Thoughts regarding India's demonetization

A friend asks me regarding my thoughts on India's experiment in demonetization:

My response: I am not going to comment extensively on demonetization. When I comment on economic issues, I hold myself to a higher standard and hope that I am summarizing the literature, rather than sharing my own viewpoints on the matter. As an example, within this last week when two journalists reached out to me requesting comments on things I have worked on in the past, it still took me longer than an hour to read articles and think through my response. And those were things that I have researched on. I haven’t researched on demonetization and am not a macro economist so therefore it would take me even longer – at least several hours – to read the evidence that has come out/ is coming out and share my thoughts on it. So I am going to pass on that.

I will however comment about what is perhaps the most important aspect of demonetization and one I think is critical to whether this program is a success or not. And this has to do with the theme of tax evasion and compliance, a topic that I do know something about (e.g. http://tinyurl.com/y8jpvl25). To my mind, unless the revenue agencies are able to develop processes and systems which let them compare the amounts being deposited by individuals relative to what they had declared on their tax returns and then investigate discrepancies, then demonetization would be a failure. I mean if the powers-that-be were hoping that the “black money” wouldn’t get deposited in banks and that would be a one-time negative shock to the stock of wealth held by corrupt individuals, then that was a pipe-dream. So we truly will have to wait and see what happens to the tax base over a span of 3-5 years, how many people are brought into the tax net, does compliance go up, and so on and so forth before we are able to comment on whether demonetization was a success or not. (Reading through this article on Rediff doesn’t indicate to me that the negative shock I talked about was the goal of Mr. Arun Jaitley. He may however now be speaking with the benefit of hindsight and one might have to discount his statements accordingly. But Mr. Jaitley does note – “With the return of the money, the owners have been identified, he said, adding that the tax department is scrutinizing 18 lakh bank accounts with unusual deposits post note ban that do not match with previous income profile.” Reference: http://www.rediff.com/business/report/have-all-rs-1000-notes-come-back-to-rbi-post-demo-well-no/20170830.htm)

Now in best-of-class execution, one would define those goals ahead of time in order to precisely quantify what success looks like (say, a 30% increase in real tax receipts within 5 years) but I doubt this scheme falls in that category of best-in-class execution so unfortunately we do not have those objective yardsticks defined ahead of time. And so in the end I think I will have to wait for an enterprising PhD student somewhere with interests in Monetary and Development Economics to write an evaluation of the demonetization program. The state of knowledge generation is such that it will likely require more than one thesis to flesh all of this out. And that will be in the end what I base my own assessment of the program on. It would be foolish for anyone to trust folks who have always been critical of the government (and Dr. Amartya Sen undoubtedly heads that list but Dr. Kaushik Basu isn’t far behind) but that's not all. One should also exclude people who are currently employed by the government or have hopes of being so in the near future. With the National Rural Employment Guarantee Program for example, a huge initiative by the Congress government under Manmohan Singh, it is the work of one of my friends at Michigan that I trust more than anything else on the matter. It was her thesis work (https://sites.google.com/site/lauravanessazimmermann/) and as someone who is not ethnically an Indian, also likely to have been objective in its assessment.

Follow-up: Here is a piece from the Wall Street Journal describing some of the issues with detecting and monitoring tax evasion following large deposits. I think it is fair and balanced (https://www.wsj.com/articles/flood-of-cash-swamps-indias-tax-hounds-1486463407) and while it emphasizes that demonetization works only if evasion is detected, it is not shy to point out the many issues with it.