The Rise of Goliath

by AK Bhattacharya

  Looking back, it does appear that the growing stress in the banking system and the methods that should have been adopted to resolve the economy’s twin balance sheet problem resulted in a ruptured relationship between the central bank and the government. The delicate balance in the equation between the RBI and the government was disturbed. Differences of opinion surfaced between the RBI governor and the government over the manner in which the banks’ NPA problem should be resolved and how the public-sector banks’ governance structure should be revamped. Questions over the RBI’s autonomy also were raised over whether the government could tap into the central bank’s capital reserves. In the end, it was a huge disruption for the delicate balance in the relationship between the central bank and the government. This will no doubt have a long-term impact on the relationship between governments and the central bank governors of the future.

  Who were the key disrupters in the financial sector? Clearly, RBI Governor Raghuram Rajan was the primary disrupter. He put in place a series of actions to impose greater financial discipline on banks and forced them to recognize stressed assets as well as undertake corrective steps to resolve them. He may be accused of not taking those steps as quickly as possible, but the disruption he caused to the financial sector is irrefutable. Urjit Patel and Finance Minister Arun Jaitley would also rank among the other prominent disrupters. They changed the way banking stress was tackled, increasing the pressure on the banks and the overall financial system. But in that process they allowed their different approaches and strategies to resolve stressed assets to become a cause for a strained relationship between the regulator and the government. The long-term consequences of such a disruption are not yet known. It will take a lot of effort for future finance ministers and governors of the central bank to amend the relationship, repair the damage inflicted on the perception of a regulator’s independence and ameliorate the impact of the disruption that the economy experienced as a result.

  Section 12

  Demonetization

  CHAPTER 22

  SHOCK THERAPY OR A BOOMERANG?

  Nine days after Diwali was celebrated on 30 October 2016, Prime Minister Narendra Modi decided to address the nation on the evening of 8 November. Diwali is a festival of lights, celebrated in almost all corners of the country and it also marks the start of a new year for most traditional Indian businesses. But this year Diwali was spent amidst the spectre of a war looming large on India’s western borders. Just about a month earlier, on 29 September, India had undertaken what it called a ‘surgical strike’ on two sites located in the Pakistan-occupied Kashmir.1 The Pakistani Army played down the intensity of the attack. A BBC report2 claimed that there were no air-dropping of Indian soldiers into those two sites, two kilometres inside the Line of Control that separates India from Pakistan. But the Indian side maintained that considerable damage was inflicted on two camps in Pakistan-occupied Kashmir, from where Pakistani terrorists used to plan terror attacks in Indian cities.

  The Indian counterattack came within weeks of a Pakistani terrorist attack on an Indian Army base in Kashmir’s Uri, killing nineteen Indian soldiers. The retaliation from the Pakistani side to the 29 September ‘surgical strike’ by Indian forces was swift. Between 29 September and the first week of November 2016, there were more than sixty ceasefire violations by Pakistani forces along the Line of Control and the international border. According to another report, there were over 120 ceasefire violations during the same period. As many as 175 schools in the nearby areas on the Indian side were shut down in order to avoid civilian casualties due to shelling or firing from across the border. Also, Indian villages near the border with Pakistan were evacuated to minimize the number of civilian deaths on account of attacks from across the border. Already, about fifteen Indians were killed and forty more injured in this period.

  Hours before the prime minister’s scheduled address to the nation on 8 November 2016, a high-level meeting took place at the prime minister’s office. It was a routine meeting, but the context of the heightened tension on India’s western border and the firing incidents leading to many deaths was unusual. Military chiefs briefed Modi on the situation along India’s border with Pakistan and apprised him of the preparedness of the armed forces to tackle the situation on the border. National Security Adviser Ajit Doval was present at this meeting, which significantly took place on a day when one Indian soldier had been killed hours earlier due to Pakistani shelling in Jammu and Kashmir.

  So, when the government put out an advisory at around 7 p.m. the same day that the prime minister would address the nation around 8 p.m., speculation was rife about whether India was planning a second surgical strike or something similar had already been undertaken, or the prime minister would be making a bigger announcement concerning Pakistan. Such speculation was further fuelled by the news that a Cabinet meeting had been called just before the scheduled address by the prime minister.

  When the nation heard the prime minister for about thirty-seven minutes, it was stunned. Yes, a surgical strike had been undertaken, but not against any terrorist camps in Pakistan, but against high-denomination currency notes in circulation in the country. Notes of Rs 500 and Rs 1000 denomination, which accounted for about 86 per cent of the total currency in circulation, were to be denotified or annulled by midnight and a detailed action plan was outlined on how the demands for cash would be met over the next few months and how individuals could exchange their old annulled notes with the new ones in the next fifty-odd days. The prime minister spoke in a sombre mood, as though a grave threat was looming large over the economy. Viewers initially feared that a serious external security threat had engulfed the nation and only after about fifteen minutes into his speech did they realize that the grave threat was not from across the border, but economic and within the country—a threat of black money, fake currencies and counterfeit notes financing terror acts in the country. Two and a half years into his tenure, Modi had delivered his government’s most disruptive blow to the Indian economy, which will define to a great extent his governance record as India’s thirteenth prime minister.

  The Road to Demonetization

  The decision to demonetize 86 per cent of the country’s currency in circulation has been widely understood to be a sudden decision by Modi and took everyone by surprise. Few people even within the government knew of the decision before it was announced by Prime Minister Modi. The jury may be still out on whether it was a decision made suddenly or the seeds of the move had been sown many months before that fateful evening of 8 November 2016. But a few developments that took place during a period of about eight months before demonetization do suggest that the government may have planned the move much earlier, and why the decision appeared to have been taken suddenly is because utmost secrecy was maintained by the few officials that were responsible for executing the demonetization plan.

  At least eight months ago, on 29 February 2016, Finance Minister Arun Jaitley had risen in the Lok Sabha, the lower house of the Indian Parliament, to present what would be the Narendra Modi government’s third Budget—to outline the taxation and economic policy plan for 2016–17. Jaitley claimed credit for how the Indian economy had been rescued from the decelerating growth of the last few years of the Manmohan Singh government and announced how the Modi government had accelerated the growth. The government’s own data, however, showed a slightly different story. Economic growth had indeed begun slowing down and GDP growth had dropped to 5.5 per cent in 2012–13. But the recovery had started in 2013–14, when GDP growth rose to 6.4 per cent. The finance minister’s intention was to convey that the new government had taken quite a few bold initiatives to bolster the economy and boost its growth. True to form, Jaitley doled out some tax incentives for individuals and companies and made an attempt to settle the vexatious issue of retrospective taxation for foreign companies, in particular.

  The Manmohan Singh government had changed a taxation law with retrospective effect through its Budget for 2012–13. The
Income-tax Act, 1961, was amended retrospectively to force companies like Vodafone to pay capital gains tax on its purchase of controlling shares of an overseas company, whose assets and businesses were located in India. Vodafone had argued that since its acquisition of shares in the telecom company, then owned by Hutchinson Whampoa of Hong Kong, was an international transaction, it was not obliged to pay any tax in India. The government had argued that since the business underlying those shares was located in India, the Indian government had the right to levy a capital gains tax. But the government’s tax demand on Vodafone for Rs 11,000 crore was quashed by the Supreme Court in January 2012. The Manmohan Singh government retaliated in the Budget it presented in February 2012. Since there was a lack of clarity in the law, a loophole that the apex court used to strike down the government’s tax notice on Vodafone, Finance Minister Pranab Mukherjee, in his Budget for 2012–13, changed the Income-tax Act retrospectively, raising a storm of protest in international circles and even within India. Described as the Vodafone tax, this turned industry against the Manmohan Singh government and the succeeding government led by Narendra Modi was expected to provide legal clarity. But all that the Modi government did was to retain the Vodafone tax, but assured industry and foreign investors that such retrospective amendments to taxation laws would not be introduced again.

  Other efforts by the Modi government to bring about factor market reforms, however, made little headway. The government faced a major political setback on account of its failure to relax the land acquisition norms and introduce labour reforms in the first year and a half, and was preparing to undertake some big reforms—by introducing a law that would resolve stressed assets of banks by forcing time-bound liquidation or resolution of indebted companies and replacing a plethora of indirect taxes at the Central and state levels with a uniform indirect tax. The former would be later known as the Insolvency and Bankruptcy Code, which would be passed by Parliament by May 2016. And the latter would usher in India’s biggest indirect tax reform and would be known as the GST, which would be launched from July 2017.

  Little could anyone tracking the finance minister’s speech that day sense that the government was readying for a much more dramatic and disruptive change about eight months later. Demonetization was announced by Prime Minister Modi on 8 November 2016. Yet, there were perhaps some hints of the government’s thinking even at that time. They became a little too obvious, of course in hindsight. For instance, Jaitley announced a big push to the Pradhan Mantri Mudra Yojana (PMMY) for the benefit of entrepreneurs at the bottom of the pyramid. The amount sanctioned under PMMY, essentially loans on easy terms to entrepreneurs in the informal sector, had already reached about Rs 1 lakh crore by the end of January 2016 and the number of beneficiaries crossed 25 million. The target for 2016–17 was raised to Rs 1.8 lakh crore. The push for Mudra Yojana was aimed at providing financial support and incentives to small and medium enterprises, a sector that would be hit hard by demonetization. The idea was to provide them adequate financial support so that they could withstand the shock of demonetization. This became evident in retrospect when it was argued in BJP circles that if demonetization adversely hit small businesses it was because the planned Mudra Yojana failed to take off as per the government’s expectations. The RBI had indeed expressed some doubts that the loans granted under Mudra Yojana could result in more non-performing loans for banks. S. Gurumurthy, an adviser to the BJP and who later became a director on the board of the RBI, had tweeted soon after demonetization: ‘Only micro businesses suffered for finance as the full Mudra scheme to alleviate them was blocked.’3

  In another Budget announcement, Jaitley proposed to expand the reach of the automated teller machines (ATMs), particularly in rural areas. A nation-wide rollout of ATMs was planned to provide better access to financial services. Once again, the government seemed to be quietly planning for strengthening the ATM network. Post-demonetization, the use of ATMs would have become more critical for the limited cash individuals would be allowed to draw. Not only would there be a requirement of expanding the ATM network, but it would also have to be recalibrated for the new currency notes. As in the case of Mudra Yojana, the advance action on ATMs too was found to be wanting.

  The most significant announcement from the perspective of what happened to the nation eight months later was Jaitley’s enunciation of the government’s taxation philosophy and the fight against black money. ‘We are moving towards a lower tax regime with a non-litigious approach. Thus, while compliant taxpayers can expect a supportive interface with the department, tax evasion will be countered strongly. The capability of the tax department to detect tax evasion has improved because of enhanced access to information and availability of technology-driven analytical tools to process such information. I want to give an opportunity to the earlier non-compliant to move to the category of compliant,’ Jaitley announced.

  It is in this background that the finance minister announced a compliance window for a limited period for domestic taxpayers to come clean and declare their undisclosed income or income represented in the form of any assets. This was called the Income Declaration Scheme, 2016. The compliance window would essentially allow such taxpayers to clean up their past tax violations by paying tax on such undisclosed income at the rate of 30 per cent and a surcharge at 7.5 per cent and a penalty at 7.5 per cent. Thus, a penal income tax rate of 45 per cent was proposed for domestic taxpayers to wash their past sins of tax evasion. Describing it a compliance window was perhaps a euphemism. It was nothing else but a tax immunity scheme by another name. The only difference was a penal rate of tax. Thus, there would be no scrutiny or inquiry regarding income declared in these cases either under the Income-tax Act or the Wealth Tax Act. Those taking advantage of the ‘compliance window’ would enjoy immunity from prosecution as also from the provisions of the Benami Transaction (Prohibition) Act of 1988.

  The four-month window under the scheme—from 1 June to 30 September 2016—helped the government secure declaration of undisclosed income amounting to Rs 65,250 crore. This was a preliminary estimate, but helped the government mobilize a tax revenue of Rs 29,362 crore, which amounted to just 8 per cent of the total individual income taxes collected in 2016–17. The response was not overwhelming by any yardstick, perhaps because the scheme required the declarants to pay penalty, taking the overall tax incidence to 45 per cent. In contrast, the Voluntary Disclosure of Income Scheme (VDIS), 1997, required the declarants to pay an effective rate of taxation that could be in single digits and thus helped the government rake in additional tax revenues of Rs 9760 crore, which amounted to 34 per cent of the total income tax collected in 1997–98. VDIS 1997 was probably the most successful of all the eleven such tax amnesty schemes that have been rolled out by various governments from 1951 to 2016. The Supreme Court had directed the Centre after VDIS 1997 that it should desist from announcing any more tax amnesty schemes. But the government had defended the Income Disclosure Scheme, 2016, on the ground that since it had imposed a penalty on the declarant, it was not similar to the previous schemes.

  A justification for the Income Disclosure Scheme, 2016, from the social expenditure point of view was provided when the finance minister announced that the surcharge of 7.5 per cent would be called Krishi Kalyan surcharge and used for agriculture and rural economy. What Jaitley did not disclose in his Budget speech in Parliament was that the collection of the Krishi Kalyan levy would help him collect the entire amount by way of surcharge and keep it for Central expenditure without sharing that with the states under any devolution formula. While a specified share of taxes collected by the Centre is distributed among the states and Union territories in accordance with a formula devised periodically by the Finance Commissions, there is no such sharing of what the Centre levies by way of surcharges and cess. Indeed, many finance ministers in the past have sought recourse to the levy of surcharges and cess on commodities or even on direct taxes in order to mobilize more revenues for the Centre and without sharing
those special levies with the states. This is a practice that has been frowned upon by fiscal experts who believe that this dilutes the principle enshrined in the Indian Constitution on how the Centre should share its revenues with the states. The Krishi Kalyan surcharge was such a levy that the Centre was not obliged to share with the states.

  But two features of the tax compliance window scheme are worth noting. One, Jaitley concluded his announcement on the scheme by reiterating the government’s objective behind it. He said: ‘Our government is fully committed to remove black money from the economy. Having given one opportunity for evaded income to be declared once, we would then like to focus all our resources for bringing people with black money to books.’ Two, the scheme was to start from 1 June and end by 30 September, with the option to those taking advantage of the scheme to pay the due tax amount within two months of the declaration. Did the warning that the government would crack down on black money with greater force after having given taxpayers an opportunity to come clean have a signal hidden in that of what was to come on 8 November 2016? And why was the last day of the scheme kept on 30 September? There is enough in Jaitley’s Budget speech that debunks the speculation that Modi’s demonetization was a sudden unplanned move.

  It may be sheer coincidence, but it must be remarkable that even while Jaitley was announcing the drive against black money and a tax compliance window in the morning, his ministry was busy issuing an Office Memorandum detailing what the government was planning on the promotion of payments through cards and digital means across the country. It was a detailed note emanating from the Currency and Coin Division of the Department of Economic Affairs in the Finance Ministry. On 29 February 2016, it was sent to all secretaries of the central ministries, the RBI governor, the chairman of Telecom Regulatory Authority of India, the CEO of NITI Aayog and of course to the cabinet secretary. With a six-point objective in view, the grand plan was aimed at improving the ease of conducting card or digital transactions for an individual, reducing the risks and costs of handling cash, reducing the costs of managing cash in the economy, building a transactions history to enable improved credit access and financial inclusion, reducing tax avoidance and reducing the impact of counterfeit money. In particular, the emphasis on greater use of digital transactions, reduction in the use of cash and crackdown on counterfeit money was an idea that had already gripped the minds of government policymakers by then.