BOTCHED Demonetization of high denomination notes in India & Venezuela should spur development of a zero-disruptive global strategy to tackle tax-evaded income and bribe money.

The strategy should be such that it complements growth of both direct and indirect taxes. It should discard blind zeal for increase in direct taxes that adversely affects collection of indirect taxes as has happened in India. Demonetization should not let monetary policy overshadow the growth-stimulating fiscal policy.

Even in normal circumstances, the tax policy experts should always strive for an optimal mix of direct and indirect taxes that contributes maximum to economic growth & overall revenue buoyancy. Compartmentalized focus on direct taxes as is evident under demonetization is shortsightedness.

It is here pertinent to quote the findings of a research paper captioned ‘The growth trade-off between direct and indirect taxes in South Africa: Evidence from a STR (smooth transition regression) model' authored by Economist Andrew Phiri in February 2016.

The Paper says: "Direct and indirect taxes are only significantly related with economic growth when the indirect tax-growth ratio is below a threshold of 10.24 percent. Below this threshold, we observe that indirect taxes are positively related with economic growth whilst direct taxes adversely affect growth. Moreover, it is within this lower regime that we find resources collected by government can be efficiently used and that the labour growth variable has a positive effect on economic growth."

The Paper continues: "By policy implication this presents a case for fiscal authorities to exploit the nonlinear tax-growth relationship to their advantage by specifically exploiting the positive relationship found between indirect taxes and economic growth below the established threshold. This, in turn, would entail a gradual shift of reliance in collecting government revenue from direct taxes to indirect taxes".

Abrupt demonetization, without timely & adequate availability of replacement currency, wreaks havoc on the economy and public. Venezuela plunged into chaos after its demonetized initiative and had to put on hold ostensibly due to non-arrival of planes with loads of replacement currency.

Reports in media and experts' opinion show that cash drought in India has disrupted production and sales in almost all economic spheres. Demonetization has also slowed both domestic and foreign investments. It would maim growth of gross domestic product and hence tax and non-tax revenue.

Can the objective of taxing income of shadow economy and partly evaded income of organized businesses & corrupt not be achieved without demonetization? Can we develop a robust tax revenue model to tax black money and turn into white? Can there be a win-win strategy for all, which can be coupled with sweeping reforms to minimize the need for tax evasion and bribery? The answer to these questions is ‘yes' that gets elaborated later in this column.

The virtue of proposed approach can be appreciated by asking whether India's Demonetization would ultimately turn out to be a zero-sum game. Trade off the positives:1) additional income tax levied on black money and 2) monetization by Reserve Bank of India (RBI) of non-deposited demonetized notes as special dividend or as government securities with negatives.

The negatives are: 1)loss of indirect taxes (central and provincial) due to slump in output and sales and 2) the resulting decline in direct taxes receipt. The trade-off outcome might at best be zero. And this would turn into negative if we factor in colossal loss of time by citizens standing in cash queues that resulted in more than 100 deaths& other intangibles such as enhanced uncertainty for investors.

To explain Government's disruptive passion for shoring up collection of direct taxes that impacts indirect tax receipts, a brief recap of the developments would be in order.

On 8th November evening, Indian Prime Minister Narendra Modi had caught the nation off guard by declaring cessation of high denomination notes as legal tender by midnight, thereby sucking off about 86% of the money in circulation in economy in one shot. The economy has not yet been adequately seeded with new notes – a process that is likely to take several months. This also means the economy would take longer time to regain momentum that existed prior to demonetization.

Mr. Modi had reeled off a hodge-podge of objectives of demonetization: fight against corruption, black money, money laundering, counterfeit notes and financing of terrorists.

Experts know that there are many ways to tackle each of these malaises. The Government simply needs to effectively implement the existing laws and amend them to overcome handicaps if any.It has not implemented many black money-curbing recommendations of several committees. These include the recent ones such as Tax Administration Reforms Commission (TARC) and Special Investigation Team (SIT) on Black Money.

The Government overlooked good governance to derive political mileage in a society, where poor, who vote in hordes, are pitted against the tax-evading rich as the cause for their poverty.

As the Government realized bulk of the demonetized notes would be deposited in the banks for exchange with new ones, it weaved into demonetization the 2 nd black money disclosure scheme to collect income tax. The first such scheme was closed a few days before announcement of Demonetization.

The Government thus expects to shore up its revenue through two streams: 1) additional income tax collections accruing from Demonetization-linked black money disclosure scheme and 2) money from the cancelled demonetized notes that are not deposited with banks within notified deadline. RBI has not yet decided whether and how it would monetarily benefit the Government from cancelled currency that was not deposited in banks.

The demonetization is driven by the presumption that black money is stocked and not utilized for purchase of movable and immovable assets, apart from splurging it on consumption of goods and services. The Government has overlooked the velocity of black money and its seamless inflow into taxation-regulated economy.

Purchase of vehicles, electronic goods, white goods and premium life-style products with black money helps the Government get significant part of this ill-gotten cash as indirect tax receipts. The indirect taxes include excise, customs, value-added tax, service tax, education cess, cleanliness cess and several other imposts. Black money thus sustains economic growth, tax buoyancy and jobs creation.

The much-maligned shadow or parallel economy does pay indirect taxes when it buys goods from the organized sector as such taxes are part of sales price. Even a beggar ends up paying indirect taxes when he buys a small packet of biscuits. Moreover, shadow economy provides employment to millions, whose income sustains organized sector from which they buy essential items such as soap and toothpaste.

It is here pertinent to quote PWC's report captioned ‘Shifting the balance from direct to indirect taxes: bringing new challenges' released in June 2013. It says: "Customs and excise duties and other trade charges/ levies are also gaining profile. Typically these costs are not identified as taxes in the traditional sense and are buried in the cost of goods."

Demonetization demobilized black money. It rendered ineffective even white money held as cash. This massive sucking of liquidity from economy has affected sales of goods and services across the sectors.

The impact of this slump on indirect tax receipts of the Central and State Governments would be known when revenue data for next 6-12 months beginning 8th November 2016 is available. The first credible picture of the impact of demonetization on indirect taxes would be known by end of the first quarter of 2017.

This brings to the need for exploring possibility of developing an alternative to demonetization to bring black money into organized economy without hurting indirect taxes.

The alternative approach should provide a framework for cash purchase of any goods or services with the caveat that such purchases would be subject to levy of a cess. The cess can be named Garib Kalyan Cess (Poor Welfare Cess) or National Security Cess, depending on political benefit the Government intends to derive.

Under this revenue model, the Government should first specify limit of, say, Rs. 50,000 for purchase of anything. Cash purchases above this ceiling should attract proposed cess calibrated to the volume of cash spent. Cess can thus start at 1% of the sale price of any goods or service increasing up to a maximum of 20% for very high value cash transactions.

The maximum 20% cess is lower than average effective tax rate of 24.67% paid by companies in 2014-15. It is also lower than 30% income tax levied on personal income of Rs. 1 million and above.

Cess can be illustrated with a few examples. Suppose a person buys in cash a premium laptop valued at Rs. 60,000, he can be asked to pay cess at a rate of 1% of the sale value. For a car valued at Rs. 1 million, the Government can levy cess at 10% of the value in case of cash purchase. For a residence or land valued at Rs 100 million bought with cash, the cess can be 20%

For high value realty deals, the Government can prevent under-valuation of property by invoking Government's pre-emptive right to buy the property.

Under this approach, black money becomes the facilitator for increase in indirect taxes receipts and for additional cess revenue that be accounted for in the direct taxes side.

This in sharp contrast to the present situation where the Government loses or moderates indirect taxes receipts in its quest to increase direct taxes receipt.

The proposed revenue model does not disrupt economic activities resulting in job losses, loan defaults and business closures that are happening due to demonetization.

The Government can also stipulate a limit for holding money as cash with the strict penalties for breaching this limit.

In fact, the Supreme Courted-mandated Special Investigation Team (SIT) on Black Money has recommended such a legal limit. In its fifth report submitted in July 2016, SIT has an upper limit of Rs. 15 lakhs on cash holding by any entity.

SIT has also recommended that "there should be a total ban on cash transactions above Rs. 3, 00,000 and an Act be framed to declare such transactions as illegal and punishable under law."

The Government should stipulate a lower limit of Rs. 50,000 for cash transactions to facilitate injection of bulk of black money into productive economic activities.

This strategy has to be coupled with sweeping reforms across the board in economy to virtually obviate the need for evading taxes or paying bribes.

This would also call for formulation of a tax policy that strives for optimal mix of direct and indirect taxes.

As put by IMF experts, Ruud De Mooij and Michael Keen, "It is hard to design a fair and efficient revenue system."In a primer titled ‘Taxes in Practice' published in IMF's Finance & Development March 2015 issue, they observe: "Tax policy is often guided by simple rules of thumb. Sometimes, they are strikingly right. But sometimes they can be dangerously misleading."

Direct taxes-influenced demonetization fits well into this observation.