Different countries have different ways of managing economies. A few of them follow immaculate documentation standards, but most of the world follows economies that generates parallel economy. Most of these advance jurisdictions have tax heavens catering their capital inflows from world to stash launder money. Pakistan’s parallel economy is swelled mainly due to assorted Real Estates transaction values, smuggling, and untaxed revenues. In addition to this, high taxation and structural flaws in taxation polices encourages flight of capital into parallel economy.
On account of IMF’s (International Monetary Fund) revival ‘deal’, the government is seeking an ambitious tax collection target of around Rs6 trillion in next year. This is not according to ground realities of Pakistan’s economy. This year’s FBR (Federal Board of Revenue) tax revenue target is being revised downward from Rs.4.9 trillion to Rs. 4.7 trillion for 2020-21. FBR’s tax revenues to remain around Rs.4,700 billion in 2020-21. By incorporating Pakistan’s nominal GDP growth for 2021-22 which includes; a) Projected Real GDP growth 2.0 percent and b) average Inflation of 7.0 percent, FBR’s projected tax revenues would be around Rs.5.1 trillion in 2021-22. Therefore, 21.5 percent incremental growth in the tax revenues seems next to impossible.
There is an ongoing debate in media on demonetizing Rs5,000 note to curtail black economy in Pakistan. A few tax advisors are of the view that ‘this will rejuvenate Pakistan’s ailing economy, which is inevitable for sustainable economic growth’. It is like shooting in the dark.
In this article, we will examine experience of India’s demonetization? Whether demonetization of Rs.5000 note to fix large stock of black economy in Pakistan, is possible or not? If Pakistan pursues demonetizing Rs.5000 note, what would be the possible consequences on Pakistan economy?
India demonetized its 1000 and 500 currency notes of Mahatma Series, which was started on Nov 8, 2016. The main objective of demonetization drive was to fix terror financing, corruption/black money, and counterfeit currency.
Mr. Manmohan Singh, the former Indian Prime Minister, and former Governor Reserve Bank of India termed this demonetization as the “monumental mismanagement, organized loot, and legalized plunder". He had warned that the cost of demonetization would be around 2 percent of GDP growth. He went on, saying “Indian GDP might come out of the temporary shock but the deeper impact would continue.”
This demonetization negatively affected Indian Macroeconomic Stability primarily external account. This deterioration in external account hits India’s external debt stock to elevated levels. This has diminished exchange rate significantly which affected businesses, SMEs and general public. Consequently, Indian GDP growth has slowed down from 8.0 percent in 2015-16 to 6.10 percent in 2018-19(Pre-Covid).
The demonetization has had its colossal effects on Indian economy as 78 percent of all payments are made in cash, according to Reserve Bank of India in March 2017. The sudden announcement of demonization of 500 and 1000 notes, fueled liquidity shock which led to the chaos in India. Millions of the people faced problems to exchange their currency notes, who stood up for hours in long queues outside banks/ATMs across India. Over 100 people lost their lives as a result of demonetization drive. The liquidity shock had its detrimental effects, which also negatively affected informal economy. (Indian informal economy includes; Micro, Small and Medium Enterprises (MSMEs), Agriculture, Real Estate, Tourism, Gems & Jewellery, Trade, Construction and Transportation sector).
According to the RBI, “Manufacturing Purchasing Managers Index (PMI) of Manufacturing, and Services index deteriorated during demonetization drive during Nov 2016 to Feb 2017 and remained in contraction mode. This squeeze in consumer durable segments was also pronounced, which had adverse effects on the consumption of Indian Economy”. Can we afford all this with our ailing economy? Answer is “BIG NO”.
The size of Pakistan’s informal economy is estimated around 100 percent of GDP. In order to fight informal economy, Pakistan should target cash economy through its Action Plans as Turkish Government is following till to date. Turkish authorities have allocated $769 million to combat parallel economy during 2021-2023. The key objectives of Action Plans includes; a) Increasing voluntary compliance b) Strengthening audit capacity c) Increasing the deterrence of the sanctions d) Sharing database, and e) Raising public awareness. Therefore, in order to combat Pakistan’s large informal economy, policymakers must pursue Periodic Turkish Action Plans.
According to the State Bank of Pakistan, currency in circulation stood at Rs.6.54 trillion as of Feb 12, 2021. Pakistan’s Per capita Currency in Circulation stood at 31,001 compared to 43,235 in India, 21,234 in Bangladesh and 23,860 in Srilanka. This per capita Currency in circulation was at Rs. 21,119 two years back as of 30 June 2018, which appreciated by 49 percent so far since 30 June, 2018. The break-up of Pakistani currency notes of Rs.5000, Rs.1000, Rs. 500 and others are not available. The comparison of Per Capita currency in circulation and financial inclusion of region is as follows;
According to World Bank’s Global Financial Inclusion Index 2017, Pakistan’s financial inclusion is at lowest compared to its peer group. Only 21 percent of the Pakistan’s total population have access to the formal bank accounts. Whereas, 79 percent of population lack access to banking sector, which means they are more dependent on informal economy. In addition to this, 38 percent of GDP (i.e. wholesale & Retail trade 18 percent of the GDP, and agriculture 20 percent of GDP) employs millions of people in undocumented economy. These are cash-intensive sectors and drives GDP growth. The demonetizing of Rs.5000 note, could chock these cash intensive sectors and tumble fragile economy.
According to a study released by Global Financial Integrity (GFI), “cumulative illicit outflows from developing economies stood at $7.8 trillion between 2004 and 2013”. The 20 biggest exporters of illicit flows over the decade are as under;
Given the large size of Pakistan’s informal economy, demonetizing its large note of Rs5,000, could have deep rooted effects on various sectors of Pakistan’s informal economy. Before demonetization, Indian economy was growing at 8 percent of GDP, yet it lost almost 2 percent of GDP, and has had detrimental effects across varying sectors. Pakistan’s GDP stood at negative -0.38 percent of GDP. It could cost around 4 to 5 percent of GDP to Pakistan’s economy, which could take around 3 to 4 years to Pakistan to come out of this deep demonetizing shocks. This would be disastrous for 220 million nation.
In addition to this, possible consequences due to demonetization could be massive deterioration in FBR’s tax revenues, which could increase fiscal deficit to alarming levels. In addition to stagnation in FBR’s Revenues, further drop in FBR’s tax revenues could be a threat to National Security. Pakistan’s informal sector employs 82 percent of the workforce mainly in Small & Medium Enterprises (SMEs), Agriculture sector, Wholesale & Retail Trade, Construction and Real Estate. The spillover effects of chocking informal sector were observed in formal sectors as well as we learned from Indian experience. This demonetization shock could also add job losses of around 10 – 20 million across varying sectors which would increase poverty and fuel social and economic inequalities in Pakistan.
Policymakers must follow Multi-linear Action Plans, instead of viewing demonetization drive through a single angle. This demonetization of large note is to be done gradually and must avoid any abrupt actions as we observed in India. Polymer Notes with a small tracking Chip should be embedded in currency notes for effective tracking mechanism to accomplish larger objectives.
The writer is a senior tax consultant