The verdict remains out as to whether recent initiatives in India, such as the note ban and the Goods and Services Tax, will constitute significant steps forward in the country’s quest to become a modern and globally competitive industrial economy.
What we observed:
- Initiatives implemented in India by Prime Minister Narendra Modi’s administration, such as the standard Goods and Services Tax (“GST”) and the note ban (“demonetization”), have been gradually forcing individuals and corporations to adjust to new ways of conducting economic activities.
- Consequences of these initiatives have been intended and unintended, positive and negative, with a particularly large impact on the labor market and informal sectors.
- It remains to be seen whether these initiatives will constitute a significant step forward in India’s quest to become a modern and globally competitive industrial economy.
- However, these reforms in conjunction with the banking sector recapitalization seem to address many aspects of much-needed changes to the India economy – namely efficiency improvements and a subsequent investment pick up.
More than a year after India hastily implemented its November 2016 note ban (also known as demonetization), the purpose and benefits remain much debated. The stated goal of demonetization was to broaden India’s tax base and strengthen the country’s economic foundation by removing “invisible money” from the monetary system. Most would agree that demonetization has had unintended consequences with a particularly large impact on the labor market. As an example, a number of real estate projects on the outskirts of India’s cities were halted as the cash needed to pay for materials and construction workers’ wages became scarce. Companies and workers were not prepared to immediately switch means of payment from cash transactions to bank services, such as online payments and wire transfers. Job losses occurred in labor-intensive and informal industries, such as construction, agriculture, textiles, and jewelry production, due to the lack of notes in circulation and the fact that certain denominations were banned and therefore had to be exchanged immediately. Most rural Indians (estimated at 67% of India’s population[i],[ii]) don’t have bank accounts or credit cards, so the lack of bills in the system has hit this portion of the population the hardest. The knock-on effects of the note ban are many, but perhaps the largest is that demonetization was a speed-breaker for the Indian economy, heavily impacting smaller companies accustomed to working almost exclusively in cash. While demonetization has been accepted by the population, possibly due to Modi’s popularity, more than a year on, the benefits of this bold surgical strike on black money remain elusive.
In contrast to the quick design and implementation of the note ban, it was after more than 17 years of efforts that the Indian government finally rolled out a unified tax collection system in mid-2017 – the Goods and Services Tax (“GST”). The intended impacts of the GST are to increase tax collections in the long run, simplify the tax code, and reduce the hidden costs of doing business in India. For example, under the previous tax regime, each state government had the power to set its own tax rate and these tax rates were only applicable for goods, not services. As a result, informal arrangements developed between states to take advantage of different tax rates and the lack of tax collection on services. Among the many problems of the previous tax regime were significant delays in inter-state logistics needed to comply with all the different state tax systems. While the GST implementation was not without its hiccups, GST was seemingly welcomed by most of the corporates with whom we met, as publicly listed entities tend to conduct business in the organized sector and have been paying taxes for years. Given the gap in GST compliance between the organized and unorganized sectors, some leading Indian companies are actively adjusting their strategies to harness market share gain opportunities and system level efficiency improvements. It could be the case that India implemented demonetization before GST because the reduction of the informal economy was crucial for a successful GST implementation. Furthermore, GST implementation alone cannot address the issues associated with India’s large informal economy. Though it is early to make a firm conclusion, GST collection seems to be under expectations so far, which questions the effectiveness of demonetization in expanding the tax base. Instead, after demonetization, a lot of system liquidity has flown into investment-focused financial products.
