November 8, 2016 will be a memorable day for Indians in years to come. On this day, Prime Minister Narendra Modi eliminated more than 85% of Indian currency notes in circulation, wreaking havoc in common people’s lives. While the effects of this policy may take some time to unfold, will they include reduction in the size of black economy and corruption? To explore the answer to this question, it might be a good idea to look at what are the determinants of black economy and corruption.
India has a substantial informal economy, or transactions and businesses that are not registered and cannot be taxed. This informal economy employs almost 75% of the total workforce in India but only contributes 20% to GDP. It is substantially less productive than the formal economy, though it provides a livelihood to a majority of Indians. Not all the transactions in this economy are illegal and most economic activities are undertaken by people and firms that belong to the unorganised sector. Acknowledging the meaningful differences between the terms ‘black economy’, ‘informal economy’ and ‘unorganised sector’, one common theme underlying these various categories is either blatant tax evasion (in the case of the black economy) or the government’s imperfect and sometimes harmful ability to tax transactions.
Almost all countries have some degree of black economy, prompting a significant amount of research on its causes and determinants. According to a survey of such literature by Friedrich Schneider and Dominik H. Enste (2000) and Friedrich Schneider (2016), the most important and often cited causes are:
Burden of taxes and social security contributions
Increased regulation in the official economy, especially of labor markets
Decline of civic virtue and loyalty towards public institutions combined with a declining tax morale.
Clearly, most of the above reasons seem to be relevant for India, with varying degrees of intensity, giving rise to both a black economy and poor rates of tax penetration. Therefore, even if demonetisation is successful in reducing the existing stock of black money, a different set of policies would be required to reduce its growth and size in the future. Research gives us some hints about what such policies could be. For example, studying the old and new EU member states, Kamila Fialova and Ondrej Scneider (2014) indicate that one institution that unambiguously increases the shadow economy is the strictness of employment protection legislation. Timothy Besley (2004) gives us similar insights for India. The study shows that states in India that implemented pro-worker laws experienced lowered output, employment, investment and productivity in registered or formal manufacturing and an increased output in unregistered or informal manufacturing. Pro-worker laws were also associated with an increase in urban poverty. So, in order to reduce black economy, one of the things that the government could do is reform the labour laws that currently make hiring labour through formal channels costly. That may not sound positive or pro-labour, but will ultimately turn out to be exactly that by increasing employment in the formal sector. That will be a tough decision with significant political costs, which makes it a less attractive option for any political party in power. In addition, we need a social safety net in place to support such reforms.