Narendra Modi's black money fight: Short-term pain for long-term gain

Narendra Modi is walking a tightrope with his fight against “black money”. India’s prime minister has unleashed a wave of bold, and sometimes brazen, initiatives to root out income that has been illegally obtained or not declared to the taxman. But that has chilled the economy. Managing the short-term fallout is key to smoothing the path to his re-election.

Soon after Modi’s Bharatiya Janata Party took over in 2014, businesses noted it was harder to win special favours from New Delhi. A new bankruptcy law has also started to shift the balance of power from tycoons to lenders. These are significant changes, given a series of “crony capitalism” scandals turned voters against the previous government. 

Over the past year, New Delhi’s focus has shifted from elite corruption to dealing with the next layer down: ordinary taxpayers. The country has more citizens who go overseas on holiday than taxpayers who declare income of more than 1 million rupees ($15,354), Modi grumbled in a recent address to accountants, urging them to take less pride in helping clients dodge their dues.

Tax avoidance is deeply entrenched: middle-class Indians and small businesses are reluctant to hand over money to a corrupt system. Public services received in return are also dismal. Many rely on private schools and healthcare. Even in Mumbai, the financial capital, a few hours of rain can result in deadly flooding. Wading through waterlogged streets last month, one of the city’s top doctors disappeared down an open manhole. His body was found a short way across town. Horror stories like this feed the perception that taxes will be wasted.

HOARDING CASH

Modi has done a number of things to try force a change in collections. A controversial ban on big banknotes last year made people less comfortable hoarding undeclared cash. A new nationwide “goods and services tax” (GST) is based on electronic invoices, forcing small traders to enter the formal economy to claim back tax credits. New real-estate regulations mean it is harder to park illicit cash in property. 

Individuals, meanwhile, are banned from making cash purchases over 200,000 rupees, and must link biometric identity numbers to income-tax filings. All of this will make it easier for New Delhi to track who is spending what and where. 

That’s already yielding ground-level results. For example, it is no longer quite as easy or socially acceptable to brag about cheating. And even corporate lawyers say clients are no longer interested in using funky structures to minimise tax bills, preferring to play by the book. 

But Modi may be trying to do too much at once. India’s economy was already suffering from low private investment and high bad debts, before the banknote ban sparked a sharp contraction in the amount of money in circulation. There was no time to recover before the July rollout of the complex GST, with minimal preparation. Serious glitches mean claims for rebates are already much higher than expected. 

As a result, GDP growth has declined for six consecutive quarters to 5.7 percent in the three months through June. The pain will have been more pronounced in the part of the economy that is not taxed. Saurabh Mukherjea of Ambit Capital reckons, for all their flaws, tax-evading companies have driven growth in employment and might account for 80 percent of jobs. That’s potentially dangerous for Modi since he promised to create work opportunities, not destroy them. 

BALLOT-BOX TEST

To support the economy and square the funding circle, Reuters says New Delhi is now considering relaxing the fiscal deficit target from 3.2 percent. Low inflation, a narrow current-account deficit, and large foreign-exchange reserves would make a limited adjustment manageable. As long as the pain can be contained, Modi’s black money crackdown will continue apace. His bid to clean up has widespread support, with both rich and poor viewing it as overdue.

An official report last year noted India’s tax-to-GDP ratio hovers at around 17 percent, just half the 34 percent average of the mostly prosperous countries that make up the Organisation for Economic Co-operation and Development. Even Vietnam, which is roughly as rich as India on a per-capita basis, collects 22 percent. 

Moving the needle isn’t easy: India’s tax-to-GDP ratio increased only 10 percentage points over the past six decades. It will take time to bed down recent changes, but if India can in time match the ratio of its Southeast Asian neighbour, that would give the government an extra $120 billion each year to spend based on last year’s GDP. The absolute size of the economy would also grow if more people are inside the tax net. 

If Modi can pull this off and put growth back on track, he can claim to have delivered on at least one key promise when the next general election comes around by 2019. While the opposition remains in disarray, India’s premier knows that a weak economy and its negative impact on jobs is no small threat to his position.