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Convertibility of Black Money: Indian Case Paper

Words: 2245, Paragraphs: 23, Pages: 8

Paper type: Essay , Subject: Black Money

1. What is black money? Black money is essentially the currency used in ‘black economy’. Black, shadow, underground, unobserved, unofficial, subterranean, unrecorded, informal, irregular, second, twilight, parallel – are all the synonyms used for the ‘shadow economy’. The shadow economy basically consists of legal and illegal activities outside the reach of the government. Smith (1985, p. 18) provides a very broad definition of the shadow economy as ‘market based production of goods and services, whether legal or illegal, that escape detection in the official estimates of GDP’.

Table 1 gives a better view of what a reasonable definition of underground economy includes. Underground economic activities are all illegal actions that fit the characteristics of classical crime transactions like burglary, robbery, drug dealing, etc. Informal household economy consists of household enterprises that (1) are small in terms of persons engaged, and (2) are not registered officially under various specific forms of national legislation. 2. Why is there a shadow economy?

The growth of the underground economy is associated with various factors, such as rise in taxes and social security burdens, intensity of regulations in the official economy, especially the labour markets including forced reduction of weekly working time, early retirement, prohibition of not working at more than one office for government officials etc. Apart from economic factors certain non-economic factors also lead to the expansion of the underground economy such as unwillingness to show the accurate income etc.

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According to Schneider and Enste (2000) micro- sociological and psychological approaches provide interesting insights in the decision-making process of individuals choosing to work underground. For example, the decline of civic virtue and loyalty towards public institutions and decline in tax morale of the people. Burden of Tax and Social Security Contributions The most important determinant of the increase of the underground economy is the rise in tax and social security burdens [ Tanzi (1982, 1999)].

As a result of increase in tax rates people generally get involved in those activities where they can earn more and pay as less taxes as possible. Schneider and Enste (2000) state that bigger the difference between the total cost of labour in the official economy and after tax earnings (from work), greater the incentive to avoid this difference and work in the underground economy. Since this difference depends broadly on the social security system and the overall tax burden, therefore, these are the key features of the existence and rise of the underground economy.

Loayza (1996) estimates the size of the informal sector in fourteen Latin American countries and finds that tax burden and labour market restrictions increase the underground economy activity, while the strength and efficiency of government institutions reduces the underground economy. Schneider and Neck (1993) emphasize the complexity of taxation system. A complex tax schedule allows more legal tax avoidance by providing various tax exemptions and reductions. Intensity of Regulations

Regulatory frameworks are generally designed to get control over certain things. Increasing the number of regulations for any market is not a good policy to adopt; more regulations mean more restrictions which lead to increased labour costs in the official economy. Since most of these costs can be shifted onto employees, it reduces individuals’ choices to work in the official economy. As a result, they would work in the informal/unofficial sector, which thus leads to more tax evasion and increase in the underground economy.

Intensity of regulation is often measured by the number of laws and requirements such as licenses, and various other labour laws, e. g. , labour restrictions for foreigners, price controls and trade barriers. Friedman (1999) showed that more regulations are correlated with larger underground economy. They estimated that one point increase in an index of regulation (ranging from 1–5) leads to 10 percent increase in the underground economy. Social Transfers

Social transfers such as subsidies discourage people to work especially in the official economy because their overall income is higher if they receive these transfers while working in the underground economy. However, this does not contribute significantly to the underground economy as far as India’s is concerned. Pensions which have a major proportion in social transfers in India may contribute but very little to the underground economy. 3. Consequences of the underground economy and tax evasion

Rise in the underground economy decreases the state revenues, which in turn reduces the quality and quantity of publicly provided goods and services [Schneider and Enste (2000)]. The loss of revenues is then either filled through increase in tax rates or by increase in price of inelastic goods, i. e. , inflation tax. To reduce the prices in the country Government then reduces the money supply and increases the interest rate, which reduces the credit creation and the level of investment. Consequently, the overall economic activity declines.

The role of monetary policy is to enhance growth through increase in investment. In the presence of high and increasing underground economy it is a difficult to estimate how much money supply is needed to get better GDP growth. 4. The Shadow Economy in India The presence of the black economy in India first came to the forefront with the release of the Wanchoo Committee Report (Government of India, Ministry of Finance, 1971), that referred to the phenomenon as a “cancerous growth in the country’s economy which if not checked in time, will surely lead to its ruination”.

The Venkatappiah Committee Report (Government of India, 1974), which focused on the self-removal of excise taxes also felt “free to confess that we are not prepared for, and are, therefore, painfully surprised at, the range, diversity and, in certain segments of production, almost the universality of the evasion which is practiced by those who produce the goods”. Besides taxes, the extent of regulation rampant in the economy encouraging the proliferation of the hidden economy was highlighted way back in 1979 (Government of India, Ministry of Finance, 1979) by the Dagli Committee Report.

This report documents the web of regulation that seems to have stifled industrial licensing, import licensing, controls on prices and distribution channels of goods and services, credit controls and other measures in India for some decades now. 5. Convertibility of black money to white money Experts estimate that India’s black money ranges from 5% to a monster 20% of gross domestic product. The unaccounted money also feeds India’s rampant corruption machine, including election campaigns.

A study by the Mumbai-based Center for Monitoring Indian Economics (CMIE) found that each parliamentary poll generates between $10. 19 billion and $11. 33 billion of black money. Black-money laundering in India is a constantly evolving art, with a recent development being investing hidden funds in paintings. Tax officials raiding builders in metropolitan cities found that chartered accountants were advising their clients to hide their black money in art collections. Luxury cars are another giveaway, besides purchasing real estate and jewelry – India is one of the world’s largest consumers of gold.

But the stock market could be the biggest and easiest money-laundering avenue. Black money is turned white through massive profits pocketed after parting with a mere 10% capital gains tax. A large number of companies and Indian individuals are using Mauritius, a tax haven with which India has double taxation avoidance treaty (DTAT), to channelize their black money into India as FDI. High net worth individuals, especially NRIs, to minimize their tax bill, use the country to invest their money in Indian stock markets.

The controversial treaty has encouraged a number of Indian, the US and European companies to open their “ one room size offices” in that country to channelize their investments to India, while avoiding taxation, indulge in money laundering and convert their ‘black money into white. ’ Among the pioneers of Mauritius route in India was Enron, which used the gateway to establish the controversial Dabhol Power Company in Maharashtra. In 2004 while claiming that there were no any specific complaints against the Indian companies using Mauritius route, Finance Minister P.

Chidambaram said India would not prefer to sign DTAT like treaties with other countries. About Rs 40,000 crore worth of FDI had come to India from Mauritius-based firms. Commenting upon the apprehensions that some domestic companies were misusing the treaty to “channelize their black money”, Mr. Chidambaram said, “certain companies might have taken advantage of the treaty. However, all transactions had taken place within the legal framework. ” The Mauritius government had agreed to take steps to prevent the misuse of the treaty through steps like imposing a condition that no company with Indians’ interest would be registered in that country.

Further, conditions for the residential proof had been tightened. Though, with the change in capital gain rules and some strictness shown by the Mauritius government to prevent Indian companies from misusing the treaty, on papers it may not be so attractive to exploit this island country yet the treaty still offers a chance to befool the income tax officials by routing domestic black money as FDI through Mauritius. In February 2006 the central government had declared the possibility of issuing special bonds to draw “black money” into the official economy, without giving amnesty to tax dodgers, as earlier schemes had controversially done.

The Law Ministry was studying the legal basis of the no-amnesty proposal, after the Supreme Court had frowned on successive foreign ministers announcing voluntary disclosure schemes that taxation expert committees felt had only helped to legitimize money-laundering. The bonds were proposed to be repayable after three or five years with about 1% interest or no interest. In a country routinely ranked by Transparency International as one of the most corrupt in the world, tracking illegal wealth becomes a constant challenge. 6. Conclusions

If there was no tax evasion budget balance for certain years might be positive and we would not need to borrow as much as we had borrowed. There could be various possible ways to cut down tax evasion which needs strict measures such as: increase the number of legal documentation, strengthening the institutions, better governance, decrease the number of regulations which prohibit people to work in the formal economy, improvement in tax payer records, and efficiency wages could be good to prevent people both from shirking on the jobs and taking bribe.

Knowledge and information, leadership and collective action can be used as the prime weapons to tackle corruption. In the long run we can bring awareness to the people on the benefits of paying taxes which improves the tax morale of the people. Increase in the underground economy is mostly associated with the tax burdens and intensity of regulations. It is difficult for the authorities to broaden the tax base in a very short period of time but it is the most necessary thing to do, which should have been done many years ago.

Government should ensure that regulatory laws are implemented properly as they were made and reduce the number of regulations which prohibit people to work in the official economy. Instead of creating more avenues for convertibility of black money to white money, which gives all the more incentive to hoard more black money, Government should put more emphasis on reducing the intensity of regulations or at least improve the enforcement of laws and regulations instead of increasing the number of regulations.

The government should reduce its humungous size by curbing its populist measures of creating more government jobs and reduce its extravagant expenditure to make both ends meet. APPENDIX Table 1: A Taxonomy of Types of Underground Economic Activities Type of ActivityMonetary TransactionsNon Monetary Transactions Illegal Activities Trade with stolen goods; drug dealing and manufacturing; prostitution; gambling; smuggling and fraud. Barter of drugs, stolen goods, smuggling etc. Produce or growing drugs for own use. Theft for own use. Tax EvasionTax AvoidanceTax EvasionTax Avoidance Legal Activities Unreported income rom self-employment; Wages, salaries and assets from unreported work related to legal services and goods. Employee discounts, fringe benefits. Barter of legal services and goods. All do-it-yourself work and neighbor help. From Lippert and Walker (1997, p. 5) Table2: Size of the Hidden Economy for some Asian Countries (percent of official GDP in 1994/95) CountryRankSize of the Shadow Economy in % of GDP Bangladesh6 30. 2 China (only free economic zones)15 10. 2 Hong Kong12 15. 3 India9 20. 3 Indonesia11 15. 4 Japan14 10. 6 Korea (South)8 22. 4 Malaysia7 28. 3 Nepal 433. 4 Pakistan 531. 4 Philippines 238. 4 Singapore 1311. Sri Lanka 335. 3 Taiwan 1017. 4 Thailand 148. 3 Unweighted Average of the 15 Countries24. 5 Bibliography: 1. Feige, E. L. (ed. ) (1989) The Underground Economies. Tax Evasion and Information Distortion. Cambridge University Press. 2. “The Underground economy: Minimizing the size of government”, March 1998 by David E A Giles, Department of Economics, University of Victoria, Victoria, B. C. 3. Working paper “The Size and Development of the Shadow Economies in the Asia-Pacific”, April 2003 by Friedrich Schneider and Christopher Bajada 4. “Shadow Economies and Corruption all over the World: What do we really know? , September 2006 by Friedrich Schneider, Professor of Economics, Department of Economics, Johannes Kepler University of Linz, Austria 5. “Does the shadow economy pose a challenge to the economic and public finance policy? Some preliminary findings” , March 2007, by Friedrich Schneider, Professor of Economics, Department of Economics, Johannes Kepler University of Linz, Austria 6. www. freedomindia. com 7. Bruno S. Frey and Friedrich Schneider, “Informal and Underground Economy” International Encyclopedia of Social and Behavioral Science, Bd. 12 Economics, Amsterdam: Elsevier Science Publishing Company, 2000.

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