What Every Citizen Must Know…

Banking and Capital Formation, the System of Taxation and Black Money. All these are extremely important aspects of the economic scenario in our country today. Let us try to understand them.

Q. What is Capital?
A. The term ‘Capital’ denotes a resource or a combination of resources deployed for creation of assets / wealth.

Q. What is tax?
A. Tax is a certain amount paid by every individual to government which is then used for common social purpose.

Q. What are the various Forms / Sources of Capital?
A. Money, Human Resources (Skills, Concepts, Labour, etc.), Natural Resources (Land, Material etc.) are examples of various forms of Capital.
In the modern economy, Money has assumed greatest importance because it has evolved as the universally accepted medium of exchange, measure of value and store of wealth.

Q. What are the various forms of money?
A. Money can be broadly classified as follows:
M1 or Narrow Money :– This has two components, Currency Money and Demand Deposits (withdrawals by cheques). This is the money that can be exchanged without loss of value and time, i.e. Money with the highest liquidity.
M 2 = M 1 + Saving Deposits with Post Office + Time Deposits
M 3 or Broad Money = M 2 + Medium and Long Term Time (Fixed) Deposits with Banks
M 4 = M 3 + Total Deposits with Post Office and Banks

Q. How is Narrow Money generated?
A. Coin Money: Coins up to Rs. 5 are minted by Government treasuries as per government directives. This does not need any security.
Currency Money: The Reserve Bank of India determines the quantity required based on market demand and brings into circulation currency notes backed by security in the form of either Central Govt. Securities or Foreign Exchange Reserves.
Bank Money / Demand Deposits: Money generated due to credit expansion is Bank Money.
Bank money is created from Currency Money circulating through the mechanism of credit expansion in the Banking System. The ratio of Bank Money to Currency Money is also the best indicator of Capital formation taking place in the economy.

Q. How is Bank Money created?
A. Let us try to understand credit expansion via an example:
Suppose a Bank "A" has a deposit in the name of a person P. Assuming a minimum cash reserve ratio of 10%, the bank will keep Rs. 200/- towards this cash reserve requirement and create derivative deposit to the extent of Rs. 1800/-, which represents the excess reserves with the bank.
It is these excess reserves the bank uses to give loans and advances to its customers.
Let us say the borrower, Mr. M, in repayment of some business obligation gives the cheque of Rs. 1800/- to Mr. N who has a deposit account in a bank "B". Bank B now receives Rs. 1800/- and can give Rs. 1620/- as loan/advances.
Continuing the process likewise, we can see with the help of the table below, that the original primary deposit of Rs. 2000/- results in creating a derivative deposit of Rs. 18,000/-, which is ten times of the original excess reserve of Rs. 1800/-.

1 – Original Primary Deposit
2 – Original Excess Reserves
3 – Total Capital Formation through Credit Expansion with original Primary Deposit of Rs.2000/-

Credit Multiplier = Volume of Derivative Deposits / Original Excess Reserves
In our example this would be 18000/1800, i.e. 10
A higher cash reserve ratio would lead to a lower Credit Multiplier and vice versa.

Current Scenario: A Statistical Look
As per the data available on the money supply, from the www.rbi.org.in,
Currency Money = Rs. 3,35,844 Crores
Bank Money = Rs. 2,40,658 Crores

Q. Why is Bank Money important? What is the importance of Capital formation?
A. The role of a banking system can be compared to the blood circulation system within the human body. Just as blood vessels carry essential nutrients to all the parts of the human body, the banking system is expected to supply "money capital" to all eligible and needy individuals and the institutions.
The role of Capital in the economy is analogous to that of the blood in the human body. Just as the blood carries the required nutrients to the individual cell, capital promotes productivity in the economic system.
Any disorder in the circulation system, that is, an undesirable change in the quality and quantity of blood, leads to manifestation of a disease in the entire body. Similarly, a flawed capital creation and distribution system has an equally debilitating effect on the economic system.
It is a widely held belief that the currency printed by the Government is equivalent to/backed by the gold reserves and securities held in the Treasury. The surprising truth is that this practice has been discontinued since 1956 and the decision to print more currency is since based on the budgetary deficit and statistical models involving various indices like the Wholesale Price Index, Consumer Price Index etc. (developed by the R.B.I.) which connote the demand for money in the economy.
There is a fundamental difference in the effect of these two types of money – Money that is backed by Credible Reserves and Money created on the basis other factors. In that sense, money that has come into existence merely on the strength of the statutory powers of the Government is less credible than say, a cheque backed by an adequate deposit in the account, or a loan granted against a tangible asset. When money is printed without the blocking and backing of equivalent assets, it has a direct inflationary effect on the economy.

Q. Why is there inadequate Capital Formation in the Indian Economy?

• The proportion of banking transactions to cash transactions in India is 30:70 approximate. as opposed to a ratio of 85:15 in the developed nations. This naturally leads to inadequate capital formation.
• The number of customers having Credit History is very small.
• Very low penetration of banking practices in vast rural areas due to various reasons such as illiteracy, complexities and a traditional preference for cash transactions.
• To address the growing menace of NPAs, banks adopt a more cautious approach. They demand more security. Hence the common man cannot get access to loans, which leads to scarcity of capital. This then leads to the reduction in capital formation.
• It is clear that the Banking System in India is grossly underused and therefore weak.

Q. Why is the Banking System in India underused?

• Ease of cash transactions due to the availability of high denomination currency notes.
• Frequent changes in policy like interest rates, taxes etc lead to everyone preferring cash transactions rather than banking transactions.

Q. What is Black Money? How is it created?
A. Money that has been diverted out of the Legal Economy is called Black Money. Money gets diverted out of the Legal Economy from three streams: Government Revenue (Taxes), Government Power (Licenses and Permits) and Government Expenditure (Subsidies). Out of these, the flawed taxation system is the biggest cause of generation of black money, today.

Q. Who needs and uses Black Money?
A. Individuals who want to conceal all or part of their income primarily for tax evasion, and other reasons like the illegitimate/immoral/criminal nature of their occupation or a perceived requirement of ‘cash’ for transactions with similar persons, create the demand for ‘Black Money’ or ‘cash’, as it is generally called. For example, a builder demanding part payment for a flat in ‘cash’, a government Official demanding ‘cash’ in lieu of favors granted out of turn, a Politician collecting election ‘funds’ for his Party etc. The irony here is that both honest and dishonest people contribute to the relentless growth of the parallel economy. ‘Black Money’ is created by honest people struggling for their survival and used by dishonest people for all kinds of unlawful activity.

Q. How is Black Money stored?
A. ‘Black Money’ or undisclosed wealth can be stored in the form of Land, residential property, gold etc. held by proxy (Benami), but the most liquid form is hard currency or undisclosed bank accounts. High denomination currency notes are the most popular and preferred form for hoarding ‘Black Money’ for the obvious convenience.

Q. How and why is Black Money bad for the economy – in the short term and in the long term?
A. There is no real difference in the purchasing power of a ‘White’ and a ‘Black’ Hundred rupee note. However, White Money leaves footprints in Banking and other legitimate systems of economic governance. Black Money is invisible. Since it has no record, it can move freely outside the system without fear of accountability. Because of its ability to appear and disappear without leaving footprints, Black Money is the perfect vehicle for all illegal and immoral transactions. It is the official currency of the Politico-Criminal nexus, the corrupt Bureaucracy, businessmen of all sizes struggling to compete and survive in an extremely uncertain business environment. It is the preferred commodity for extortion, kidnapping ransoms, bribery, purchase of arms etc. for terrorist or criminal activities. These uses of Black Money simply denote the obvious and short-term impact on the White Economy.

The really dangerous long term effect is the creation of a ‘Parallel Economy’. This is an entirely independent, self- sustaining economy, which has all the paradigms of the real, that is, ‘White’ economy, except it uses ‘Black Money’ as its currency. As more and more taxes are slapped on the helpless taxpayers, more and more people are forced out of the ‘White’ economy into the ‘Black’ or Parallel economy. The Parallel Economy thus grows constantly and the White Economy shrinks simultaneously. The Government falls short of revenue and increases more and more taxes in desperation, finally turning to indirect taxation as the only viable ‘answer’ to non-compliance. The terrible debilitating effect of Indirect Taxes on essential commodities and services turns up the heat on all segments of society and they turn to the Parallel Economy in increasing numbers for survival.

At some point many years ago, the Parallel Economy overtook the White Economy and today is estimated to be many times larger and growing. Today it has overwhelmed all legitimate systems of governance. It is nearly impossible to get anything done in a government office by legitimate means and channels. The same office moves with great efficiency as soon as ‘Cash’ is flashed.

The all-pervading influence of Black Money has a disastrous impact on the social fabric of the country. Hard-working citizens are forced to compromise on their natural urge to be honest and some day, to disconnect emotionally from our country. They start looking at migration as the only solution to all their woes. Those who do not have that option, decide that they have to be realistic and ‘join the trend’ in order to survive. As seen above, the parallel economy does not distinguish between honest and dishonest citizens. Instead, it forces everyone to his/her knees and makes them play to its own set of rules. Moral degradation results in a painful increase in stresses and leads to an atmosphere of general insecurity and inadequacy.

Q. Can Black Money be eliminated? How?
A. There have been several half-hearted efforts based on half-baked theories, by various governments in the past. The notable ones being the attempts to phase out currency of high denominations. The "ArthaKranti" Proposal on the other hand, is a Comprehensive and Designed System that can effectively eliminate the entire Parallel Economy at one stroke and rejuvenate the White Economy beyond recognition.
For the first time in the history of Independent India, a logically designed, custom-made system of Taxation, which completely adheres to the canons of taxation and promises far reaching social impact, is available. The question before us is not 'How can Black Money be eliminated?’ The real question is ‘How soon?’