How the Black Economy Grew in Post-Independence India

07 February, 2017

Arun Kumar is an eminent economist who has been studying the black economy in India for close to four decades. His 1999 book The Black Economy in India is among the foremost accounts of the black-money problem in the country. 

In Understanding the Black Economy and Black Money in India: An Enquiry into Causes, Consequences and Remedies, released in February 2017, Kumar discusses the misconceptions around black money, the growth of the black economy and remedies to curtail it. “Suffice it to say that the demonetization has had little effect on the problem of the black economy,” he writes in the introduction to the book.  In the following extract from the book, Kumar explains the origin and growth of the black economy—a parallel or illegal economy, which encourages the rise of black money—after 1947. Kumar contends that this economy remains unaffected by demonetisation, and contributes to making socio-economic policies less effective. 

Independent India started with high aspirations but a weak democracy because the power was transferred from the colonial masters to a relatively unaccountable political class and a civil service that was accountable mostly to the ruling elite. As the democratic aspirations of the national movement weakened, the political class became more corrupt. The government of India report of 1956 argued for the need to keep the black economy in check so that more resources could be raised for development. It found businesses generating profits from black market activities in all sectors of the economy.

The Indian national movement understood that colonial rule was responsible for not only impoverishing the common man but was also the reason he was unable to better his lot. Therefore it was decided that society as a whole had to overcome these basic problems (poverty, education, health and so on) of the people and the state was given a large role in economic matters. The optimum utilisation of resources required, among other things, central planning, which required the licensing of capacity in industries. This reinforced the role of the state in the economy.

Due to deindustrialisation in India during colonial rule, Indian capitalists were too small to generate the capital necessary for the creation of the essential infrastructure for transportation and power, for example. They lacked the technology and capital to invest in basic goods like metals and petroleum, or in capital goods manufacturing. The corollary was that a large public sector was needed to support both the growth of the private sector and the planning process. This required the mobilisation of savings in a country that was poor. Consequently, consumption had to be restrained through taxation and limiting the production and importation of luxury goods. Imports were limited so as to conserve the foreign exchange required to import capital goods for development. A strategy of import substitution was adopted to boost industry and high customs duties were introduced for this purpose.

In 1944, representatives of Indian big business drew up a plan of industrialisation in post-independence India that contained the above-mentioned elements of policy. These plans were also incorporated in the industrial policy statements of 1948 and 1956. However, what the business class agreed to collectively, they undid through their private actions by fouling up policies through illegality. They cornered licenses by bribing authorities and creating monopolies for economic gain. Corruption was introduced into various development activities and projects in order to make extra profits. This would not have been feasible without the connivance of politicians and the bureaucracy. Luxury goods, or those goods that were either banned or faced high customs duties, were smuggled in.

As India developed, the size of the middle class increased and the shortages of basic goods (eg. food, scooters, cement) or basic services (eg. telephone and railway reservations) appeared. Queues formed for each of them, and soon thereafter black markets developed. Businesses took advantage of these black markets and corruption spread to the lower levels of society. Big business in India realised that the manipulation of trade and economic policies required close proximity to political power. It started exercising direct control over the political process by financing political parties and individual candidates for legislatures. It also increasingly interfered in appointments at the senior levels of the bureaucracy in key ministries.

There was growth in illegal business practices in India during the oil crisis and a sharp increase in the petro goods prices in the 1970s. The sudden wealth generated by the oil-exporting countries, especially in West Asia, led to large-scale economic activities there, but as they lacked the necessary skilled labour (carpenters, plumbers, drivers, teachers, engineers, doctors), they imported it from South Asia on a large scale. These migrants started sending money back home to their families. This encouraged the spread of hawala internationally because the hawala operators provided cheap services and a premium on the money sent through them. Simultaneously, this service also allowed Indian businesses to send their capital abroad.

In 1991, the government liberalised economic policies. This meant their marketisation, namely allowing the greater play of the markets in the economy by reducing government intervention. Controls and regulations were greatly reduced throughout the economy.

Economic liberalisation meant massive concessions to the private sector—whatever it had been demanding in the 1980s was granted. Direct taxes were reduced, licensing was eliminated, imports were liberalised, and so on. There was the elimination/reduction of controls such as restrictions under the Monopolies and Restrictive Trade Practices (MRTP) Act, Foreign Exchange Regulation Act (FERA), reservations and licensing. The role of the public sector and planning was minimised. With the establishment of the World Trade Organization (WTO) in 1995, there was a further opening up of the economy to foreign trade and capital. As the white economy grew, so did its black counterpart. But its nature changed. Anything could be imported, and the private sector was allowed to produce luxury goods. The shortages of telephones, automobiles, televisions, and other consumer goods disappeared, as did the black markets associated with them. But as restraints on business declined with the weakening of the state, businesses indulged in corruption on an even larger scale. For instance, they could take their money out more easily as exchange controls were relaxed. They could play around more easily in the financial markets to generate more black income.

Gold inflow is an example of the above argument. During the period that its import was banned (until 1992), approximately 160 tons of gold were smuggled into the country. The amount of gold inflow increased to 900 tons by 1998; of this amount approximately half was smuggled into the country. Thus, the legal imports increased but so did the illegal inflow. This was a consequence of the profit that could be made on smuggled gold since it was also part of the hawala transactions and the smuggling of goods that was taking place. The loss of savings to the country increased 5.5 times. Gold is an unproductive investment since it does not lead to further production as happens when one sets up a plant or a business. Further, since India does not produce enough gold to meet demand, it is imported, and for that savings flow out. The more the investment in gold the more the loss of productive capital to the economy. Also, due to its linkage with other forms of illegality, its flows result in more black-income generation.

Just as with gold imports, all across the economic spectrum criminal activity increased. A triad of corrupt politicians, businessmen and the executive which was already in place changed its style of functioning and the way it shared the gains from corruption. Many politicians became businessmen—openly or by setting up proxies who at times were their family members. Businessmen also entered politics in larger numbers. Privatisation and the establishment of the infrastructure of the private sector (in public-private partnership mode) offered new opportunities for making illegal gains by cornering resources like land, forests and mines. Greater participation by the private sector since 1991 in the education and health sectors has also created enormous opportunities to indulge in illegalities. As has been mentioned, the number of scams and the amount of money involved per scam has grown exponentially in the decades since then.

The generation of black income involves illegality, and the available data suggests that illegality has been growing even though crimes are often not registered. Systems have been set up to bribe politicians and the executive for the adulteration of food and medicines, for not declaring the full output produced so that profits are generated off the balance sheet and so on. The working of the market mechanism has not dented these structures.

The increase in the collection of direct taxes as a percentage of the GDP since 1999 is cited as an example of the working of the market mechanism leading to better compliance. But as has been shown in a 2007 Alternative Economic Survey article, the rise in this ratio is not due to a reduction of the black economy through improved compliance with the tax regime but due to the dramatic rise in the income of the corporate sector. So the black economy has continued to grow.

In brief, systematic illegality and corruption in the country has its roots in big business and the triad it helped create so that it could manipulate policy. This has led to the strengthening of organised crime in the country. The problems fostered at the borders with neighbours and the hawala links for flight of capital have enabled the linkage between local illegality and transnational crime to grow. Finally, the indiscriminate opening up of the economy in 1991 has led to a further spread of illegality and crime.

This is an extract from Understanding the Black Economy and Black Money in India: An Enquiry into Causes, Consequences and Remedies, by Arun Kumar, published by Aleph Book Company.