3 lakh cap on cash transactions – How effective will it be?

In a previous article, I had tried to reason that withdrawal tax will have limited effect on back money as it tries to stem the source and does not affect the downstream flow. In the annual budget however finance Minister Arun Jaitley has proposed to ban all cash transactions above Rs. 3 lakh instead of taking the withdrawal tax route. In principle, GOI is trying to reduce black money by attacking the utility of money.

The argument seems to be that if cash cannot be utilized, there is less incentive to accept cash and so an overall reduction in the cash economy. Here we are trying to reduce the seller’s motivation to accept cash. So let us now try to look at transactions from the seller’s perspective and analyze the effect of a cash limit on undisclosed transactions in the cash chain.

Since the restriction is based on size of transaction, here is a representative cash chain based on transaction size from the seller’s perspective:

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Cash chain
Cash squeeze and cash transactions

Basically independent of the size of transaction, a cash chain terminates at the bank. So, only the last transaction preceding the bank deposit is of interest here. This transaction cannot be more than the proposed 3 lakh limit. As long as the last transaction is less than the upper limit, a cash chain will exist.

In short, as long as someone in the chain is capable of breaking the cash received into smaller components, the outflow for cash will be available and as long as there is an outflow, black money will exist.

It is not as if this move will be completely ineffective. Big cash purchases are mostly in the luxury goods, Jewellery and Real Estate segments. Car manufacturers, luxury goods manufacturers will not be able to split their invoices into smaller amounts thus plugging some holes. Gold can be bought in small quantities, but then it will be a dead investment as it will be tough to sell it off again in small quantities.

However, small ticket purchases which cover most of our day to day needs are not covered and they will continue to exist. Professionals who have a dual source of income – white and black (corrupt officials, merchants and service providers who accept both digital and cash etc.) can utilize the cash component for day to day needs and save the white component for posterity. Real Estate also remains a dark spot as builders will be able to utilise cash by paying contractors as they have done after Nov 8th.

Principally this move is good as it reduces the power of cash. This is aimed at downstream transactions and not just the mouth of the cash chain. However, this will plug only a part of the high ticket transactions while leaving the smaller ones untouched thus not really promoting a cashless economy. More steps will have to be taken to further reduce the buying power of cash so that large amounts of accumulated cash cannot be easily utilized.

To borrow a metaphor from my previous post – if we imagine the cash chain to be a long pipe with numerous leakages, this restriction will plug a few leakages but as long as water can circulate within the pipe and flow out from other nodes, the black economy remains alive and kicking.

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