By Arun Kumar
As we have seen, black incomes comprise factor incomes, property incomes that are not reported to direct tax authorities. What escapes the indirect tax net is also not reported to the direct tax authorities. Hence production is only partially captured in the white economy data. Further, as we have seen, illegal activities are not reportable, hence they are completely out of the tax net and entirely black. It has been shown that wages are inflated to show higher costs and generate black incomes. Revenues are shown to be less through under-invoicing and wages (costs) are over-invoiced (shown to be higher). Hence, profits are shown to be lower while wages are shown to be higher. Consequently, the income distribution is more skewed than depicted by the white economy data.
Further, as the black economy grows relative to the white economy, the share of profits rises. Since profits tend to be much larger than the wages, the share of high incomes rises and since more is saved out of high incomes, the share of savings in the economy rises. This is important since it has an impact on incomes in the economy via the investment multiplier. The investment multiplier tells us how many times of the investment is the national income. This multiplier is the inverse of the savings rate in the economy, so it falls as the share of black economy rises. Consequently, as the black economy grows, for a given level of investment in the economy, the level of income is lower.
It has also been shown that the rate of investment in the economy falls due to the black economy. This is a result of a) capital going abroad via flight of capital. So instead of capital being invested in India it is invested abroad and leads to shortage of capital in the country; b) due to the ‘digging holes and filling holes’ phenomenon, the value of investment is effectively less than it should be, as explained earlier; c) there is over-invoicing of capital so that what is recorded is more than actual and so on. To explain, a businessman investing in an industry claims to have invested, say, `100 crore whereas they may have only invested `80 crore. The extra amount of `20 crore is siphoned off. This is called over-invoicing of capital and results in the generation of black income. The decline in the overall level of investment results in a lower level of output in the economy.
The actual input-output ratio of the economy is lower than that suggested by the white economy. This results in problems of planning and failure in execution. In simple terms, suppose the government is planning for 100 while the economy is actually 162 (because of the black economy), so the state is planning for the wrong amount of requirement of steel, energy, transportation and so on.
The incremental capital-output ratio rises because of the inefficient use of capital due to the black economy. The rate of growth that is achieved is, therefore, lower than the potential rate of growth. (The potential rate of growth is the rate of growth which could be achieved if the black economy is eliminated so that the productivity of investment becomes higher and the level of investment rises.) The graph below shows just how much better off the country would be without the black economy.
This explains the seeming paradox that while the black economy leads to a higher level of output, employment and growth rate, it actually lowers the level of employment and output and rate of growth compared to the potential of the economy. What it means is that the actual rate of growth is higher than that shown by the white economy but lower than the potential rate of growth. The reason is that productivity of investment is lowered by the black economy due to wasteful investment and misuse of capital as argued above. This can be captured by the following formulation:
rp > rb > ra > rw
where rp stands for the potential, rb for the black, ra for the actual and rw for the white economy rates of growth respectively.
Thus, although the black economy generates output and employment, far more is lost than gained.
Monetary policy is adversely affected since the money available in the economy has to circulate the black economy (in addition to the white economy). Money has to go around faster than if there was only the white economy. Additional liquidity in the economy is required but that is not captured by the official data since it is not factored into the equations used by the Reserve Bank of India (RBI). Consequently, the velocity of circulation—i.e. how many times money has to change hands in a year—calculated with white economy data turns out to be incorrect. The consequence is that it becomes difficult to control inflation. For example, if there is a shortage of, say, onions, it is exacerbated by the inflow of black liquidity which aggravates the shortage. Thus, if the shortage was actually 10 per cent, it could rise to 25 per cent because suppliers simply hold their stocks of onions in anticipation of the increase in prices. If at 10 per cent shortage the price was to rise by 25 per cent, with a 25 per cent shortage the price rise could be as high as 400 per cent. Even if 10 per cent of the onion stocks rots due to poor storage, the traders stand to make a killing. Under these circumstances, even if the RBI tightens money supply it does not help. The issue does not remain a purely monetary policy matter but becomes one of political management. So the principal task of the RBI, namely controlling inflation, slips out of its hands.
Excerpted with the permission of Aleph Book Company from the book, Understanding the Black Economy and Black Money in India, by Arun Kumar.
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