Impact of Demonetization on Taxes

Finance Minister, Arun Jaitley, surely had reasons to smile when he announced a growth in direct and indirect tax revenues for the April-December 2016 period. Of course, demonetization was only present in the months of November and December and could also manifest with a lag. However, it is surely gratifying that the government reported 12% improvement in direct tax collections and a 25% increase in indirect collections for the Apr-Dec 9-month period. Does it mean that the demonetization impact on income growth has not been as acute as originally anticipated? Here is a break-down of how the taxes stacked up for the first 9 months…

Indirect Taxes: How the 3 key components stacked up…

The first major component of Indirect taxes viz. excise duty is an impost on goods manufactured in India. On a point-to-point comparison, the excise duty revenues were up by nearly 43% for the first 9 months. One of the reasons could be that the government continues to be aggressive in imposing excise duties on petrol and diesel. Over the last 2 years when the price of crude was falling globally, the government of India substantially boosted its excise revenues from petrol and diesel. This has a significant impact as excise on oil constitutes nearly 40% of all excise collections in India. Higher excise on petrol and diesel seems to be the key driver for higher excise revenues in the first 9 months of the current fiscal. Some experts also feel that due to demonetization individuals may have pre-poned their purchases to use up their old currencies. However, this is unlikely to have been a very significant factor.

Another important component, Service Tax, also saw a 24% jump in collections in the first 9 months of the fiscal. This is surprising because the PMI-Services fell sharply to 46.7 for the months of November and December and that means demonetization did impact the services sector. While there is intuitive evidence of services aggressively shifting to the digital mode of payment, the growth of digital transactions in November and December has not been very exceptional. The only question is whether this service tax figure includes the extra collections under the Indirect Tax Dispute Resolutions Mechanism. The government has not clarified on the subject.

Lastly, we come to the subject of customs duty collections. Growth in customs duty in the first 9 months was tepid at 4% and has been largely attributed to the sharp fall in gold imports in late 2016 as compared to late 2015. This should be seen as a major positive because gold imports are an unproductive way of using up precious forex resources. To that extent, the tepid growth in customs duty should be seen as positive for the Indian economy.

Direct Taxes: How the 2 components stacked up…

Personal income taxes were up by 24% for the first 9 months of 2017. This is, of course, based on the advance tax data available as of the end of December 2016 and that may not be too vulnerable to the demonetization effect. However, one can intuitively conclude that the de monetization may have led to a lot of unaccounted money entering the normal money stream. This may have forced tax on a lot of incomes that would have otherwise gone unaccounted. Normally, the interim data on taxes are not adjusted for refunds and once the refunds are considered the actual growth may be lower. Of course, this also includes the collections from the Income Disclosure Scheme (IDS), which was a one-time amnesty scheme. But there are two positive takeaways. Firstly, the impact of demonetization does not appear to be acutely negative. Secondly, the demonetization and the clampdown on black money may have pushed a lot of individuals and businesses into the tax fold. That may be a big positive from a long term perspective.

Corporate tax collections have also witnessed a 10% growth in the first 9 months. Of course, the impact of demonetization on the top-line of auto companies has been quite bad and these may eventually get translated into lower taxes. Also, the impact on corporate taxes may show up with a lag effect. The fact remains that the feared negative impact on corporate taxes has not been visible.

Summing up the tax collections story…

To sum it up, the demonetization impact has not been too sharply negative. At least, the initial tax numbers show more of buoyancy than pessimism. But the big takeaway could be that that there has been a distinct shift towards better compliance. How that will translate into tax collections when it is combined with GST remains to be seen. But the moral of the story is that the demonetization exercise may have actually pushed the unorganized sector into organized mode. The net outcome of the entire exercise may be greater compliance and a wider tax base. If that entails a small price to be paid in the short term, then it surely appears to be worth the effort!