Let there be no doubt: Demonetisation will affect India’s GDP adversely. To understand how, assume a small country with four citizens. Arun the architect has a Rs 100 note which he uses to pay Caran the carpenter for building a house. Caran then uses the Rs 100 to pay Dhruv the doctor, who in turn uses the Rs 100 to buy groceries from Gauri the grocer, who then pays Rs 100 to Arun to design her house.
In this hypothetical economy, Rs 400 changed hands even though there is only one Rs 100 note. The GDP of this country, which is the sum of all the goods and services produced by its citizens, is Rs 400.
Blow for the Economy
If Rs 85 is now removed from this economy through demonetisation, Arun only has Rs 15 to pay Caran who now does not have enough money to go to the doctor, who then can’t buy groceries from Gauri, who in turn does not have enough for her house. The GDP of the country drops from Rs 400 to Rs 15.
This example shows how the movement or velocity of money is key to economic growth. The higher the velocity of money, the higher the GDP. Removing money from the economic system has devastating effects on transactions, velocity of money and economic growth.
It doesn’t matter whether the money is black or white – as long as it is circulating in the economy resulting in transactions, it creates growth. India’s economy was the fastest growing one in the world before demonetisation, so clearly the presence of black money was not hurting economic growth.
Fair Treatment of the Human Capital
Many in the country have the misconception that once black money is removed, somehow India will be magically transformed into El Dorado, the mythical city of gold.
Even if the government could somehow recover all the stashed black money, the proceeds would go back into the hands of the same government whose departments and agencies are the major sources of this embezzlement, to begin with.
And, sadly, instead of fixing the institutions and tax policies that create black money, politicians will continue to perpetuate the myth that the only thing stopping India from becoming a major super power is not their incompetence, but black money.
Let’s be clear: Less black money will not make India richer. It will only mean more tax collection for the government and a bigger government. What makes a country richer is human capital: Either more people working, or the same number of people working longer, or the same number of people working harder (higher productivity).
This human capital needs to be treated fairly, and when a government becomes obsessed with raising tax rates to a point that it discourages human capital, it drives off the top contributors of ideas, products, and services.
The French government drove away many top entrepreneurs to Belgium by raising income tax rates to 70 percent. Similarly, the government of Maryland passed a special tax on millionaires in the hope of collecting an additional $106 million in revenue. However, it didn’t account for human behaviour as 1 out of every 3 millionaires left the state resulting instead in a tax loss of $200 million.
Obsession With Tax Revenue
Unwise tax policies and a government obsessed more with black money than the creation of growth, will unfairly tax those who create wealth and in the end make everyone poorer. What may appear obvious is often an illusion in a complex ecosystem like the economy where behavioural responses like greed, fear, loss of confidence are far more relevant than the obvious and measurable responses.
It is uncertain how demonetisation will affect long-term consumer and investor psychology, but if economic history is any guide, the immediate future doesn’t look bright.
Modi and his team need to wean themselves away from this obsession of squeezing every drop of tax revenue out of the economy. Increased tax revenue is the result of economic growth and not the cause behind it.
The outdated notion that taxing the private sector and transferring that spending power to the government will expand the economy has been thoroughly discredited, yet lawmakers continue to return to this strategy. Historically, governments have rarely, if ever, outperformed the private sector in generating productive growth.
Boosting Economic Growth
Instead, Modi should focus on building institutions that give a boost to the economy. The only way to get millions out of poverty is to create wealth by removing impediments to growth, reducing regulations, simplifying the tax code, lowering regulatory and political risk and making it easy for businesses to create wealth.
When it comes to economics, the government is not the solution, it is the problem. Libertarian novelist Ayn Rand put it best when she referred to it “ as the separation of State and Economics – the abolition of all forms of government intervention in production and trade – in the same way and for the same reasons as the separation of Church and State".
Focus on Big-Bang Reforms
The economy is a complex mosaic of consumers, small businesses, exporters, importers, farmers, manufacturers, labour unions, banks and countless other stakeholders. It is a dynamic and somewhat chaotic system that is too complex for anyone to try to run, manage, plan, or design. The economic history is replete with examples of hubristic leaders who thought they could fix the economy but ended up ruining the lives of millions.
Modi should stop trying to 'fix’ the economy and focus instead on big-bang proposals to reform corrupt government institutions, and provide efficient delivery of public goods like electricity, clean water, basic education, healthcare, transportation, and ensure equal justice for all. His obsession with black money will only hurt his development moniker and create problems for him in 2019.
(The writer is Managing Director, Centre for Environmental and Economic Policy. He can be reached @SanjivbDr. This is a personal blog and the views expressed above are the author’s own. The Quint neither endorses nor is responsible for the same.)