The best way to contain the black money menace is to improve governance and quality of services, avoid excessive regulations, impose stringent penalties and have a compatible tax structure, an RBI report released on Thursday suggested.
Giving global examples, the Financial Stability Report (FSR) released by the Reserve Bank also said an increase of one percentage point in personal income tax rates in the US tends to increase the size of shadow economy by 1.4%.
Similarly, a one-point increase in a regulation index corresponds to a 10% rise in shadow economy, it added.
Stating that the term 'shadow economy' may refer to black economy or black money, FSR report said, "The best way to contain shadow economy is to improve governance and quality of public services, avoid excessive regulations, impose stringent penalties and have a compatible tax structure."
It further said one of the biggest problems of the shadow economy is that it renders official statistics unreliable and severely impacts policy formulations by governments. Citing the US example, the FSR report said loss of tax revenues may force governments to hike tax rates, which in turn may further encourage greater activity in shadow economy.
"While the impact of shadow economy on direct tax revenues is a concern, its role in contributing to indirect taxes and economic growth is debatable," the report said. "There is also evidence in some economies of dynamic mobility between the official and shadow economies depending on the relative 'net' wage levels; this in turn is an indication of the influence of tax rates and rigidities in labour markets on the size of the official versus shadow economies," it added.
The report acknowledged that estimating the size of shadow economy also referred to as 'System D' in some quarters, is challenging but referred to an OECD report which said that half of the world's workers were employed in it. It also cited an article published in Foreign Policy magazine, which said the global black market approximately valued at USD 10 trillion, is the world's second largest 'economy' and is also the fastest growing one.
While announcing the move to scrap old Rs 500/1,000 notes on November 8, Prime Minister Narendra Modi had said it is aimed primarily to fight the scourge of black money in the system.
The demonetisation move has re-kindled the debate on what could be the ways to fight the black money menace. Earlier in 2014, the then RBI governor Raghuram Rajan had questioned the efficacy of demonetisation exercise in fighting the problem of black money.
"It is often cited as a solution. Unfortunately, my sense is the clever find ways around it. They find ways to divide up their hoard in to many smaller pieces," he had said in 2014. "It is not that easy to flush out the black money. Of course, a fair amount may be in the form of gold, therefore even harder to catch. I would focus more on the incentives to generate and retain black money. A lot of the incentives are on taxes," Rajan had said.