Outside the US presidential election, the other big news today is the abolition of Rs 500 and Rs 1000 currency notes just enacted by India’s PM Narendra Modi. By most measures, this is a watershed moment in the move to register undocumented assets held by a small proportion of Indian families – not necessarily in a good way since its effect will likely be regressive. However, not only does the holding of large volumes of cash feed un-reported asset prices cycles (especially real estate) but permits the transmission of wealth across generations with no record, further fueling unchecked wealth inequality. Most countries (including once India) have used the estate tax – a tax on the assets of the deceased, prior to inheritance – as a tool to curb endless wealth accumulation. Curbing cash based transfers for inheritance is important because such transactions between the dead and the living are easily hidden from authorities. Let me make a small simple example of how this proceeds.
Person A has a home worth Rs 1 crore as measured by the market and (say) Rs 0.8 crore as per the circle rate criteria enacted by the municipality. On selling this property for Rs 1 crore and reporting a ‘white’ price of Rs 0.8 crore for stamp duty, person A has made Rs 0.2 crore in unreported capital gains which escapes the tax authorities. This assumes the buyer has made a cash payment of Rs 1 – 0.8 = 0.2 crore to person A. Now suppose this person A does nothing with this cash (mostly large bills) and at death his/her progeny inherit this volume of cash. There is no estate taxation anymore in India (Estate Duty put in place in 1953, was abolished in 1985) so as it is this direct inheritance costs nothing to the inheritors although they will pay taxes should they sell any of their inherited property. But Rs 0.2 crore is lying unchecked and can be used to make further undocumented real estate purchases, benefit from asset price appreciation, make further unreported capital gains and the cycle continues. The flow of inheritance is given by the formula:
where b is the flow of inheritance relative to GDP, m is the mortality rate, d is the average wealth of the decedents vs the wealth of the living and is the ratio of private wealth to GDP. For the sake of rough approximations, let us assume that 50% of wealth is stored as cash (not entirely inaccurate) and as per the RBI’s calculations 86% of this cash was held as Rs 500, Rs 1000 notes. Given LIC’s mortality rates of approximately 2% for wealth holders let us further assume a 5:2 ratio of the dead-living wealth. The last measure assumes a 4% net of depreciation rate of accumulation over one lifecycle so that Rs 1 transforms to Rs 2.5 in 30 years. Based on the Harrod-Domar-Solow formula, at 5% economic growth and a 20% private rate of saving .
or the flow of cash based inheritance is worth 8.6% of GDP – Rs 172 billion. This is essential un-earned (inherited) wealth which can continue to fuel parallel asset bubbles in the real estate market. By removing this channel and forcing registration of large sums in these denominations, the state at least can register unreported wealth. Now in the first place, the cycle of transmission is halted partially because so much wealth is brought under scrutiny, but suppose we now re-impose the estate tax at an average rate of 40%, this raises a possible tax revenue of Rs 68 billion annually or around 3.4% of GDP. This is no small figure compared to direct tax collection. Since India has scrapped the wealth tax, there is no other measure to restrict endless wealth concentration. Why not use this measure to curb black money also to re-introduce the estate tax – a one time tax on unearned wealth – to further strengthen arguments made by Pratap Bhanu Mehta here?
On a related note: this policy challenges our assumptions about liquidity preference due to the low carrying costs and fiat guarantees associated with cash. Storing Rs 1 crore in bills of 100 is hard, though the Rs 2000 note will offset this (it can be tracked apparently). During financial crashes, there is a retreat from illiquid assets towards cash – this policy reverses this outcome. With the abolition of these denominations, the retreat is the other way – into bank deposits and financial assets. Technically, it is not rational with inflation threats to store wealth as cash. I expect investments into legitimate capital assets with a guaranteed rate of return.