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Is higher service tax leading to more cash with the public?
April, 25th 2016

One criticism of bankers and money market dealers of the Reserve Bank’s monetary policy conduct in the past year has been the rising liquidity deficit in the interbank market.

Since December 2015, banks have been borrowing Rs 1.5-2.5 lakh crore from RBI to meet their daily CRR requirements. The governor addressed this complaint fully and squarely in the April 4th policy when he said he will reduce the liquidity deficit in the interbank market to zero.

The following is an effort to understand why the RBI is finding it difficult to bridge the liquidity deficit in the system.

RBI needs to print incremental cash for two reasons:

1. It needs to provide cash for the extra goods and services produced during the year. This is roughly equal to the nominal GDP, and has been ranging between 10-11 percent in the past two years. RBI has been providing this by buying government bonds or dollars and this is reflected in the growth in reserve money.

2. The second reason why RBI needs to supply cash is to replace cash withdrawn by the public from the banking system.

As the table above indicates this currency being withdrawn by the public has suddenly shot up in the past two years. It has grown by 33.6 percent in 2014-15 and by 54 percent in 2015-16.

Also note that in most of the past ten years, the rate of growth of currency with the public is below the growth of reserve money and of M3. But in 2015-16, rate of growth of currency is 2 percentage points more than reserve money and nearly 4 percentage points more than M3 growth.

This alarming growth in currency with the public is something the RBI probably didn’t anticipate and is perhaps one of the reasons why its planned infusion of liquidity fell short last year. But why are Indians withdrawing more cash? This is counter to the trajectory of economic and financial development.

As economies become more developed, more people pay each other through credit cards or internet payments. In most developed economies cash is hardly used in transactions. India appeared to show that trend. As the table indicates, the rate of increase of cash in the system has been falling for the past ten years (with the exception of 2011). But this trend reverses sharply in 2014-15 and 2015-16.

This alarming rise in the use of cash has not been explained by anyone. The governor alluded to more cash being withdrawn during election years. But since 2007, India has had two general elections and many state elections. Why should cash usage rise only in the past two years. The election explanation is clearly inadequate.

Here’s one hunch: is the rise in cash usage because of the dramatic jump in service tax? Service tax imposition started in the nineties but was reserved for only a few services. Only in 2012-13 it became applicable to all services barring a negative list. The rate was also raised from 10 to 12 percent that year.

But the big jump in service tax rates came in 2014-15 when they were raised to 14.5 percent and thence to 15 percent in the 2016 Budget, when the Krishi Kalyan cess was added to all service taxes.

Anecdotal evidence suggests that at higher tax levels, tax morality is beginning to dwindle. More and more service providers – like beauty salons, restaurants, doctors, contractors – are willing to charge 15 percent less, if the service is paid for in cash. And now I hear customers are demanding they be allowed to pay in cash so that they can reduce their costs by 15 percent.

The latest I heard: a co-operative housing society wanting to get its building replastered and whitewashed before the monsoons, decided to pay the contractor largely in cash. The bill -- a fat Rs 25 lakh -- would have looked larger with a 15 percent tax. To avoid this expense, residents were asked to withdraw as much as Rs 1 lakh each in cash to pay the contractor.

Black money is an old scourge in India. But it is possible the black economy or the cash economy just got a little larger and more ubiquitous since 2014, when service tax became more universally applicable and was also hiked considerably.

While the fiscal authorities need to plug this evasion, for the RBI, this may pose a big challenge to keep the liquidity deficit in the banking system near zero.

Base money today is Rs 21 lakh crore. To provide for 10 percent nominal GDP growth the RBI has to buy 2.1 lakh crore of dollars or government bonds. If cash from the banking system leaks at the same pace as last year i.e. if Rs 2 lakh crore is withdrawn, the RBI will have to print an additional 2 lakh crore to replace cash disappearing from banks. But if there is a further 50 percent increase in cash leakage, the RBI will have to replace Rs 3 lakh crore.

This, in addition to providing growth money, will mean the RBI may have to buy close to 5 lakh crore of dollars or bonds. Given net government borrowing of 5.3 lakh crore this year, it appears the RBI will be buying half the bonds issued by the government.

The connection between rising service tax incidence and cash leakage is only a hunch, but it may well be worth investigating. The Chief Economic Advisor has recommended a revenue neutral GST (goods and services tax) rate of 18 percent. If all goods and services moved to 18 percent, then it appears we could see a sharp burgeoning of tax evasion and hence of black money.

The GST has been acclaimed as an unalloyed benefit. The sharp rise in cash transactions indicates GST will bring its share of worries for the monetary and fiscal authorities.

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