EDITORIAL: In the last decade, authorities had supposedly lent focus to expand documentation of the economy. But, quite the opposite happened. Cash economy started to thrive, and there is still no stopping it.
Historically, the currency (cash) in circulation was always high in Pakistan for a host of reasons. However, growth in the cash economy since 2015 is unparalleled. One can link it to the imposition of higher taxes on the formal sector and an ever-rising number of non-filers of tax returns.
The currency in circulation (CIC) as a percentage of broad money (M2) hovered at 21 to 23 percent during fiscal years (FYs) 06-15, and suddenly it jumped to 26 percent in FY16, and it has remained high since then. In the last year (FY23), it increased from 27 percent to 29 percent.
The cash in circulation stock stood at Rs 9.1 billion as on June 30th, 2023, and the flow in the last year was at a staggering Rs 1.5 trillion. This depicts how the system is responding to discrimination between taxpayers and non-taxpayers. Those who choose to remain documented are being further subjected to imposition of new taxes and levies while those who opt to remain ‘non-filers’ are enjoying impunity by just paying a small additional sum in the form of withholding tax (WHT).
The increase in CIC in FY16 started with an imposition of higher WHT on non-filers — especially on banking transactions. At that time, discussions had begun on data-sharing from banks of potential tax evaders and using technology to broaden the tax net.
The response was that people started fleeing the documented economy. The next push began in FY2019-20 when a proposal was approved in the budget that fiscal year that business transactions above a certain sum would require CNIC sharing — this raised eyebrows.
Although, the condition was never implemented, the undocumented sector grew further and the CIC to M2 ratio jumped from 27 percent in FY19 to 29 percent in FY20. Thereafter, there were some serious efforts in relation to documentation by incentivizing the formal sector and the market responded by a slight decline in the CIC to M2 ratio that came down to 27 percent in FY22.
However, FY23 proved to be a far worse year to-date. And the CIC to M2 ratio is now at a new high, even though the nominal interest rates are at a multi-decade high.
People have been compelled to forego the opportunity of having 20.5 percent return, that banks are obliged to pay on savings when the policy rate is 22 percent because most banks exhibit reluctance to take ‘Time-Deposits’ and one bank even asked its customers to either convert their savings accounts to current or close their account and move elsewhere.
The result is that increasing number of people prefer to keep the inflation-infected currency in cash instead of in current account as they do not earn any return on their funds and risk being dragged into the documented sector.
The M2 grew by 14.5 percent in FY23 while the CIC jumped by 21 percent. One reason for higher CIC growth last year is very high inflation which stood at 28 percent while food inflation was even higher.
The cash economy is higher in the rural segment while inflation in rural settings — especially food inflation. That disproportionate growth in nominal food and grain markets is one of the prime reasons for higher growth in the CIC last year.
An even more serious problem is the questionable government response, which is not conducive for growth of the documented economy. This year, the tax on banking transactions for non-filers has been re-imposed. Additionally, the taxes on documented sector — be it corporate and salaried class — have been significantly increased, and there is nothing to discourage those who are not paying the due share of tax on their income. That is further aggravating the documented sector and pushing the marginal taxpayer to informality.
How can CIC be brought down? Some argue in support of the Indian formula of demonetization. However, Indian experience was not good. After demonetization, Indian CIC to M2 was down from 17 percent to 15 percent immediately; but within two years, it was back at 17 percent.
And in the process, Indian GDP fell briefly, and consumers faced immense difficulties in converting the currency notes. Some suggest that ending Rs5000 notes is a way to reduce CIC. Well, when the Rs5000 bill was issued, its value was around $85 and now the note is not even worth $20l. The experience may have similar or even worse results for Pakistan as was the case in India. This may push the dollarization in the economy more.
The key is to incentivize the informal sector towards documentation through a carrot-and-stick policy. However, lately, the stick is only being used for formal sector and the carrot is left for undocumented folks to grab it with both hands. This must be reversed. Otherwise, the informality will keep on growing and the burden of fiscal imbalance will bring the economy down to a total collapse.
Copyright Business Recorder, 2023
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