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The higher education sector, real estate deals, mining income etc., are major sources of India’s black economy (hereafter mentioned to as “informal economy / informal income / informal money“) and is nearly 75% of the size of its reported Gross Domestic Product (GDP). These are among the findings of a confidential report commissioned by the government and accessed exclusively by The Hindu [August 4, 2014].

The major sources of informal economy

• Disclosure of lower or nill profits to the taxation authorities;
• Corruption money.

The growth of the informal economy is poor enforcement of tax laws. According to the estimates reported in Schneider and Enste [2002], for example, the informal economy on average is only about 15% of GDP among OECD countries, and thus small enough that it should not be a driving factor in the choice of tax structure. However, among developing countries, the median size of the informal economy they report is 37% of GDP, ranging from 13% in Hong Kong and Singapore to 71% in Thailand and 76% in Nigeria.

With such a large informal sector, any effects of the tax structure, or of government policies more generally, on the size of the informal sector can be of first-order importance in the choice of these policies. Yet at this point, we know relatively little about how policies affect the size of the informal sector, or why the informal sector is so much larger in developing than in developed economies.

One approach to examining the role of the informal sector explored in the past is to assume that only certain goods can be produced in the informal sector. Taxes on the formal sector leads to lower demand for goods produced in the formal sector which expand production in the informal sector. This additional behavioral response lowers optimal tax rates, particularly on those goods where this potential response is greater. Piggott and Whalley [2001] use this reasoning to argue for lower taxes on services relative to goods, since services can more readily be provided by informal firms.


The causes for the informal economy:

1. Unrealistic Tax Laws and Tax Frauds: Early years of Independence, government put lots of thrust on levy and collection of tax revenues with huge rates of direct as well as indirect taxes. Both the steep rates of taxes and informal economy grown paralelly. In 1951, the first Voluntary Disclosure Scheme was brought in and again in 1965,  followed by the 1975 and 1997 Disclosure Schemes. Below are some of the taxation provisions helping un-recorded money flow:

• Presumptive taxation schemes available for non-corporate assessees;
• Excise duty exemptions for small scale industries;
• Threshold limits under various taxation laws.

2. Different rates of Excise Duty on different varieties of same product: Levy of excise duty for instance on textiles and cigarettes are at different rates, this leads to tax evasion through misclassification of output goods. In textiles, separate rates of excise duty are charged for cloth of different varieties. Manufacturers regularly downgrade a product to pay lower rates of excise.

3. Price control policy of the government on certain industries: Price regulation on commodities such as cement, steel, paper, vanaspathi, tyres, fertilizers, sugars though on a lesser scale also a cause of increase in informal income.

4. Quota system: Quota on import of certain products leads to selling them at premium price.

5. Export incentives: Several export incentives in the past under direct and indirect taxes lead to over pricing of export goods. Thus benefited by excess claim of duty draw back as well as total tax exemption on export profits. Income tax exemptions on export turnover lead to benami expot transactions thereby converting informal income into formal channels has became a easy route.

6. Scarcity of commodities and goods: When essential commodities are in scarce, people pay higher than the controlled price, which generates informal income in the hands of commodity dealers. The scarcity of cooking gas, cement, kerosene, sugar, refined oil, etc., has always resulted in illegitimate transactions and informal economy.

7. Political election expenditure: Each general election involves huge circulation of physical cash. No one including big corporates can stand honestly away from political funding.

8. Real estate transactions: Always there is a large variation between consideration declared in the document for registration purposes and actual consideration in real estate transaction.

9. Illiteracy: The government is providing various tax exemptions / deductions on capital gains on real estate transactions. For example sale of rural agricultural land is totally exempted, even if the period of holding of such land is only one day. Even on such transactions people are afraid of accepting formal channels of money such cheque, draft or electronic transfer.

10. Privatisation: In the past two decades several industries were opened up for private sector including insurance, banking, telecom etc. where a licence or permission is necessary to do such business involving hefty circulation of informal money in political as well as bureaucrats circles.

11. Government subsidies and benefits: The Union and State governments takes up fuding several public welfare schemes, promotion of agriculture and other industries are not reaching the targetted beneficiaries of the scheme and these schemes are fortune enough for political or bureaucrat favoured circles.

12. Mining industry: Allotment of mines at very low prices or informal sub-lease of the same may amounts to increase of informal economy.

13. Routing through agricultural income: Since the agriculture income is exempt from tax, the informal money accrued from non-agricultural sources is sought to be converted into formal income by showing its source as agricultural.

14. Artificial scarcities: Artificial scarcities are created by hoarders and speculators who indulge in black marketing. Thus they are instrumental in reducing supplies of goods and raising their prices.

The effects of the informal economy:

1. Inflation: The existence of informal economy in all countries due to corruption, tax evasion etc. increases the aggregate demand of various goods and services. People spend such informal money extravagantly, thereby creating unnecessary demand for goods or services. This tends to raise the price level further.

2. Concentration of financial power illegally: People with informal money often indulge in illegal criminal activities where the state administrative may not do enough justice to their victims.

3. Increase inefficiency

4. Growth in economic disparity

Remedies to the informal economy:

The developing nature of the economy of the country brought with it both steep rates of taxes and informal incomes. In 1965, the Voluntary Disclosure Scheme was brought in followed by the 1975 Disclosure Scheme. Finally, the need for a permanent settlement mechanism resulted in the creation of the Settlement Commission.

Tax Reforms: Certain important policy and administrative reforms carried out over the past few years are as follows :-

a. The policy reforms include :-

• Lowering of rates;
• Withdrawals / reduction of major incentives;
• Introduction of measures for presumptive taxation;
• Simplification of tax laws, particularly relating to capital gains; and
• Widening the tax base.

b. The administrative reforms include :--

• Computerisation involving allotment of a unique identification number to tax payers which is emerging as a unique business identification number; and

• Realignment of the available human resources with the changed business needs of the organisation.

Enhanced enforcement of taxation laws: Perhaps we lack the best enforcement methods, e.g. modernisation of all sectors with information technology. Certainly information technology helps to pool information from different sources. However, the key problem is acquiring reliable information, not processing it.

Adhar and PAN mapping to various accounts or transactions benefits the goverment to acquire reliable information.


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