holdings for private use, as well as provisions for confiscation of cash held beyond such prescribed limits. However, such laws need a broader political consensus to emerge for their acceptance in Parliament."

We find that political parties do disburse cash to voters prior to elections and for which a huge amount of cash is held and transported from one location to another. For instance, one report suggests that in the recent Andhra Pradesh byelections cash valued at as high as Rs 32 crore was seized prior to the polls. These were presumably meant for distribution to voters.

An earlier report pertaining to last year's elections in Tamil Nadu suggested that Rs 24 crore in cash was seized by election officials.

There are many other reports which give us a clue that cash is held and transported in huge quantities not only for bribery at elections, but for other black money transactions. It is important that we bring in the necessary changes in the Coinage Act, 2011, and other relevant acts to make holding of cash above a threshold level, say Rs 10 lakh, punishable. This threshold can be arrived at by the Reserve Bank after taking into account the requirements for genuine cash transactions in the economy like marriage and religious ceremonies, wage disbursals in construction activities, etc. This limit should not be applicable to obviously banking institutions and corporates having construction/project activities where substantial amounts of cash disbursals take place.

In developed economies like the US, there are no restrictions per se in terms of holding or transporting cash domestically, unless it is suspected to be drug money. Even there, transactions beyond $10,000 in cash are expected to be notified to the Internal Revenue Service (IRS) by shops and establishments. Of course, there are restrictions on the amount of dollars one can transport during immigration/emigration. But since the US is a well developed economy, most of the transactions are conducted through plastic cards or banking channels.

In our country, cash transactions are more to avoid taxes and generate black money. The higher the denomination, the easier it is to transact and transport. Taking into account our situation, we should evolve laws to prohibit the holding of cash beyond a threshold level and this will go a long way in preventing disbursals for black transactions.

These two steps - demonetising Rs 500 and Rs 1,000 currency notes and creating a threshold limit for cash holdings - will facilitate a reduction in domestic black money transactions. These decisions will not eliminate domestic black money, but will help reduce it to some extent. Probity in public life comes in an incremental fashion since we have reached the nadir. Are our parliamentarians and other opinion makers ready for at least incremental steps to reduce domestic black money?

R Vaidyanathan is professor of finance at the Indian Institute of Management, Bangalore. These views are personal