Four years ago, I wrote a middle on these pages highlighting the relationship between the cash economy and the network of black transactions.
It is gratifying when one's ideas see fructification, even if it takes this long for them to sink in. Unfortunately good ideas can be ruined by poor implementation.
Moreover, poor or ill-conceived implementation can create a climate that militates against improvement or better implementation later.
There are many examples of this from our long and sorry history of state intervention in economic management. A recent example is the interesting experience of the turnover tax. This tax was a good idea.
The basic economic logic was simple: it did not discriminate on risk and risk-taking behaviour as the capital gains tax in use did. But the way in which the tax was decided upon and implemented created an uproar that almost led to the baby being tossed out with the bath water.
Fortunately cooler heads prevailed: discussion and dialogue led to the tweaking and calibration of the tax that made it quite successful and even popular, if any tax can be said to be popular. A similar risk awaits the finance minister's initiative against the cash economy.
To rescue this initiative from the somewhat inept treatment in the Budget speech, it may be fruitful to return to some of the basic premises of my original argument.
The central point is that the system discriminates against the use of more formal, easily monitored methods of transacting such as cheques and credit cards. This happens in several ways.
Banks and service providers levy user fees on these services. Second, cash services are implicitly subsidised by banks who do not price the use of teller services, and by the state that provides the increased security needs of the cash transactions at no additional charge.
Moreover, the state itself effectively mandates the use of cash in many places, including tax payments, where cheques, credit cards and the Internet find little or no space. Given this background it is clear that we need to rectify the cost allocation between using cheques and credit cards on the one hand and cash on the other.
But is imposing a tax on withdrawals the right answer? It is here I part company with the FM. In rectifying distortions, the use of the correct instrument is as important as the desire to remove the distortion. To this end it is important to spell out some of the elements of what must go into a correct policy.
Before analysing the merits of the Budget proposal it is important to dispose off a non-issue. Some of the criticism against this proposal has questioned the link between the black economy and cash transactions in banks.
This is mistaken; the black economy and the white economy are not in separate watertight compartments. They constantly interact with each other.
For instance, people buy goods and services with white money/ income but the sale or transaction is not recorded. The nexus between these two economies is the cash transaction network that is mediated by cash deposits and withdrawals from the banking system.
Attacking the black economy, thus, requires a better monitoring of this process. In order to do this it is important to examine the nature of the cash transaction economy.
Some simple questions that need to be answered in this regard are: what are the patterns of cash transactions in the banks? What is the distribution and size of cash deposits and withdrawals?
How do they differ across different categories of account holders, traders, industry, public service organisations, and so on.
Geographical and regional characteristics would also be of relevance. The largest users of cash facilities are likely to be traders and organisations with large public dealings.
For them investment in modern techniques of transactions is expensive and not compensated for by the state. These are the entities who must be encouraged to shift away from cash-oriented transactions.
To do this we need to create a well-crafted system of incentives and charges. Taxes for this purpose are a bad idea, since they are a blunt tool that cannot discriminate between categories of users.
Taxes must also be constitutionally justifiable: the validity of a tax on cash withdrawals may be questioned. It would need creative interpretation to justify the withdrawal tax in terms of the allowable categories in the Union list.
Moreover, as a colleague pointed out, why Rs 10,000 a day, why not Rs 70,000 a week or Rs 300,000 a month! Why a tax on withdrawals alone and not on deposits and so on. All of this is completely unnecessary.
The point is that accounts with a high proportion of cash transactions should bear a greater portion of the cost of providing teller and cash management services. A better solution than the proposed tax would be to levy cost-based charges in proportion to the size of the cash transactions in an account.
The best place to do this is at the bank level since these costs will vary from bank to bank and from location to location. The charge on cash usage should be higher in areas with higher labour and security costs.
Second, the state creates a number of disincentives on the use of formal payment systems. It needs to balance this with some incentives. Thus, rebates or concessions could be given to tax payers who do a larger proportion of their business in formal transactions. This could, for instance, be built into the Value Added Tax system.
Further, the present pattern of charges that banks and credit card companies levy for usage or cheque clearing seems to based more on considerations of raising revenues rather than on the cost involved.
They should be discouraged from using such transactions as source of revenue; these should be mandated to be explicitly linked to costs. More importantly, the costs of providing banking services must be distributed across different services in a more equitable manner.
Basically, what is needed is a re-balancing of the costs associated with alternative methods of settling transactions. I can understand the bureaucracy wanting to use taxes: that is an instrument they have understood, and they would rather not learn anything new!
But the government must guard against the temptation of creating ever-new categories of tax. Where taxes are used, they must be carefully designed and new taxes must be discussed widely before implementation. One does not have to go much further than the current brouhaha over the ill-conceived fringe benefit tax.
Thus, I would recommend the following to the finance minister:
The minister should be commended for recognising an important facet of dealing with the problem of the black economy, but it is equally important that the task is not made more difficult by this knee-jerk approach of saying "If it is measurable, let me tax it."
The author is professor, Department of Economics, Delhi School of Economics, Delhi University.
