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Nov 08, 2019

The Vast Difference Between What Demonetisation Achieved and How It Was Perceived

What matters now is the meta narrative about how India debates, makes and implements policies. If too many people in politics feel that this kind of decision won the Uttar Pradesh election, then we may have more of such actions

Note: This story was first published on November 8, 2017 and is being republished on November 8, 2019.

It was a good fancy of an old Platonic: the Gods, who are above men, had something whereof man did partake, an intellect, knowledge, and the Gods kept on their course quietly; the beasts, which are below men, had something whereof man did partake, sense and growth, and the beasts lived quietly in their way; but man had something in him, whereof neither Gods nor beasts did partake, which gave him all the trouble, and made all the confusion we see in the world, and that is opinion.

∼ John Selden (From The Table Talk of John Selden)

Demonetisation has inspired innumerable written and spoken words. However, the words (and numbers) that are conspicuous by their absence are: the analysis that may have suggested, on the eve of November 8, 2016, that the decision seemed suitable for its objectives. The thought process has not been clearly articulated, and the narrative has shifted so many times that it is difficult to cobble together a rationale from all the assertions.

It is not yet clear, for instance, how the following facts were reconciled while taking the decision:

  • One, the finding presented in the Economic Survey, 2015-16 that India’s income tax collection is better than expected at our level of economic development. Or the finding from a World Bank study published in 2010 that India fares quite well in terms of the relative size of its shadow economy.
  • Two, the finding the from finance ministry’s analysis (see table 4.3) of data from thousands of raids conducted by tax authorities that less than 5% of undisclosed income was found to be in cash form.
  • Three, the high expected costs, given that most shops and establishments did not have infrastructure for digital payments, and there were well-known bottlenecks for remonetisation, such as the recalibration of ATMs or the logistical problems of getting cash to remote areas.

It is possible that the government’s analysis still showed a reasonable chance of success, but this analysis has not been published.

The three original objectives of demonetisation were: eliminate fake currency; inflict losses on those holding black money (and create fiscal windfall in terms of enhanced dividend from the RBI and additional tax collection); and disrupt terror and criminal activities. Soon after, another objective was added: making India a ‘less-cash’ society. Let us consider how the decision has impacted these objectives.

The attacks on black money

Demonetisation was expected to inflict losses on those holding black money. One line of attack was to force losses by making it difficult to deposit unaccounted cash. This would have also created a fiscal windfall, as RBI could have extinguished those liabilities and paid a higher dividend to the government. Another line of attack included improved collection of taxes, by better enforcement and improved voluntary compliance.

Extinguishing of unaccounted cash

Between November 8 and December 31, the government took several steps, and changed rules multiple times, to make the deposit of unaccounted cash difficult. According to the RBI’s Annual Report, notes worth Rs 15.28 lakh crore (about 99% of the demonetised notes) have been deposited. This does not include the cash with district cooperative banks and Nepalese citizens and financial institutions. Eventually, perhaps less than 0.5% of the cash would remain unreturned. Black money holders may have taken losses while laundering their unaccounted cash, but this means black money only changed hands. So, the first line of attack seems to have failed.

Tax enforcement and compliance

Another line of attack is extraction of more taxes, by better tax compliance and by better enforcement by tax administration. In analysing this, it is important to distinguish between: a) the period following demonetisation, in which the existing equilibrium was unsettled by the shock of demonetisation, and b) the steady state after that, wherein another equilibrium would be reached. These periods are qualitatively different, and different incentives operate upon tax evaders during these periods.

The unsettled equilibrium may have impacted tax collection in at least three ways:

  • Improved voluntary tax compliance: Some people may have got scared of the wrath of the government and voluntarily admitted their undisclosed incomes, and paid taxes on it.
  • Laundering of unaccounted cash: Some people may have facilitated laundering for others by depositing the cash, reporting some additional income and paying tax on it. This would have helped black money holders avoid losing unaccounted cash and generated some income for the launderers
  • Improved enforcement: Some people may have got caught trying to launder money. Further, even though many managed to deposit unaccounted cash, the informaton on suspicious transactions may lead to enforcement opportunities, which would yield additional tax collections

It is difficult to disentangle the additional collection due to voluntary compliance by tax evaders and that due to laundering through third parties. Only investigations can reveal this. We can try to estimate the aggregate impact.

Impact on tax collection

A press release issued on August 31 by the Central Board of Direct Taxation stated that 1.26 crore more taxpayers have been added in 2016-17. This is about 26% higher than the number of taxpayers added in 2015-16, when 99.98 lakh new taxpayers were added. The number of new taxpayers added in 2015-16 was about 27.5% higher than that in 2014-15, when 78.37 lakh new taxpayers were added. Since the definition of “new taxpayer added” was changed from 2014-15, this series does not go back further. So one could argue that there is no discernible improvement in tax compliance. However, the number of new taxpayers added is not a robust measure of impact on tax compliance.

Since the threshold for taxable income has remained unchanged since 2014-15, income growth itself adds more taxpayers every year. The Economic Survey 2016-17 has shown that the average income reported by the new individual taxpayers added in 2016-17 was Rs 2.7 lakh. Since the threshold is Rs 2.5 lakh (Rs 3 lakh for senior citizens and Rs 5 lakh for super senior citizens), the distribution cannot have many new high-income folks. So it seems that most of these new taxpayers have been added simply because their incomes just crossed the threshold in 2016-17. Some of them may be laundering money for others, but since there is no acceleration in the rate of growth in the number of taxpayers, this is far from obvious.

Also read: Fact Check – If Indira Had Carried Out Demonetisation, Would Modi Have Needed To?

Further, tax may be evaded by those paying taxes and filing returns, while under-reporting their incomes. Therefore, a better indicator is: was the tax collection higher than it would have otherwise been?

Comparing year-on-year increase in tax collection is not helpful, because tax collections depend on economic conditions. One way to overcome this problem is to normalise the tax collection using measures of underlying economic activity. However, a challenge in doing this for specific quarters is that changes in rules (such as deadline for filing, mandate of advance tax), changes in administrative processes (eg. dates for refunds), or special schemes can make collections in certain quarters vary quite significantly from those in the corresponding quarter of the previous year. For instance, Q1 of 2012-13 witnessed a huge increase in collection over the corresponding quarter of the previous year, but this was because of front loading of refunds in the previous year.

The methodology* I used to estimate additional tax collection till the first quarter of 2017-18 (also see the table below) gives an estimated  collection of about Rs 13,300 crore during these three quarters (about 2% of the direct tax collection during these quarters). If we accept this estimate, it indicates modest but non-trivial additional tax collection on account of demonetisation.

Direct tax collection between Oct and June (Rs. crore) GVA (Industry and Services) at current prices (Rs. crore) Ratio (in percentage)
2011-12 377998 5208985.98 7.26
2012-13 418624 5834696.84 7.17
2013-14 477839 6594547.43 7.25
2014-15 512703 7152626.29 7.17
2015-16 551809 7848271.35 7.03
2016-17 647249 8658170.03 7.48
Average (before demonetisation) 7.18
Additional collection (as percentage of GVA) 0.30
Additional collection (In Rs. Million) 26,002
Additional connection (minus pre-demonetisation IDS) 13,302

It is difficult to know how much of this additional growth was because of voluntary compliance, laundering of unaccounted cash through third parties, or enhanced efforts by revenue administration. In any case, all these reasons are related to demonetisation and therefore this additional collection can be attributed to demonetisation.

Use of intelligence generated by cash deposits

It is being argued that, in the coming months, the government can use the intelligence about suspicious deposits to investigate and extract additional taxes. At the moment, we can only discuss the potential efficacy of this line of attack, as only time will tell how it works out. To believe that these deposits would lead to large-scale additional tax collection, one will have to make certain assumptions.

First, one will have to assume that a large number of black money holders have acted irrationally. If, as the estimates show, cash was indeed less than 5% of the undisclosed income of black money holders, even the destruction of the entire unaccounted cash would have led to a relatively small loss to them. The fact that they chose to get most of the cash deposited, either directly or through others, suggests that they must have found ways to hide the trail. To be sure, some of them may have miscalculated the risks and will get caught, but this is not likely to be a large number. The low declarations under the Pradhan Mantri Garib Kalyan Yojana (Rs 4,900 crore of undisclosed income) also suggests that money was laundered easily. It was an amnesty scheme with a penal tax rate and lock-in for a part of the deposited money for a few years. So, to believe that there are easy trails to be picked from cash deposits, we have to assume that those who have otherwise been gaming the system, have less than 5% unaccounted wealth in cash form and could have legally convert black money to white under PMGKY, still risked their entire unaccounted wealth by depositing the unaccounted cash while leaving a trail.

Second, one would need to assume that the capacity in tax administration can be easily expanded. Suspicious cash deposits need to be investigated. On finding evidence, a tax claim is raised by the department and penalty may be imposed. If the claim is large, almost surely, it would be appealed, first with a commissioner, then in the tribunal and eventually perhaps even in high court and Supreme Court. All these steps – investigation, prosecution and adjudication – are necessary to pin down those who deposited black money. These steps are required to ensure that innocents are not penalised. However, capacity constraints exist at each of these steps. The time of tax officers, prosecutors and adjudicators is not an easily-augmented resource. What makes it more difficult is that this is likely to be a large volume enforcement – a large number of small-value cases. Also, people depositing black money would have made some efforts to mix black money with white money. It is like looking in a haystack for needles camouflaged to look like hay.

There is also a risk that this sudden increase in caseload may lead to an organisational rout – “a collapse of organisational coherence and integrity”. It is already leading to the dilution of processes. The Finance Act, 2017, made several amendments to the Income Tax Act to expand, with retrospective effect, certain powers of the tax authorities. A provision was amended to give powers to the authorised officer conducting search and seizure to provisionally attach property that they find, for a period of up to six months and with the prior approval of senior officers. The power to call for information from a person against whom there is no proceeding has now been given also to junior-ranking officers. Such changes risk reversing years of reforms to infuse more rule of law in tax administration.

On the prosecution side, the CBDT rules say that the tax officials must not file an appeal if the tax effect is less than Rs 10 lakh. The rule can be changed, but it was made for good reasons – to prevent the department from wasting resources in pursuing small-value cases. The adjudication process is already choked up. The CBDT has been taking measures to ease the burden, but this cannot be done overnight. A report in 2014 stated that at that time, the tax department used to lose 80% of appeals in the Income Tax Appellate Tribunal. If the standards of investigation and prosecution suffer because of the volume of caseload, this number may become higher.

This needs to be seen in the context of 29.2% increase in personal income tax collection that the government is targeting in 2017-18. Given the state of the economy, it will be difficult to deliver this. So the tax administration may get tempted to use their powers to take draconian measures to extract taxes. This is probably not a good way to build fiscal capacity. Expanding the capacity to collect taxes is a long-term task that requires building capabilities in the tax administration, while upholding the rule of law and the basic principles of government accountability.

We should also give a thought to honest taxpayers. It is easy to say that they need not worry, but if laundering has happened through a large number of small-value deposits, it is prima facie difficult to distinguish between those laundering money and those who were living cash-based but legitimate economic lives. The tax evaders will lawyer up, while others, including firms in cash-intensive businesses, may be unduly harassed.

The steady state

On the impact in state steady, the key question is: how has this episode affected the game between the state and the tax evaders? Those evading taxes are playing a dangerous game. Whether they go honest, and to what extent, depends on their subjective perception of the government’s ability to catch them. How did the experience from November 8 to December 31 change their understanding of the government’s capacity to enforce the law against them?

One narrative is that it signalled the government’s serious intent to go after tax evaders and has permanently altered the assumptions of tax evaders. This is not as obvious as it may appear. It is also possible that this experience may have emboldened tax evaders. In the days and weeks that followed the decision, they saw the government trying to ensure that the cash is not deposited and still failing almost completely.

Also read: As Opposing Narratives on Demonetisation Clash, Even Modi Can’t Fool All the People All the Time

It was a spectacle that was painful for most of us, and a kind of endorsement of the assumptions with which systematic tax evaders operate. While the government’s commitment was not in question, its capacity was. A threat needs to be backed by the capacity to enforce it, and the experience of demonetisation raised serious doubts about the government’s capacity to have its intent (force black money holders to destroy cash) implemented. This may have hurt its credibility. So to say that this episode would surely have instilled some fear of government into tax evaders’ hearts and minds is to deny what happened in the winter of 2017. Whether and in which direction the assumptions of tax evaders have shifted would be clear in the coming years.

The impact on digitalisation

The reasoning behind the urgency to go less-cash has not been properly articulated. The economics of cash are complex. There are very robust and clean economies that are cash-intensive, and there are relatively weak and corrupt economies that have much lower cash in circulation. Also, the preference for cash depends on a variety of factors. For instance, unreliability of connectivity may encourage people to play safe and use cash. In any case, on the move towards a less-cash economy, two indicators are being widely cited: the currency in circulation and the usage of electronic payments.

Currency in circulation

At the end of 2015-16, the total notes in circulation were worth about Rs 16.4 lakh crore, about 12% of that year’s GDP. Just before demonetisation, the total notes in circulation were worth about Rs 17.5 lakh crore. On October 13, 2017, the notes in circulation were worth about Rs 15.93 lakh crore. The average rate of increase in the last two months has been 0.86% per fortnight. If we assume that this pace continues for the rest of the year, the currency in circulation would reach about Rs 17.2 lakh crore by the end of this financial year. As a percentage of GDP, it would be about 10.25-10.5%, depending on the GDP forecast used. So demonetisation may end up reducing the cash to GDP ratio by about 1.5% of GDP. It is debatable whether this is a game-changing shift in the importance of cash.

Use of digital payments

There are a variety of digital payment instruments available in India. In our analysis, we consider: credit cards, debit cards, NEFT, IMPS, pre-paid instruments and mobile banking. UPI was launched only in mid-2016 and the data series on its usage begins in November 2016. So although UPI seem to have received a shot in the arm because of demonetisation, we cannot estimate the impact. For other instruments, there is data that goes back years. Usage of these instruments had been growing quite rapidly even before demonetisation.

NEFT IMPS Credit cards Debit cards PPI Mobile banking Total
2013-14 75.90 900.00 29.45 25.56 60.10 67.81 54.62
2014-15 27.97 300.67 23.42 33.57 226.49 83.15 87.17
2015-16 21.92 116.14 26.90 48.30 33.18 151.55 48.11
Source: RBI

We need to find out whether there has been an acceleration in the rate of growth. Introduction of a number of other steps to encourage use of digital instruments makes it difficult to isolate the impact of demonetisation. So the question we can try to answer is: did demonetisation and all these other steps together lead to an above-trend acceleration in the usage of digital instruments?

We construct a pre-demonetisation regression time trend for usage of each of these instruments in the two years before demonetisation. We extrapolate the time trend for the post-demonetisation period based on pre-demonetisation trends. We then super-impose the actual usage during post-demonetisation. As the graph below shows, an above-trend usage has persisted for debit card (at 95% confidence interval). Above-trend change usage has not persisted for NEFT, IMPS, pre-paid instruments, credit cards and mobile banking. Significantly, as the graph below shows, the total volume of usage for all these instrument put together did not sustain an above-trend performance. Demonetisation did have a short-term ratcheting effect, but this did not persist for instruments other than debit cards, which is also now getting closer to the trendline.

A model-based test of structural break in the time series of data on usage of digital payment instruments could also help estimate the impact. However, it is difficult to find a suitable independent variable to build the model. Digital payments have been growing rapidly because of changes in regulations, technology, customer behavior, and other factors. An independent variable should be observed at a monthly frequency, not be affected directly by the event in question, and should have a clear correlation with the usage of digital instruments. One option is to use a measure of money supply as the independent variable, but this is problematic, because cash is a component of all these. Demonetisation, whose impact we wish to understand, directly affects these variables. So, using these measures to predict trend growth of digital payments, and then to estimate the above or below trend performance is not methodolgically sound.

Elimination of fake currency and disruption of terror/criminal activities

The total fake currency in the system was estimated to be Rs 400 crore. It is safe to say that fake currency in Rs 500 and Rs 1000 denominations was eliminated, as those notes can no longer be used anywhere. This is, however, a small and temporary benefits, as counterfeits of the new Rs 500 and Rs 2,000 notes are already getting intercepted. It is difficult to estimate how the decision may have affected terror and criminal activities. For instance, there is no difference in the number of terror incidents and terror-related fatalities in areas affected by left wing extremism, before and after demonetisation. In Kashmir, the incidents and fatalities have actually increased. Prima facie, it would appear that these activities have not been disrupted. However, to say this with certainty requires a deeper understanding of how these activities are conducted. Intelligence agencies may have observed disruptions in these networks, but they do not report such observations.

The costs of demonetisation

Demonetisation may have had a variety of costs: for the economy, for the integrity of institutions and the social costs.

First, there is a clear decline in economic activity. GDP grew by 5.72% in Q1 of 2017-18, down from 7.92% in Q4 of 2016-17. A survey by the Centre for Monitoring of Indian Economy has estimated that about 1.5 million jobs were lost between January and April. Credit growth is at a record low. To what extent these problems are on account of demonetisation is difficult to estimate. However, it can be said that this is at least partially attributable to demonetisation. The decision came at a time of sluggish private investment growth, poor export performance and weak private consumption. It is likely to have worsened the situation, first by delivering a major demand shock, which may have transmitted, via reduced production and capacity utilisation, to investment sentiment. Even if demonetisation led to 0.5% deceleration in this year’s GDP, it would be a cost of about Rs 80,000 crore.

Second, there are many reports on the severity of the blow to certain key clusters of small and medium enterprises in India. Many have been pushed into failure. Although these are anecdotal, a common narrative is emerging from a number of clusters, where much of India’s job creation happens. This is not, as one supporter of demonetisation jibed, a celebration of informality. It would have been great if informal firms had become more formalised, but it seems that many of them have been simply destroyed. Destroying organisational capital and jobs in the informal and semi-formal sectors without fresh job creation in the formal sector or transition of enterprises toward formalisation does not appear to be a good outcome. So far, there are only vague assertions about formalisation, with no evidence cited to back the claims.

Credit: PTI

How people saw demonetisation quickly became, and sadly continues to be, something of a political Rorschach test. Credit: PTI

Third, the decision has been expensive for the RBI. Mopping of liquidity from banks and the increased cost of currency printing eroded the RBI’s earnings. Its income for the year decreased by 23.56%, while its expenditure increased by 107.8%, leading to a sharp decline in the RBI’s surplus. Government had to absorb part of this cost, in the form of lower dividend from the RBI. The RBI transferred only Rs 30,659 crore, which is less than half of the dividend paid last year.

Fourth, the decision has been expensive for the banks at an already difficult time. They had to devote more than two months almost entirely to this exercise. The Centre for Monitoring of the Indian Economy estimated that the transaction costs to banks may be about Rs 35,000 crore. In addition to these direct costs, there may have been indirect costs. At a time when the senior management should have been dealing with the NPA crisis on a war footing, they were enlisted for an altogether different warfare.

Fifth, there were costs incurred by the individuals and households, who had to forego consumption and stand in queues for cash. While for most it was mere inconvenience, some who were in more difficult situations, had to pay a very dear price for this situation of having assets but not being able to use them.

All said and done, for those looking to clutch at straws, there are a few straws floating around. Modest “benefits” have been booked, and others may accrue over time, but they are not likely to be substantial. More importantly, when it comes to costs, there is the perennial straw of the difficulty of attributing macroeconomic problems to a specific decision. If so inclined, a person can, wrongly, insist that the deceleration in GDP growth and destruction of jobs have nothing to do with demonetisation. It is difficult to prove conclusively to what extent these problems are due to demonetisation. This creates the space for political spin. There is no joy for the critics. It is a tragedy if laudable objectives are not achieved. On the other hand, the supporters seem to deny the reality altogether.

How one assesses a situation depends substantially on how one frames it. Therefore, beyond objectively estimating the economic impact of the decision, it is also interesting to understand the variety of ways in which this momentous decision was framed. These perceptions are suggestive in their own right.


The webs of meaning

In the absence of a clear and detailed theory of change put forth by the government, the decision quickly became a kind of political Rorschach test, with people reading into it what they bring to their political lives.

Partisans mostly took positions along party lines. For a short while, however, the opposition parties were confused, because seemed difficult to effectively communicate opposition to a decision framed as an attack on black money. With a few notable exceptions, big business leaders either stayed quiet or gave scores ranging from 8.5 to 10 out of 10, much like their assessments of union budgets. Perhaps this is less a commentary on them, and more a reminder of how expensive it can be for a business leader to criticise a government in India. Similarly, most celebrities from entertainment and sports, who cared to speak about this issue, came out in support.

Not all those who supported the decision were partisans or pro-cyclical. Many had other reasons to support the decision. As the anthropologist Clifford Geertz put it, we live most of our lives, suspended in “webs of significance” that we ourselves have spun. The way we framed this issue shaped our judgments. One could try and deduce a variety of perspectives and sentiments underpinning the support for demonetisation. Here we focus on support that seemed to be based on larger ideas. Some of these carry great constructive potential for the society, but in this situation, they revealed certain incongruities.

The “technological utopianism” perspective

Many prominent persons from India’s IT sector and technology industry expressed excitement about the potential jump in digitalisation and data-richness. Most of them did not even pay lip service to the questions of due process, property rights and even to the decision’s effectiveness vis-à-vis its main objectives. Confirming a stereotype, only digitalisation seemed to matter to them. Their responses revealed the excesses of this technocratic perspective of social and political problems.

Such thinking seems to be based on an idea of social progress as something that moves along a straight line, with accumulated knowledge leading to improvements along pre-defined terms, rather than a dialectical process of conflict and compromise. Although this is not a new perspective, in today’s India, it could take giant proportions. At various strata of society, India has a number of influential citizens who have accumulated influence through excellence in hi-tech industries. Some of them want to bring their ideas to government. In many ways, this is good, because there are problems that can benefit from prudent applications of technology. However, if taken to the extremes, this “governance-as-an-engineering-problem” is a dangerous perspective, especially at our stage of development, when negative rights are not properly secured, and institutions are relatively weak.

Also read: Seven Little Lies the Government is Still Peddling About Demonetisation

It may not be such a good idea to have programmer-kings guide our governance. Given the Frankenstein-esque character of technology, we need to think not just about using technology but also reining it in. Our future may be somewhere between these perspectives, between those who underestimate the potential of computers and those who over-simplify the intricacies of human life.

The “idealist” perspective

Many citizens, drawing on their reservoirs of idealism, welcomed the opportunity to make sacrifices towards a larger good. It was great to see this sentiment being expressed by so many citizens. Idealism is necessary to guide our orientation and to name our longings, but it is probably not a wise counsel for plans and actions. Realism is required to understand our potentialities, which, at a given time and place, are not infinite, lest we embark upon Quixotic pursuits.

Governments and social associations can occasionally tap into this idealism, but it is incumbent upon them to not be indulgent with this resource. Otherwise, it may give way to cynicism, which will corrode a key source of order in our society.

This idealism was, in some cases, rendered ambiguous. Some people tried to impose these sentiments on fellow citizens who were more skeptical (or perhaps realistic). Professional soldiers were invoked as instrumentalities in the games of one-upmanship played in ATM queues. For such individuals, was it idealism, or just a mask for the impulse to dominate fellow men? Or perhaps it was a bit of both, as the history of idealism is marked with a tendency to confuse one’s idealism with the common good, and then to impose it on others. We are in the grips of a paronoia that is fueled by the self-image of a glorious, ancient civilisation and has been boosted by 25 years of high economic growth. Many of us believe that we as a nation are destined for greatness. In this context, one can see why there was much impatience with those not buying into the idea of demonetisation as a big reform.

The “hard state” perspective

There are those who believe, perhaps for good reasons, that the Indian state is too soft. For them, the sheer signalling effect of the government being tough was good enough. By now, those with this perspective may have been disappointed by demonetisation. As the experience of the last one year shows, it is one thing to threaten, quite another to make good on a threat.

Sometimes, taking an ambitious decision, the government can create a “pull” effect to get its machinery to respond, and in the process, both its real and perceived strength can be enhanced. However, in the case of demonetisation, the gap between the ambition and the capacity was so huge that, instead of systematic building of capacity, the premature load bearing seems to have disoriented the government machinery. In the process, some capacity building may have happened, but so far we have not seen any evidence of that.

It is also important to consider the kind of “hard state” we want. Whether it should be a state that is willing to ignore the rule of law to enforce a law, or a state that balances the consideration for the rule of law and its enforcement duties. The somewhat arbitrary nature of the demonetisation decision seemed to project an imprudent image of the state.

This call for asserting a “hard state” image without the hard work of building state capacity appears to be like placing the cart before the horse. The China envy misses some of the most important facts about that country. First, as Yasheng Huang and others have shown, the Chinese story, when it first took off, was much more about increased economic freedoms, directionally liberal political freedoms, and respect for the rule of law, than the simplistic narrative of a “hard state” driving growth would suggest.

Secondly, to the extent that the Chinese state has succeeded in “command and control” solutions, it is riding on two millennia of accumulated state capacity. We in India do not have that kind of capacity in the government, because much of our state building has happened in the last two hundred years. We cannot wish it into existence by announcing overnight cancellation of 86% of currency.

The “entrepreneurial state” perspective

Some admired the boldness of the decision as a welcome departure from the non-poetic language of techno-bureaucratic governance. There were many such characterisations of the decision: “a big risk by an entrepreneurial state”, “a natural experiment”, “the romance of policy”, “a big bang reform”. Implicit in these was an approval of the decision as a sign of shifting away from “business as usual” to an innovative approach that they think is required to make India great again.

There were many unique features of this decision that evoked a feeling of romance among those so predisposed. First, it was politically risky. The government did not have to do this. Popularity of the government and the prime minister was high. The BJP traditionally receives support from the trading and business communities, and a lot of business in India is cash-based. While some people alleged this was a political decision with no regard for its impact, common sense suggests that those who took this decision wanted it to succeed. Political motives do not make impact irrelevant, because impact also has political ramifications.

Also read: Templated Tweets, Trolls Deployed to Proclaim ‘Success’ of Demonetisation on Social Media

However, it was not obvious why this particular “experiment” had a reasonable chance of working. The arguments were not forthcoming as to why this was a worthy experiment and not just an irresponsible gamble. Those suspending judgment about this mega experiment should have at least explained why it was reasonable for a government to run such an experiment, given the facts about black money, fake currency and the potential costs. All we heard and read were general statements about how this experiment by an enterpreneurial state will help India become a more formal, rule of law society. It was like a gnostic approach to politics – the wise ones know all there is to know, and those who don’t know cannot be told.

An experiment pre-supposes the capacity to adapt to make it work. In a well-known paper, Albert Hirschmann proposed the idea of the “benevolent hiding hand”. It is essentially this: since human creativity can overcome obstacles in unpredictable ways, it is desirable to under-estimate the difficulties of the tasks we embark upon, as human creativity would overcome the obstacles. For policy-making, this translates into accepting decisions where the expected net benefits are small, because human ingenuity and creativity would respond to push up the benefits and bring down the costs. In the context of demonetisation, this would mean that once it took the decision, the government would find ways to create significant net benefits, irrespective of gloomy ex-ante predictions. This is an interesting argument. However, history teaches a different lesson. Hirschmann had used eleven examples to back his argument. In a 2015 paper, Bent Flyvbjerg and Cass R. Sunstein, working with a much larger sample (327 cases), found that the benevolent hiding hand is rare, and in most cases (78%), it is a “malevolent hiding hand” at work, which “blinds excessively optimistic planners not only to unexpectedly high costs but also to unexpectedly low net benefits.”

This suggests that, in taking such decisions, a government should be assume that, in most cases, its initial assessments about how things will play out will prove to be too optimistic. Especially in decisions like demonetisation, where some other rational actors (eg. black money holders, money launderers) are trying to minimise the benefits, it is naive to assume that the outcome would be better.

Needless to say, governments can and must take risks. The key problems with demonetisation as an experiment were: the disruption was too big, uncertainties were too many, and problems it sought to solve were relatively small – small portion of black money in cash form; small value of fake currency; already rapid growth in digital payments.

Those who ought to know and tell

Many interesting perspectives and sentiments were deployed to justify support for the decision. However, on hindsight, most of them appear to be misplaced. One of the reasons why this happened is that those whose duty it was to know and tell did not act according to their duty.

These are the people whose main task it is to intermediate between reason and politics.

The economists and policy analysts are trained to analyse such a decision and make reasonable conjectures about how it would play out. Their analytical standards are set by their peers, who are supposed to hold them accountable. Second, the journalists are supposed to be suspicious of power. This suspicion is essential for the sacred role that they play in the society, where the State has substantial resources to put forth its viewpoint, but most others in the society do not have those resources. This suspicion distinguishes journalism from propaganda.

While the partisans supporting the decision were working over-time to generate a depiction of this decision as a panacea, many economists and journalists did not take a sufficiently analytical and critical perspective of this momentous decision. Sure, some in the media were critical, and some were reporting stories from the field. However, if we accept that the media should have a critical bias, the overall coverage of demonetisation simply does not pass that test. Day after day, one read propaganda masquerading as analysis. Among economists, it was painful to see elders making baseless assertions and casting aspersions, without the kind of subtlety one expects from analytical narratives.

One of the strangest spectacles was to see how some prominent economists and business journalists decided to take their stance based on a purely “political” perspective of the decision, asking whether it will help the ruling party win elections. They seemed so comfortable with this exercise of power that instead of interrogating the use of power in terms of its consequences for the society, they analysed the consequences for those wielding power. There were even “told you so” stories after the UP elections, taunting the critics for being elites living in echo chambers.

The point here is not whether the political perspective is insightful or not, but whether economists and journalists should also try and assess such a decision in terms of the process of decision-making, quality of implementation, and impact on the society.

Credit: Twitter

Should those in the public sphere applaud policy-making aimed purely at winning elections? Credit: Twitter

Among those commenting on demonetisation in popular media, some were counselling delayed judgment. Some were cautiously optimistic – predicting that the benefits that accumulate over time will outweigh the costs, but they were not under-playing short-term costs or exaggerating short-term benefits. However, they appeared more agitated by the critics than by the cheerleaders. Others advising against quick judgment were simply waiting for the experiment to play out, without any clear predictions about its consequences. All those who were neutral towards the decision stood on a common ground: they gave the government the benefit of doubt, and did not consider it important to analyse the decision critically.

This benevolence cannot be just about accepting the power of the government to take such a decision, because those powers allow a wide range of decisions, from which any thinking person would have to discern those that deserve a benefit of doubt. Anyone giving the benefit of doubt is implicitly accepting the “nature” and “content” of the decision, even while they are delaying judgment about the expected consequences.

It is a sad reflection of the character of intellectual life in our country that such a decision did not get the kind of anatomisation it deserved, and most of the discussion was dominated by assertions untouched by facts and analysis. Even now, we are reading how the decision was a shot in the arm for rule of law; how it is leading to formalisation of the economy; and so on. Most of these assertions are offered without evidence and even without pointing at reasonable pathways.

Timely and well-informed criticisms could have helped the government make some course corrections. This feedback loop was considerably weak when it mattered the most. In fact, it seems that the social media and the new digital media gave much more space for critical analysis of the decision. To further skew the incentives, many of the government appointments in the last one year seem to be rewarding those who supported this decision. Will our republic be served well if everybody becomes a politician, tilting their analysis based on their political motivations?

Executive power, at home and abroad

Debates about the use of government power reveal certain perennial tensions inherent in the nature of this power. For good reasons, we accept that the government should have coercive powers. However, it is not obvious that this power will be used exclusively to serve public interest. While we worry that this power may be applied tyrannically or incompetently, we also need to give the government some flexibility. The functions that require the most flexibility include: law enforcement, internal security challenges, external threats, foreign policy choices, and so on.

These functions involve persistently adversarial actors that pose threats to order in our society. For instance, enforcement presumes non-compliance, with some folks trying to game the system to their advantage. Government needs to see breaking of laws as an affront to the dignity of the law and of the community that lives under it. Governments have to actively diffuse such schemes, and crack down on those carrying them out. What complicates matters further is that often it is not obvious what is a systemic crisis deserving of extraordinary effort, and what can be addressed by more routine measures. By demonetisation, was government responding to actual necessities, or was it just tilting at windmills?

Also read: Demonetisation’s Failure Won’t Hurt Modi, He’s Already Changed the Narrative

As the theory goes, we create and empower the state because we are afraid of each other. But then we constantly struggle to ensure that the state itself does not tyrannise us. We could try to understand this tension in terms of two contrasting doctrines of government power:

  • The “checks and balances” doctrine: This doctrine emphasises formal checks and balances to help mitigate the risk of executive power running amok, and ensuring that the power is used for the purpose it was given for. Checks and balances may include some kind of: clear separation of powers; detailed procedures for policymaking; a federalist structure; expansive scope of judicial review; etc, This is a somewhat legalistic perspective, seeking to place moral limits on the exercise of power. It is based on a suspicious view of power, and seeks to minimise the risks of tyranny. However, once institutionalised, this doctrine creates its own power politics that may help sustain it
  • The “necessities” doctrine: This doctrine underplays the importance of formal checks and balances, and primarily conceives executive power in terms of the necessities it responds to. In this perspective, there are a plethora of problems that must be any means, and accountability is ensured more through popular opinion and elections, and less through intricate checks and balances. In this view, rational politicians are expected to behave in a manner consistent with the public interest, or else they will lose their power, which ultimately comes from the people. It is, at its core, a doctrine that says that those in power should do what they can get away with, and they need not give regard to conventions. Those who cited the example of UP elections are the final validation of demonetisation expressed a sentiment consistent with this perspective.

Both these doctrines run through the history of politics. The “checks and balances” doctrine is found encoded to varying degrees in many modern Constitutions, including ours, but the Madisonian design enshrined the American Constitution is a paradigmatic example. The “necessity” doctrine is found more in theory and in practice, and less in formal designs, revealing itself at certain times, and in certain places. Even in the US, after the September 11 attacks, this perspective seemed to gain credibility, as the doctrine of inherent powers of the executive was taken to its extremes in the name of responding to necessities, and used to justify even torture. Most Constitutions, including ours, do give extraordinary powers but they are typically limited for certain states of exception, and do not allow the State to neglect all of the Constitution.

The “necessities” doctrine encourages a strong bias for action over deliberation. This doctrine also has a strong bias towards expansion of government power, as the government can always find problems it can present as necessities (from social justice to world domination), and seek powers to solve them. Once accumulated, these powers are hard to diminish. So, there is a certain irreversibility about the consequences of this perspective, which is a cause for caution. Further, the “necessities” doctrine is also more accommodative of a majoritarian impulse. Deriving its legitimacy exclusively from solving problems of the people, the executive cannot stand up to the majority when the majority asserts tyrannical demands over a minority. This doctrine is close to populism. This doctrine is also more likely to produce great leaders, giving them the space to do great things (and to make great mistakes).

The “checks and balances” can sometimes decelerate the pace of decision-making. While they often prevent big mistakes from being made, they also slow things down, and frustrate those looking to the government for solutions. The “checks and balances” can sometimes appear to substitute ends with means, making the process more important than the objective, and lose sight of the big picture. It is consistent with the picture of a bureaucracy that is busy with itself, unmindful of the fires that may be burning around. Further, blind partisanship can turn “checks and balances” into weapons of unconstructive obstruction. The “necessities” doctrine was implicitly invoked by calls to change the role of the Rajya Sabha, which is an important check in our Constitutional design, as it appeared to be obstructing the government’s legislative agenda. This doctrine may not be amenable to great leaders, but is likely to produce good leaders, who are mindful of their limits.

Although these are stylised, somewhat simplified descriptions of these doctrines, which in reality co-exist, we need to consider which version of which doctrine we endorse and champion, while applying the limited influence we have as citizens. Partisans may prefer the “necessities” doctrine when in power, and the “checks and balances” doctrine when out of power. However, for most others, whose primary motivation is not partisanship, there is a choice to be made. We in India face many challenges, some of which the government has a role in overcoming, but we have also experienced the consequences of government overreach.

Most citizens will never seek or wield real political power. Our power is the illusory power of a passive sovereignty dispersed among the people. The conventions that instill checks and balances protect us from excesses. In India, where the state’s capacity is low, checks and balances can help ensure that the capacity is not mis-allocated to grand but unworkable ideas. Accountability can help shape the nature of state power. We need at least minimal checks and balances. This should begin with reform of the laws.

Section 26(2) of the RBI Act was invoked for demonetisation. The representatives who voted to give powers to RBI and Central Government under this Section probably did not envisage that this power will be used for enforcement against black money. They gave the power without stating the purpose for which it was to be used. Even a broad statement about the purpose of this power is not there. A power that is used for routine elimination of old series of notes transformed into a power to enforce against black money. This weaponisation was made possible by the vagueness of the statute, and by the absence of any general checks and balances on the decision-making by the RBI and the government. There are many such laws in India that give broad powers to government or other agencies, without clearly stating the objectives or defining the process for the use of the power. It would be make sense to advocate for legislative reforms that limit such powers to their intended purposes, and mandate a minimum process to be followed for use of a power. The process should at least include ex-ante analysis of impact, consultation with stakeholders, and proper planning and resourcing for implementation. The analysis could be something as simple as a clear statement of the rationale that describe why the decision makes sense.

Parliament will probably make these amendments if the citizens signal that they care for the checks and balances. The government could also voluntarily adopt certain checks and balances, if it gets signal from the people that this important to them. However, the formal checks and balances have limitations. Unless citizens, especially analysts, media professionals and others take responsibility to supply the public good of critical analysis, governments can get away with doing the bare minimum. Needless to say, the courts also have an important role in this.

Looking forward

At this point, what matters is the meta narrative about how India debates, makes and implements policies. If too many people in politics feel that this kind of decision won the UP election, then we may have more of such actions. If, instead, we learn that there is value in deliberation, analysis and preparation, then we may try to build those kinds of capabilities. What is at stake in this debate is the fate of the Indian policy process.

The lessons for the policy process are rather elementary. First, while political leadership takes decisions and is accountable for their consequences, they can benefit from analysis. Second, government needs to be realistic about its capacity. It is best to build on what we have, and to be realistic about where we can go. Other than perhaps expansion of negative liberties, there are very few causes that justify radicalism. Third, institutions need to be cultivated over time, otherwise they will fail us when it matters the most. The one institution that could have probably prevented this was the RBI Board. The fact that, as has been reported, it did not even protest, reflects deeper institutional weaknesses. Fourth, even though it is a misnomer to call demonetisation a reform, the decision demonstrated that difficult decisions can be taken. This should lead to a revision of what is considered feasible in policymaking. Fifth, the communication about policy is very important. Credibility of government and RBI suffered because of the arbitrary and unexplained changes in rules, discontinuation of data releases, and other implementation failures. There was a certain callousness about the way things were communicated

To put these “lessons” in practice, we may first need a fuller understanding of ourselves as an inter-dependent political community. The biggest challenges our society faces require the political process, with all its contestations, conflicts and compromises, to work well. Unless we find ways to constructively engage in political dialogue with those we don’t agree with, about matters that affect us all, we will be unable to make the most of our political life.

The conditions in which politics operate are deteriorating because of our poisonous civic discourse. The government and its supporters instantaneously framed any criticism of demonetisation as a defense of black money, and cast aspersion at the critics of the decision. The senior most leaders led this way of framing. The social media environment has been consistently vicious. The amount of mistrust and hatred that has been brought out cannot bode well for our Republic.

It seems much damage is being done by a handful among us, who are so covered in layers of ideology, that they cannot see that the debates are within a community. The language of total victory and humiliating defeat is not for democracies. As Wilson McWilliams put it, “Democracy is for friends and citizens, not for masters and slaves.”

Suyash Rai is a Delhi-based policy analyst. Views expressed here are personal. The author thanks Ajay Shah for useful discussions.

*I used the following method to estimate additional tax collection till Quarter 1 of 2017-18:

  • Begin with the time series on direct taxes, and the time series on Gross Value Added for industry and services (in current prices) for the October-June period since 2011-12. GVA (industry and services) is a measure of the base of economic activity. Agriculture is not taxed.
  • Construct a time series of the ratio of direct taxes to the base of economic activity during the period between October and June since 2011-12. Considering the three-quarter period as a whole helps partially overcome the seasonality induced by tax policy changes.
  • Calculate the average ratio for the series, and take this as the baseline scenario for the period between October 2016 and June 2017.
  • Estimate the expected tax collection during the latest period by applying the average ratio to the GVA during this period. Deduct this from the actual tax collection to estimate the additional tax collection.
  • Deduct the collections under the Income Declaration Scheme that closed in September, 2016. Additional collections under this scheme cannot be attributed to demonetisation, because it closed before demonetisation. During October and March, 2016-17, Rs. 12,700 crore was collected under IDS. The remaining amount is to be deposited by September 30th 2017. We assume that Q1 of 2016-17 saw no collections under IDS, as the deadline is in Q2.
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