After Cobrapost

It's likely that probe into KYC violations will be delayed or derailed, while Cobrapost's funding would be scrutinised

Cobrapost has thrown sand in the wheels of commerce by drawing attention to the flouting of know your customer (KYC) norms across the banking system. Those KYC norms make it difficult to invest white, black or grey money productively. By circumventing KYC and enabling cash flows into the official economy, the bankers were arguably performing a service that benefited the economy at large as well as their clients.

At least a quarter, probably a third, or more, of India's actual gross domestic product (GDP) is "grey" and consists of activity unrecorded by the tax system. Some of that activity is criminal. But a large part is legitimate and innocuous, apart from tax evasion. Most of this grey money is stashed away in lockers, or transferred overseas, rather than invested in India.

If it was all invested in the official economy, GDP growth would accelerate a lot. India's incremental capital output ratio (ICOR) is between six and seven, given the official savings rate (about 30 per cent of GDP), the current account deficit (five per cent) and the GDP growth rate (5.5 per cent).

Let's assume the grey economy is about one-third of official GDP (it is between 20 per cent and 42 per cent by various estimates). Assuming savings rates similar to the official economy (admittedly, a big assumption), grey savings could be 10 per cent of official GDP. Off the cuff, therefore, "grey savings" could contribute 1.5 per cent of additional growth and taxes could be collected on them as well if they were officially invested.

The stings also come at a particularly inconvenient time. Given recessive conditions and a big current account deficit, there is an urgent need to attract fresh investment. If, out of sheer embarrassment, the KYC loopholes are now plugged, new laundry systems will have to be devised and field-tested in a hurry. Plus, there's a stream of elections coming up, culminating in a general election. There's no way to fund election campaigns without tapping the grey economy. Campaign spending is legally capped. It's Rs 16 lakh per Assembly candidate, while Lok Sabha candidates can spend up to Rs 40 lakh - that is about Rs 4 per voter. In reality, it takes Rs 7-8 crore per candidate to run a serious Lok Sabha campaign.

The convoluted Indian tax code encourages all manner of contortions in investment flows. It blocks normal routes into the official economy and instead opens back doors. Investing in India is, therefore, akin to financial yoga. Investors must perform the fiscal equivalent of scratching their right ears with their left legs.

Participatory notes, for example, allow fund inflows from unknown overseas sources. Religious trust funds are tax-exempt, which is another back door since anybody can set up a religious trust. Political parties may receive anonymous donations of up to Rs 19,999.99 in cash - over 90 per cent of official political funding is via anonymous donations, according to a study by the Indian Institute of Management, Bangalore. Going by party funding, multitudes queue up at all hours in front of the party treasurers, each contributing their Rs 19,999.

It would be easier to junk the current system with its absurd distortions than to plug KYC loopholes cosmetically. A simpler tax code with lower, flatter rates would work better in terms of revenue accruals and also in enabling GDP growth. But a simple tax code would also reduce the discretionary powers of the people administering it and that is probably unacceptable.

Quite likely, investigations into KYC violations will be delayed or derailed, while Cobrapost's funding would be minutely scrutinised, just as Tehelka's was. In Tehelka's case, it was alleged the funding came from a Congress supporter; Cobrapost's backers may well be alleged to have Bharatiya Janata Party antecedents.

A few low-level bank employees will be sacked. Some banks will be fined for breaking the Eleventh Commandment. The Reserve Bank of India will "clean up the system" and then push ahead with Basel III compliance. And India will stumble along with sub-optimal growth and a huge grey economy.