On Tuesday, November 8, 2016, India’s Prime Minister, Narendra Modi, announced that he would pull 500 and 1,000 rupee currency notes from circulation. The move is an attempt to nullify untaxed (“black”), corrupt, and counterfeit currency. Eventually, new bills will replace the old ones, but in the meantime, only low value notes will be considered legal tender. As The Indian Express, “Rs 500, Rs 1000 currency notes stand abolished from midnight: PM Modi” reports:

In a major step to check black money, Prime Minister Narendra Modi on Tuesday announced demonetization of Rs 500 and 1000 currency notes with effect from midnight, making these notes invalid in a major assault on black money, fake currency and corruption. In his televised address to the nation, Modi said people holding notes of Rs 500 and Rs 1000 can deposit the same in their bank and post office accounts from November 10 till December 30.

How reasonable a policy is this? That is, will it accomplish its purpose while minimizing collateral damage?

A Few Facts

A few basic facts about the Indian economy will provide valuable perspective.

• 90% of transactions in India are conducted using cash.

  Most transactions are legally conducted by people who don’t earn enough money to pay income taxes. As Tyler Durden reports in “Indian Economy Grinds To A Halt After Cash- Ban: "Faith In System Shaken"”:

India is overwhelmingly a cash economy, with 90% of all transactions taking place that way. Most of these transactions are legal, consisting of relatively small amounts, and frequently done by people who don’t make enough money to pay income tax.

• The two notes being demonetized, the 500 and 1,000 rupee notes, constitute 86% of the currency in circulation (see Justin Rowlatt, “Why India wiped out 86% of its cash overnight”)

• People must exchange the demonetized currency for lower denomination notes through their bank.

Yet, over half the Indian population does not have a bank account. Moreover, almost one-quarter of the people don’t have basic ID, which is required to open a bank account (see Figure 1).

Figure 1

How the Process of Demonetization Is Being Implemented

Now let’s consider how the currency exchange, or demonetization process, works (see, for example, Justin Rowlatt, “Why India wiped out 86% of its cash overnight”). The mechanism essentially partitions people into one of four groups:

1. People who currently don’t have a bank account can either

a. Open an account and exchange money, or

b. Find someone else with an account willing to exchange money for them.

2. People who currently have a bank account and have up to 4,500 rupees (roughly $69) (some sources say 4,000 rupees) in 500 and/or 1,000 rupee notes can go to the bank or an ATM and exchange their higher denomination bills into lower denomination bills.

3. People who currently have a bank account and have between 4,500 rupees and 250,000 rupees (roughly $3,670) in 500 and/or 1,000 rupee notes can exchange 4,500 rupees into lower denomination bills and then deposit the remaining money into their account.

4. People who currently have a bank account and have more than 250,000 rupees in 500 and/or 1,000 rupee notes must provide evidence that they’ve paid income taxes on this money.

a. If they can provide evidence of taxes paid, then they can exchange 4,500 rupees for cash and deposit the remainder in their account.

b. If they cannot provide evidence of taxes paid, then they owe income taxes plus penalties on any amount exceeding 250,000 rupees.

So what is the likelihood that people will fall into these different categories?

India’s Distribution of Wealth

The first step to answering this question is to ask what the distribution of wealth looks like. The wealth in India is vastly concentrated. The Top 1% of the population owns over one-quarter of the wealth, the Top 10% owns about 62% of the wealth, and the Top 20% owns over three-quarters of the wealth (see Figure 2).

Figure 2

India’s Distribution of Income Taxes Owed

Next, I assumed that the distribution of annual GDP in India across the population is similar to the distribution of wealth and used that to estimate the distribution of the population across tax brackets for 2015. The results, shown in Figure 3 suggest that

• The bottom 80% of the adult population earns too little to pay income taxes,

• The adults at the top 20% income level fall into the lowest tax bracket (10%),

• The adults at the top 10% income level fall into the middle tax bracket (20%), and

• The adults at the top 1% income level fall into the high tax bracket (30%).

Figure 3

My estimates in Figure 3 suggest that 2015 income taxes owed total about 10% of GDP. In “Business Owners Try to Undercut India’s Move Against ‘Black Money’,” Raymond Zhong reports that income taxes constitute about 6% of GDP.

Government revenue from income tax is less than 6% of the size of the economy in India. In advanced nations, the average is around 12%.

My estimates are thus consistent with Raymond Zhongs figures, together with the fact that only about 1% of Indians pay income taxes. In other words, my estimates suggest that if 10% of GDP is owed in income taxes, but only 6% of GDP is actually paid, then about 60% of owed taxed fail to be paid.

So the implications of my estimates of the distribution of the Indian population across tax brackets for the demonetization plan is this: The vast majority of Indians would owe no income taxes or penalties on any 500 and/or 1,000 rupee notes that they would like to exchange. Yet, these are the same people who are most likely to lack ID and/or bank accounts and thus be hindered in their ability to exchange their funds.

Tax Rates for Untaxed Black Money under Demonetization

So now let’s consider the taxes and penalties that would be owed on any redeemed notes for which proof of taxes paid cannot be established. Justin Rowlatt indicates that taxes and fees on funds over 250,000 rupees (roughly $3,670) would be taxed and penalized at a combined rate of 300% of the owed tax.

There is no limit to the amount that can be deposited in bank accounts until the end of December, but the government has warned that the tax authorities will be investigating any deposits above 250,000 rupees (£2,962).

Breach that limit and you will be asked to prove that you have paid tax. If you cannot, you will be charged the full amount owed, plus a fine of 200% of the tax owed.

So what does this tax and penalty schedule look like? The schedule is provided in Figure 4, which suggests that people with about $25,000 in untaxed currency above the 250,000 rupee threshold will lose about 60% of their total funds (not just the excess) to taxes and penalties.  People with about $50,000 in untaxed currency above the 250,000 rupee threshold will lose about 75% of their total funds to taxes and penalties.

In other words, under the demonetization plan, people with untaxed currency will end up losing a majority of any reclaimed funds to taxes and penalties.

Figure 4

People’s Responses to Demonetization Plan

Anticipating that people might try to make multiple exchanges of small amounts of currency in order to avoid any taxes or penalties, the Indian government restricted people to a single exchange transaction. They’re enforcing this by marking people who have made exchanges with permanent ink, the same type they use in elections to enforce one-time voting. As the BBC reports in “India's rupee crackdown sees money- changers ink-marked”:

People have a limited time to exchange the notes for smaller denominations, but will have their fingers marked.

The government wants to stop holders of "black cash" offloading their old rupee notes in small tranches.

Authorities often use indelible ink to stop people from voting more than once in Indian elections.

Buy Hard Assets

One of the most obvious ways to cleanse stashed cash is to use it to buy hard assets, particularly gold. In “The Strange Consequences of India's Unprecedented Banknote Ban,” Anirban Nag confirms that this has, indeed, been happening:

There was a surge in demand for luxury watches after Modi’s sudden announcement as wealthy Indians rushed to make costly purchases with unaccounted cash.

A new gold rush also emerged soon after Modi’s announcement…

Other more interesting hard asset sales have been proposed. Soutik Biswas describes some such examples in “How India's currency ban is hurting the poor”:

A salesman of a shop selling mobile phones in an upscale Delhi suburb told me that a man walked up to his shop on Wednesday with 3 million rupees in cash and offered to buy up his entire stock of iPhones. (He said the owner balked, and shut shop.) A politician in Bihar walked into a jewellery shop and bought gold ornaments worth 20 million rupees.

The sellers of the assets will be forced to deposit the currency themselves and thus pay taxes on it. If the sellers would not have otherwise reported the currency, then prices may very well go up to account for sellers now having to pay taxes on the revenues collected from people trying to launder black money.

Pay for Current and/or Future Goods and Services

Another alternative for cleansing money is to pay off past bills or prepay for future goods and services. Again, Soutik Biswas provides examples:

In Kolkata, a dengue patient reportedly settled his 40,000 rupees hospital bills in coins.

…

A builder in the capital has apparently paid his daily wage workers two years of advance salaries with the expired cash, leaving his workers to exchange the money.

In “India's War On Cash Is Forcing The Rich To Beg The Poor For Help,” Tyler Durden reports on one cad who wasn’t so successful in using hoarded funds to pay off unpaid alimony:

A divorced man who had defied the courts by refusing alimony to his wife was seized with a new respect for the law and offered to pay her the arrears - in the banned currency notes. The judge threw him in jail until he paid in the new notes.

Buy Notes at Discount to Reuse/Resell

Another possibility for monetizing demonetized notes is to sell them at a discount to someone else who may be able to launder the funds himself. Soutik Biswas reports that this is, indeed, a “thriving” activity:

There is also what is being called a thriving 'discount scam': people are offering to buy stocks of scrapped notes at a premium, before laundering the expired money.

Pay Poor People to Exchange and/or Deposit Funds

The government recognizes that people may not be able to exchange their notes themselves and allows for these people to exchange their funds using someone else’s account. PTI describes how this process works in “Rs 500, Rs 1,000 currency notes banned: RBI explains the rationale behind move”:

A person with no personal account of her own can avail of this exchange facility via a relative/friend's account with written permission. But while exchanging, one should provide the evidence of permission given by the account holder and own valid identity proof.

The exchange can also be done through a third party provided one gives a written authorisation letter with the bearer, who should also prove the identity.

Unsurprisingly, people with hoards of black money are taking advantage of this by paying poor people to exchange funds using the poor people’s accounts. Tyler Durden describes the new-found humility rich people have been showing their servants in an attempt to convince the servants (and other poor people) to change money for them:

Maids, drivers, nannies, and cooks in India are experiencing unusual politeness from their employers. Beyond the work they do every day, they suddenly have another use – to launder the undeclared cash which the rich have been hoarding in steel wardrobes, under the mattress and in under-bed storage.

…

Domestic staff and factory employees are going around with big grins, delighting in the panic and anxiety etched on the faces of the fat cats who never showed them any consideration, not to mention the delicious irony of being beseeched by their now squirming masters.

Burn/Ditch Notes

Finally, if hoarders think the costs of trying to exchange and/or deposit black money are greater than the benefits, they might simply resort to ditching or burning their loot. More from Tyler Durden:

In their desperation to get rid of their ill-gotten money, rich Indians are dumping sacks of notes into the River Jamuna in New Delhi. Some have made a bonfire of their cash at some deserted place before running away to avoid identification.

Likely Effects of Demonetization Plan

Finally, let’s consider the overall benefits and costs the demonetization plan is likely to achieve.

Benefits

The most obvious benefit of the demonetization plan is a “flushing out” of black money from the system. While, of course, the government hopes that black money will not start up again once the new 500 and 2,000 rupee notes begin circulating, this is likely a pipe dream. In this case, the plan will end up being “at best, a one-time flushing out of the system and the return of black money is likely if not inevitable,” as Soutik Biswas describes it.

Another clear benefit is any revenues collected in taxes and penalties on exchanged currency. However, taxes and penalties will be limited to the extent either (i) that people would rather destroy their black money than redeem it, and/or (ii) that currency (outside the country) does not make it into reclamation sites before the December 30 deadline.

Also, to the extent that people anticipate future demonetizations, there is the potential benefit of a drop in the use of black money in the future. Given the nature of the Indian economy, however, I think this effect will be minimal.

Costs

The direct costs of the demonetization plan include all the costs of orchestrating the withdrawal of old notes, the printing and circulation of the new notes, and the costs of refitting machines that accept and dispense cash. As Anirban Nag notes in “The Strange Consequences of India's Unprecedented Banknote Ban”:

… the need to reconfigure the country’s 220,000 cash machines so that they can dispense the new 500 and 2,000 rupee notes, which do not fit into existing ATM cash trays

Perhaps an ironic cost of the demonetization plan is any losses of money to bribes paid by people trying to expedite or facilitate the exchange process.

Aside from the taxes and penalties themselves, another cost to the people who decide to come forward and report untaxed funds is the future risk of being tracked and targeted by the government. Given that the majority of these funds will be lost to taxes and fees (up to 80%, as noted above) anyway, the future risks to these people are likely not worth the costs. Many of the people in this situation will therefore probably choose to write off their funds. As Tyler Durden indicates,

The Income Tax and Excise Departments’ ability to gather data will increase exponentially. So will their discretionary powers, when they can query people who pay large sums in cash into their accounts. This might lead to an exponential rise in demands for under-the-table payoffs to officials in those departments in the next year. Also, India has no Privacy or Data Protection Laws. That data could be sold to all sorts of people and I cannot begin to guess what the consequences could be.

A more insidious cost of the demonetization plan is the loss in faith it will cause in India’s currency system. All else equal, loss in the faith of a currency will cause that currency to depreciate in value relative to the value of other currencies. Tyler Durden describes this loss in more detail.

Our entire monetary system depends on trust. A banknote is a piece of paper that says the RBI will give the bearer another similar piece of paper, or make an entry in an electronic ledger for that amount. The system works because everybody believes that those pieces of paper will be accepted by everybody else and therefore, money serves as an useful medium of exchange. This move has shaken that trust.

Another large cost associated with the demonetization plan is the loss in economic activity associated with the disorder and the losses in liquidity occurring from the time of the initial announcement on November 8^th, through the time until the new currency has been fully introduced into the system. Given the massive havoc that’s been reported to be occurring in India since the announcement, it sounds like costs of lost economic activity will be substantial.

In sum, Mondi’s demonetization plan will have a strong negative impact on the financial well-being of the majority of citizens, most of whom already struggle financially.  Yes, there will be a one-time flushing of black money from the system. However, any potential windfall collection of taxes and fines on reclaimed black money will be severely limited, due to the massive fines and future risks associated with reporting untaxed funds. There will also be a huge loss in economic activity associated with the chaos and illiquidity of the economy during the transition process. And the fact that the old bills will simply be replaced by new ones simply paves the way for a new black money system to appear once the new bills start circulating. It sounds to me like the demonetization plan was extremely poorly designed, where the costs will be overwhelmingly larger than any benefits achieved, hitting the poorest classes the hardest.