In banknotes we trust

Pakistanis have a lust for cash. At least that is what the numbers show. The cash an average Pakistani holds, according to back-of- envelope calculations of a friend in the State Bank, is about three times his average income, as against near-zero in the advanced economies. The phenomenal growth in currency in circulation (currency issued less bank deposits), from 835,541 million to 3,898,848 million over the last ten years, seems to vindicate his stance.
There is further supportive evidence. At almost 37% Pakistan boasts of about the highest CiC/bank deposits ratio - several times that of the first world, and way above even our neighbours India, Bangladesh, and Sri Lanka. Twist the prism and you see Pakistan's deposits to GDP ratio among the lowest in the world.
Simply put, many Pakistanis, especially the traders and quite a few momineen, don't trust the banking system. They would rather keep their cash stashed away than deposit it in a bank.
There could be a case for growth in CiC in an inflationary environment - you need more to purchase the same - but our propensity to hoard cash manifests itself even in times of lower inflation, as now. Either there is a mismatch between government figures of inflation and our perception of it, or CiC and inflation are not directly correlated.
Another possible explanation could be the relationship between CiC and foreign exchange reserves - the imperative of balancing liabilities (CiC) and assets (reserves) on the central bank's balance sheet that makes CiC grow when reserves grow. We score that out too as our reserves have been falling.
Despite the obvious risks of storing cash (theft and damage as well as loss of relative value due to inflation that is not compensated for by interest or investment earnings), and despite the availability of alternatives like plastic and ATMs to meet immediate cash requirements, our urge to hold cash remains strong. Why? Why do others deposit and we don't?
Over the last few years, we have been treated to this now jarring hymn of financial reforms. The recurring note has been greater 'inclusivity', short hand for extending the banking system - through branchless banking as well as a larger network of bank branches - to make it easier for us to transfer cash from pillows, or wherever we park it, to banks. It is clearly not working as our CiC/deposit and deposit/GDP ratios demonstrate.
The other great objective of financial reforms has been the 'documentation of the economy'. Sorry, this too turns out to be a wrong number. Informal economy thrives on cash transactions and the robust growth of CiC certifies its good health.
The third objective was to force greater numbers to join the ranks of (tax) filers. There has been too marginal an increase in the number of filers to provide a cause for satisfaction. (Indeed, at least one study shows in 2007 there were 2.1 million filers; miraculously, a million filers have disappeared in between).
If the undeclared objective was to boost revenues, well, that didn't quite work out either. People are smarter than the tax collector. They are good at circumventing. For every rule they find two loopholes. Withholding taxes on banking transactions have contributed only marginally (less than 1%) to total FBR revenues.
Taxing banking transactions has failed to meet all its objectives. Besides, it has hurt small businesses and created a distinct class of 'non-filers' that the law now recognizes.
We don't have to walk a mile to find out why our hymn of financial reforms has become discordant. We lost the turning when we failed to read the signpost - that first parable of public policy "we shape the tools and thereafter the tools shape us". We shaped the tools of transactional taxes (aka withholding taxes) on cash withdrawals, etc., and now they are shaping the outcome: less banking inclusivity, less documentation, and not more people rushing out to file their tax returns.
We also ignored the other principle of public policy: if you don't have laws that have willing acceptance of the majority you should have demonstrable force to ensure compliance. The taxes on banking transactions had neither.
The question that the policymaker should have wrapped his mind around is why there is such a high demand for currency. If the answer is because it provides oxygen to the informal economy (the hugely profitable business of hoarding commodities being not too insignificant a part) then it quickly follows that it is high taxes, coupled with weak enforcement, that make a compelling case for the cash option.
The solution, then, is to sharply lower the taxes, not slap new ones.
If we don't lower the tax rates the hope of broadening the tax base will remain a forlorn hope. The coming administrations are also going to sing the song of a broadened tax base, with the same results, unless they understand better the reason why so many businesses prefer cash transactions.
In these pages, we have pleaded for the big stick. Government has to be taken seriously. If the perception is that you can get away with it then no reform, and tax policy reform is as difficult as they come, can take place.
The challenge is not in designing the reform policies. The challenge is in creating more winners than losers.
Once you have done the cost-benefit calculus of policy reform, you need a good communication policy, to garner support, both in numbers and vigour, for the reform process. This is where politics and policy making come together.
Our pleadings for the big stick come with a caveat: big stick is necessary but rarely sufficient. Policy success demands incentives too, whether tangible or not. It is dictatorships that depend on stick- dominated fiat, and are therefore short lived. Democracies sustain themselves by making reforms more palatable; by giving the governed something in exchange for what they are being asked to give up; by incentivizing acceptance.
Once you have provided a fair trade-off make sure the big stick is for all to see. The message has to be very clear: government means business.
Low rates of taxation, simplified procedures, and a minimum interface with the inspector and the regulator is the trade-off the government can offer to turn the black economy into white.
Lower the broom after this trade-off. Strike the fear of God amongst the recalcitrant.
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