Will tax on withdrawing cash fix tax evasion or black money?

It is no secret that the Modi government is undertaking various steps to move India towards a cashless or less-cash economy. The government believes that cashless transactions can help in curbing generation of black money as every such transaction will be documented. Government further believes that this will hurt fake currency mafia as well as push people towards better tax compliance.

While there is no doubt that cashless transactions will indeed help achieve those objectives, the move that pushes people towards cashless transactions need to be analysed for their effectiveness and feasibility. Demonetisation was one such step that was widely debated.

Now the next move – reportedly suggested by a panel to the government – is to introduce tax on cash withdrawals above 50000 rupees, so that people prefer cashless transactions. The panel is headed by Andhra Pradesh Chief Minister Chandrababu Naidu, who believes that the government could accept the suggestion and incorporate it into the Union Budget that will be presented on 1^st February this year.

But will this withdrawal tax really help achieve the objectives of curbing black money and parallel economy? Let’s try to understand the issue:

The Cash Chain

Here is a representative cash chain. Cash is withdrawn from the system and from then it travels through various mediums till it reaches the bank again.

Overall, the cash chain has 3 types of transactions:

1. Type I – Where cash is withdrawn and used for an unaccounted transaction
2. Type II – Cash to Cash unaccounted transactions
3. Type III – Cash transactions which are disclosed

Of the 3, Type I and II can be termed as ‘Black’ transactions as they are not accounted for and among these two, only Type I will be taxed. Additionally, Type I is only the trigger which sets into motion the downstream transactions.

Type II which form bulk of the transactions in the cash chain will not be affected at all. Imagine this flow as a race track where you place a small speed breaker at the start of the track. Once you cross the initial hurdle you are free to step on the accelerator.

One argument here is that II and III are dependent on I and if Type I is reduced it will have a downstream impact on the other types as well. To test this argument, let’s dive a bit deeper and look at the Type I in detail.

The Buyer’s Burden

Since the proposed concept is to tax the buyer, it is the buyer who has to make the decision as to which mode of payment he prefers. So let us look at transactions from a buyer perspective:

1. Low Hanging fruit: These are the transactions where the buyer can easily shift to other modes of payment. This is the low hanging fruit where alternatives are readily available and suit the buyer. So buyer will be tempted to go for non-cash means of purchase. For example, buying groceries from organized retail or merchants who accept cards, buy from e-commerce sites etc.
2. Hard to Crack: These are the cases where even if the buyer wants to pay by card, seller offers no such alternative. Such transactions will not be affected by withdrawal tax. For example, Auto driver does not accept card, doctor does not accept card, a small-scale manufacturer wants to buy raw material but seller wants cash, contractor employs daily wage labour who does not have a bank account, BMC official asks for bribe to sign on papers etc.
3. Where Cash withdrawal is cheaper than the alternative: It is highly unlikely that the withdrawal tax will be very high (say 10-20%). Most probably it will be in the sub 3% bracket. 3% is also a deterrent but not in cases where the alternative is even more expensive. For example, Paying bribe to the traffic cop rather than getting a challan, sellers passing on the transaction charges to the buyer if payment is by card, buyer wants to save taxes while registering property etc. Plus the tax slabs are higher than withdrawal tax and the seller can always offer a nominal discount if payment is by cash to save taxes. Transactions of such nature will also not be affected by withdrawal tax.
4. Cash is King: The fourth type are the ones where buyer himself wants to hide the transaction. Here he has no alternative but to pay by cash. These will also not be affected by the proposed tax. For example, Buying drugs!

As we drill down deeper we can observe the gamut of transactions which the buyer will reconsider due to transaction tax are very low. Only Type I type of transactions will fall under this tax and even these will only be partially impacted. Cash will slowly seep through and build up reserves in the Type II transaction market.

Additionally, withdrawal tax is making cash dearer. And what do we do when something becomes dearer? We hold it close. Velocity of cash will reduce and people will also be reluctant to give cash back to the banks. As time passes and ample cash is available in the market, power of withdrawal tax will reduce severely.

In short – you cannot fix a long pipe having numerous leakages by placing a thin filter at the mouth of the pipe. Water will slowly seep in, build up and start leaking again.