Decision To Scrap Rs 500 And Rs 1,000 Notes: A Windfall For The Government?
New Delhi : RBI Governor, Urjit Patel with Finance Secretary Shashikant Das showing specimen notes of new Rs.2000 during their press conference in New Delhi on Tuesday. (Photographer: Shahbaz Khan/PTI)

Decision To Scrap Rs 500 And Rs 1,000 Notes: A Windfall For The Government?

The impact of the government’s decision to withdraw Rs 500 and Rs 1,000 notes will be felt by everyone – customers and businesses but also the Reserve Bank of India and the government.

As the implications of Tuesday’s announcement start to sink in, economists note that the decision to demonetise could have an impact on the RBI’s balancesheet and consequently allow it to increase its dividend to the government. This, in turn, could prove to be a fiscal relief.

An indication of this expected relief comes through in the sharp fall in government bond yields in the last two days. To be sure, an expected improvement in banking sector liquidity has also led to a sharp fall in bond yields.

Decision To Scrap Rs 500 And Rs 1,000 Notes: A Windfall For The Government?

How Will This Impact The RBI’s Balancesheet?

The impact will start to flow through the RBI’s balancesheet.

The decision to cancel currency notes of Rs 500 and Rs 1,000 will mean 86 percent of all currency by value and about 24 percent by volume will be taken out of circulation.

Some of this will flow back once there is adequate supply of these new notes and people start to use them.

But, remember, one of the key reasons behind this move was to clamp down on the black economy. A part of this is cash which has been hoarded by some individuals who haven’t paid tax on it. If these individuals suddenly deposit huge hoards of cash into bank accounts, without adequate proof of income, the taxman will come after them. On Wednesday, the government warned that cash deposits above a Rs 2.5 lakh threshold could attract tax plus a 200 percent penalty in case of income mismatch.

To avoid penalty and potential action from tax authorities, some people may choose not to deposit part of their old currency notes, even if it means a loss to them. For the system, as a whole, this means that the currency in circulation will actually go down.

This is how analysts explain it:

  • The RBI has a balancesheet of assets and liabilities
  • Currency issued is on the liabilities side of the RBI’s balancesheet. A corresponding entry is created on the asset side by investing in, say, treasuries
  • If the currency in circulation falls but assets remain the same, that could result in revaluation gains or an increase in networth for the RBI
  • This, in turn, may give the RBI an opportunity to pay out a higher dividend to the government
To the extent that some portion of the currency in circulation will become worthless, monetary liability of RBI reduces. Now, notice that in the current case, there is no change in assets of RBI (unlike a balance of payments shock where both asset and liability sides adjust downwards). What reduces is only the liability side, i.e., currency in circulation declines. This, in our view, should be offset by rise in non-monetary liabilities. For example, rise in net worth or some sort of reserves of the RBI, which can then be transferred to the government in form of higher dividends.
Kapil Gupta & Prateek Parekh, Edelweiss Securities

To be sure, no one has a clear idea of how the logistics of such a transfer would work and whether the rules permit it. But economists say that if there is a one-time transfer from the RBI, it could bring significant relief to the government’s finances.

How Large Could The Impact Be?

The answer to this question is also in the realm of conjecture and depends on the amount of currency that does not come back into circulation.

Soumya Kanti Ghosh, chief economist at State Bank of India has some estimates. In a report released on Thursday, Ghosh noted that during the 1978 demonetisation, about 25 percent of the cash in circulation did not come back into the system for fear of getting tracked or penalised.

“If we safely assume that 25 percent of the cash with public not converted this time also, (though this figure may be significantly higher), it turns out to be Rs 2.5 lakh crore,” said Ghosh.

This will impact the RBI’s balancesheet in a positive manner, as the unaccounted money that is not coming back will reduce currency liability of the RBI and hence the asset size should also get reduced proportionally. This will open up a fiscal windfall for the government that can be used for need-based funding.  
Soumya Kanti Ghosh, Chief Economist, State Bank of India

A Tax Windfall?

Apart from the indirect benefit that may accrue to the government via the RBI’s balancesheet, the government could also stand to benefit from increased tax collections. If at least a part of the unaccounted for money comes back into the banking sector, the government stands to gain by taxing that money.

The government will get reports of all cash deposited during the period of November 10 to December 30, 2016, above a threshold of Rs 2.5 lakh in every account, Revenue Secretary Hashmukh Adhia said on Wednesday.

According to Adhia, the tax department will match large deposits with income returns and if there is a mismatch, action may follow. He also cautioned that any mismatch would be treated as tax evasion.

"This would be treated as a case of tax evasion and the tax amount plus a penalty of 200 percent of the tax payable would be levied as per the Section 270(A) of the Income Tax Act," said Adhia in a series of tweets.

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