Demonitisation
Many economists argue that most black money isn’t buried in people’s backyards, but circulates in the economy.

Since the 2014 general election, “black money” has been widely discussed in the public, the overall tone of the discussion suggesting that hoards of money are lying in banks or stored secretly in houses and the like. 

Prime Minister Narendra Modi’s televised announcement on Tuesday night, stating that the Rs 500 and Rs 1,000 notes would be withdrawn in an attempt to curb black money, took everyone by surprise. It also seemed fully in line with the image described above.

According to The Economist, the two denominations of currency represent 86% of all the currency in circulation (equivalent to 11% of GDP). The report also points out that nine out of 10 workers are employed in the informal sector, raising questions of how demonetisation will affect this large group of people. 

Given this profound effect demonetisation will have, much of the recent discussion has centred around attempting to explain the nature of black money, the activities that generate it, and the effectiveness of the government’s  move in that context.

Here is a simple explainer on black money:

What is black money?

Black money is basically undeclared money. It is generated either by illegal activities or by legal activities that are not reported to the government. Therefore, this money is not accounted for in taxes.

Black money, economists argue, doesn’t necessarily mean that it is stashed in someone’s mattress. Often a large part of it is in circulation. According to economist Abhijit Sen, “a large part of the black money is actually the liquidity for a very large economy”. 

Economist Prabhat Patnaik says that the term black money is actually a misnomer. Writing for The Citizen, he said: “Actually when we talk of “black money” we have in mind a whole set of activities which are either entirely illegal, such as smuggling, or drug-running, or procuring arms for terrorist organizations, or are undertaken in excess of what is legally permitted, or are not declared at all so that taxes are not paid on them.”

In July 2010, the World Bank estimated that the weighted average size of the “shadow economy” of India (as a percentage of the GDP) was 20.7% in 1999 and 23.2% in 2007. 

Minister for Finance Arun Jaitley told Parliament in July that there is no estimation of how much black money is actually stashed abroad, and that the figures that existed were estimates by NGOs and economists. 

According to journalist Josy Joseph, author of A Feast of Vultures, much of the understanding of how black money works in India actually comes from investigations abroad of contracts obtained by foreign companies in India, which are then brought to the attention of Indian authorities.

Will demonitisation actually help?

An analysis of income-tax data between April 1 and October 31 this financial year by Hindustan Times found that the cash component of money acknowledged by black money holders as ill-gotten wealth, was just 5%, i.e. Rs 408 crore. Additionally, the HT report says that the actual amount of hard cash recovered would be much lesser because the IT department clubs currency and ornaments into one category. 

The report also points out that the likelihood of people – tax evaders and corrupt public officials – stashing cash in their homes is very less because of sheer logistics. Rs 1 crore in Rs 1,000 notes weighs 13kg and requires space of at least one sq ft. 

Prabhat argues that black money, like white money, is meant to earn profits rather than remain stashed away. He says that a sizeable chunk of black money is operated through banks abroad, and that some argue that this sum is larger than the black money operated domestically.

The Mint reported that “While it is true that not all of the undeclared wealth in the country is stashed abroad, tax havens such as Switzerland and Panama provide an attractive option to many companies and high-net-worth individuals in India as well as other countries to evade scrutiny from local authorities.”

A finance ministry official told HT that ill-gotten wealth enters the formal economy through real estate and shell companies. 

The report quoted a research paper that attempted to trace the origins of the concept of a tax haven. According to the research paper, the ruling in a 1929 case in the UK paved the way for tax havens. The UK’s House of Lords ruled that since the Egyptian Delta Land and Investment Co. Ltd. company conducted the bulk of its business in Egypt, it should not pay taxes in Britain even though it was registered in the UK. 

Eventually, this judgment laid the foundation for the concept across the British empire. At present, an estimated 50 tax havens, mostly tiny island countries or territories with separate jurisdictions within countries, function as tax havens. 

Although the Indian and American economies and economic systems are vastly different, an example from the US could perhaps help understand the nature of tax evasion and its effects on the public. A study of 50 American companies by Oxfam America found that, “the share of tax havens in American corporate profits has increased from less than 5% to more than 20% between 1984 and 2012”.

The study also found that these companies “collectively earned $4 trillion in profits from 2008–2014, and received approximately $27 in federal government loans, loan guarantees and bailouts for every $1 they paid in federal taxes during that period”.

The Oxfam report noted: “The US loses as much as $111 billion each year due to corporate tax dodging. We should not lose sight of why tax dodging matters to average people. This loss of revenue prevents adequate investment in education, infrastructure and other critical public needs that can reduce poverty, create jobs and build greater economic opportunity.”

The Mint report quotes a study published in the Monthly Review, which notes that many Indians “park their wealth in Mauritius before "re-investing" in India “tax-free”. The report said that Mauritius became Asia’s leading financial centre through “bilateral tax arrangements” related to “suspected tax evasion”. Foreign investment to India routed through Mauritius is about 44%. 

In his book A Feast of Vultures, journalist Josy Joseph wrote that the Department of Industrial Policy and Promotion (DIPP) noted that “it is apparent that the investments are routed through these jurisdictions (Singapore and Mauritius) for avoidance of taxes and/or for concealing the identities from the revenue authorities of the ultimate investors, many of whom could actually be Indian residents, who have invested in their own companies, through a process known as round tripping’.

Josy alleges that the biggest case of black money parked in offshore havens being investigated by Indian authorities is that of business tycoon Gautam Adani. 

“The Adani group allegedly took out over Rs 5,000 crore to tax havens, using inflated bills for the import of power equipment from South Korea and China, the SIT on black money was told by the Directorate of Revenue Intelligence (DRI) and the Enforcement Directorate (ED),” Josy writes.

The Mint reports that one of the most common ways to avoid paying taxes in countries where taxes are high is to use transfer pricing, i.e. “selling cheap and buying dear among different arms of a multinational corporation to lower incomes and avoid taxes in a high-tax country”.

The Mint report also states that 300 economists across the world had called for an end to the tax haven regime, because tax evasion directly harmed poor countries.

Referring to the Panama Papers, the economists said that “the secrecy provided by tax havens fuels corruption and undermines countries’ ability to collect their fair share of taxes”.

While stating that they differed on the desirable levels of taxation, they all held the view that “territories allowing assets to be hidden in shell companies or which encourage profits to be booked by companies that do no business there, are distorting the working of the global economy”.

An investigation by the International Consortium of Investigative Journalists made public in April revealed that the names of around 500 Indians were part of the leaked Panama Papers. These include wilful defaulter and former Rajya Sabha MP Vijay Mallya, and other businessmen who live in and have interests in different parts of south India, such as Chinnamaruthu Shanmuga Sundarapandian and Dinesh Parameswaran Nair.

Although this does not by default mean illegal activity on the part of these businessmen, the documents generally allege that the law firm Mossack Fonseca helped clients launder money, dodge sanctions and evade taxes with offshore accounts. The papers leaked show that 72 current or former heads of states are also among the people whose names figure in the leaked Panama Papers. 

More south Indian names tumble out of Panama Papers’ closet