Significant Structural Benefits On Cards For India

The government’s stunning move late on Tuesday to demonetise Rs 500 and Rs 1,000 currency notes by replacing the former and discontinuing the latter – and announcing a new Rs 2,000 note — will have a transitory impact on GDP growth in the short term, but will spell significant structural benefits over the long term for India, believes CRISIL.

India thousand-rupeesAccording to it “The quantification of the transitory impact on GDP is difficult given there are only guesstimates on the size of the cash economy. But millions of small enterprises in the unorganised sector that use cash to transact will be inconvenienced for a while. Cash-dependent, consumption-led sectors will also feel the pinch, while investment demand will be tempered in the short term.

Over the long term, however, Tuesday’s move could change the face of the Indian economy; improve the government’s fiscal position and tax compliance. The size of the cash economy will shrink, as will black money generation avenues, because of better cash-flow trails. Inflation would tread down as demand slows in the short term, but the impact over the long-term would be neutral.

In 2007, the World Bank estimated the size of India’s shadow economy at 23.2% of GDP. Assuming this ratio still holds, that’s about $479 billion unaccounted for. Much of that money should get mainstreamed because of the demonetisation move”.

The Macro Picture

Government revenues should see buoyancy in the medium-to-long term

According to CRISIL “The direct positive impact will be felt on government’s tax revenue collections, its ability to spend on infrastructure investments and the resultant impact on growth. Inflation, we believe, will see some downward pressure in the short term because cash transactions will reduce. In the long run though, as government spending rises pushing up employment and incomes, demand will revive. Therefore, we expect the impact on inflation to be neutral in the medium-to-long term.”

Tax to GDP ratio can improve materially

“Income tax collections are expected to see a kick-up as funds earlier unaccounted for enter the banking system and eventually get taxed. The one-time impact on tax collections could be high. However, in the longer run, better tax compliance and some initial disincentive to hoard cash could push up direct tax collections in the medium term.

The government has already said declaration of unaccounted income because of demonetisation is liable to be taxed / penalised at a rate of 30 to 120% depending on the source. Already, the Income Declaration Scheme of the government which ended in September is expected to add close to Rs 300 billion to direct tax collections over fiscals 2017 and 2018.

Currently direct tax collections are just about 5.5% of GDP and about 50% of total tax collections, and this contribution is expected to rise going further. This will also help the government stick to its fiscal restraint path”.

Public investments to rise and drive jobs and income

Over the last two years, fiscal savings on account of lower oil subsidies gave the government room for infrastructure spending. Higher direct tax collections will now allow the government to further increase such spending. This is critical given that private infrastructure investments remain weak. It will also have positive spill over effects on employment and income.

As investments drive up the supply capacity of the economy, overall GDP growth is expected to benefit in the long term. In the short-term, GDP growth may get impacted negatively as the cash based economy feels a crunch and consumption and investment moderates.

According to a 2013 report, value of cash transactions in India, as a percentage of total consumer payments was approximately 86% in 2012. This number might have come down in last few years led by some pick-up in electronic transactions, but at that level still is quite high.

Tax rates could edge lower

Higher income tax collections arising from better compliance would also offer scope to reduce income tax rates over the long term, which would increase disposable incomes. This can have a positive impact on consumption demand in the long term.

Downward pressure on inflation

CRISIL expects lower demand to exert downward pressure on inflation in the coming few months. Categories such as housing, transport and food that tend to have a higher cash component could see downward price pressures in the coming months as demand is negatively affected. Also, rural areas which have a higher share of cash transactions could see a sharper dip in inflation compared with urban for most categories. That said, in the long run, as government spending rises pushing up employment and incomes, demand will revive”. Therefore, CRISIL expects “the impact on inflation to be neutral in the medium-to-long term.”

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S Kapeed