Corruption and Black Money: What Next?

Dec 17, 2016

Corruption is a hot-button topic in India. The Anna Hazare movement for a Jan Lokpal bill offered a glimpse of the popular opinion. The Swiss bank 'black' money was a hot election topic. The average Indian is chafing against the chains of bureaucracy and corruption. After all, India is rated among the most corrupt nations.

We're a young nation with an educated populace looking for better living standards. Today's hyper-connected world lets us see the possibilities across various nations. How did some nations improve their per-capita income so fast?

Corruption is an easy target for a young and restless nation looking for a scapegoat. Demonetisation is targeted at 'black' money, which is linked to corruption. But while the move may act as a 'reset', it is unlikely to affect the root cause.

The 'black' economy has a significant impact on the Indian economy. Firstly, It acts like a hidden tax across the system...a 'shadow rent' across all transactions. The official tax rates do not account for the bribes and 'speed' money required to get things done. Real estate prices do not factor the split between white and black money. In other words, nobody makes decisions based on official taxes and prices.

For example, a key indicator for real estate investors is the 'estimated' rental yield. Analysis of the recent official transactions in that locality will not tell you the real price. That's because it won't include the 'black' component demanded by the seller. The stated transaction price is not a good investment indicator.

The second effect is related to public policy. Ambitious targets for rural education, health, and subsidies are not matched with results. Only a fraction of the tax collections are effectively converted to results. A large portion of the funds are siphoned through corruption.

The National Rural Employment Gaurantee Act (NREGA) is a classic example. This scheme assures 100 man days of work to rural families in India. Over an eight-year period, Rs 2.6 trillion has been spent. Noted economists Jagdish Bhagwati and Arvind Panagariya have estimated that it takes Rs 5 of spending (under NREGA) to deliver a benefit of Rs 1 to the poor. That's what you get when you mix corruption and inefficiency.

The third most crippling effect is the loss of capital. India is a capital starved country - capital investment per capita (estimates based on World Bank data) is $500 compared to $11,000 in the US and $3,500 in China. Capital is a key component of fast growth. But when money is deemed 'black', there is an incentive to take that capital out of India.

Generators and Circulators

Black money is intertwined with all other transactions. One man's black money becomes another man's white money. For example, bribe money can be used to pay for a plumbing repair. The bribe (black money) is now white money in the hands of the plumber. There are countless such transactions in an economy. The service sector is a prime target for circulating black money.

The generators of black money are of more interest (or should be). A white paper published by the government in 2012 references two key categories of black money generators. The first category is criminal activity. These are anti-social activities like smuggling, trafficking, and bribery.

The second generator is tax evasion. This refers to legitimate income that is not declared to evade tax. Some common methods are real estate price split (as in the above example), over-invoicing costs, and understating inventory.

Dealing with anti-social activity is an important lever. It involves ensuring growth. A growing economy means less people will be drawn to illegal means. It also involves ensuring effective administration of law and order. An effective system can be a strong deterrent.

A 1998 IMF working paper on corruption recommended reducing the 'demand for' and 'supply of' corrupt acts. The demand can be reduced by simplifying regulations and avoiding price controls. A simple and transparent regulatory structure will increase adherence to it. More people will be happy to go through the legal processes, reducing the 'demand for corrupt acts'.

The supply can be reduced by improving public salaries and enforcing stricter controls. When a government officer is well compensated and strong controls and laws are in place to prevent and punish corrupt acts, the incentive to provide corrupt alternatives will drop. The cost-benefit is skewed towards following the legal process.

Concerning tax evasion...my submission is that the curb of anti-social activities will have a knock-on effect. Lower corruption implies better social expenditure outcomes. It also means higher business profits and re-investment. A removal of the shadow tax will increase the incentive to comply.

We already know popular opinion is against black money. A few steps to attack the generators of black income - growth-related reforms, simplification of rules, and administrative efficiency - can help curb this problem.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.