Black Money – Generation and Investment cycle

What is Black Money?

With all the agitations that are going on, its first important to understand that how black money is generated and invested. Black money is money that is not declared as Income and hence transaction is carried out in cash. To better understand how black money is generated and invested, lets take this fictional story.

First the generation of black money:

B a government officer at a utility company. His work involves getting in touch with the small and the big guys in the industry. Assume for a moment that he is corrupt. Because of his authority, he is able to demand and get bribes for doing his work (sincerely or insincerely). Depending on the works he approves, the payments can be either a few hundreds or go into thousands (now a days many posts are such that a single bribe runs into lakhs, but lets not go into those guys). While Initially its easy to handle and dispose off the money to purchase any items required for his home / daily needs, as the amounts build up, only option is to invest somewhere since the cash cannot be put into a bank account lest it comes to the notice of Income Tax authorities.

The Investment

One of the easiest way to dispose the black money is to invest in real estate. I will show why it seems to make sense for both the buyer and the seller to deal with black money.

For the Seller: Assume the Seller has purchased the site at  Rs.500 per square feet a couple of years ago. Due to the boom, the current price stands at 3000 and he is very much interested in selling to book profits. Theoretically a sale at 3000 should yield him a short term (since its not 36 months from purchase) profit of 2500 (which will further negate a bit due to Indexation benefits).

But here comes a loophole of a sort. If you are selling a stock, price is transparent and you cannot hide the profits. But the real estate market being a opaque and non transparent market, prices are linked to what is called as the Government rate. Government rate is the rate that is fixed as the base price for calculating stamp duty charges and generally are lower than the market price.

Assume that the Government rate is 1000 (in Bangalore, I know many such areas where govt rate is 25% of market price). Our seller can sell the site at 3000 per square feet and still claim to have sold at 1000 since that is what the Govt rate is and generally agreements are made at Govt rate.

By doing this, he is able to avoid paying Short Term Tax that would have been otherwise applicable. The Buyer (our Govt officer) too wants such a deal since that will allow him to dispose off his growing currency chest.

Once the deal is finalized, the payment consists of 2 parts. The first part is by way of a Demand Draft for the amount that they are disclosing as their transaction price. This price is shown as the transacted rate and stamp duty paid on it, the second part is a exchange by way of cash for the remaining amount.

The Government hence looses on

1. The Short Term Tax Payable
and
2. The Stamp duty payable on the transaction.

Of course, the state does have a few laws to deal with it.

When buying a property that costs over Rs. 25,00,000, the Income Tax Act requires you to inform the Income Tax department, along with all the details of the flat you are buying. There is a prescribed form for this. The Income Tax Department has the right to purchase the flat at the same price as you have agreed to buy the flat instead of you and auction the flat in the open market. The idea behind this section of the Income Tax Act is that if the Income Authorities feel that the property has been sold below the market value then the Income Tax Department will acquire the property and sell it at the fair market value. The objective of this chapter is to try and cut out the black money transactions from property transactions. [Rule-48(K)]. (Source: http://is.gd/sQBmz8 )

But I have heard about such thing happening is very rare despite there being thousands of transactions that take place.

Now here is where one of the things that Ramdev has proposed seems to make sense. Its the withdrawal of 500 / 1000 currency notes. Most persons have voiced a negative opinion on that issue and I too believe that it alone cannot bring down corruption. But the idea is to make it atleast cumbersome.

As of today. much of India’s trade prefer’s cash to card. While branded jewellerly stores accept both without any additional fees, most small jewellerly stores ask for cash rather than card. And if its a card, one has to pay a additional service charge as well. The idea is to dissuade the buyer from paying by way of card where one can have a audit trail.

But if the notes are withdrawn, it becomes very cumbersome for handling large amounts. Today a One Lakh bribe can be easily pushed in a envelope. Think of pushing a 1 Lakh bribe via 100 rupee denomination. Storing the black money becomes still more cumbersome. In the above property case, if say 20 Lakhs (in Black) is paid via 1000 Rupee notes, it comes to just 20 bundles. On the other hand, if its to be paid via 100 Rupee bills, it comes to 200 bundles. While a handbag would be good enough to transport the sum earlier, now it will need the services of a suitcase.

Of course, the problem of corruption will not come down due to this one simple act. Only way is to get out of corruption is to make rules simpler but enforce them strictly. Also liberalization helps massively.

 

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About Prashanth

Have been a full time participant in the stock markets since 1996. Run a Yahoo Group where focus is exclusively on discussions of the Indian Markets using Technical Analysis as the tool (groups.yahoo.com/group/technical-investor)
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4 Responses to Black Money – Generation and Investment cycle

  1. Soham Das says:

    Lets accept that, at the very start that such a system exists because there is a visible and wide enough exploitable loophole in the public policy of the government. More specifically, the real estate policy of the government. And the solution to such "idiotic" public policy loopholes is to close it, not "manage" it , by allowing more half baked steps which are aimed to attack one particular problem. Policymaking is like a chaos theory, "a tiny fluttering of butterfly in Brazil can cause hurricane in Mexico" , and so it is with allowing such regulations.TO be thought in more congruent terms, cancer is a deadly disease but its cure is not incentivizing doctors to put as many band aids as possible on the patient.What we need is real estate reforms, and not banning of 500/1000 buck notes.

  2. prash454 says:

    Agree. Where there is arbitrage, there will always a play :). What is the Real Estate reforms that you think will solve or at least make the problem manageable? As I said, banning 500/1000 does not provide you with the remedy but just acts as another layer of dis-incentive. Know of a very recent case where a 80 Lakh property was registered for 30. And this is a middle class family I am told.

  3. Soham Das says:

    A few of which I can spot out of the top of my head:1. Stop the practice or policy of zoning of lands.2. Start recognising market price as the real price (huuuge necessity)3. Bring property title reforms (huuuge necessity)4. We need a proper unified data system and allied policies to have land records management.

  4. prash454 says:

    I think the Government is working n title reforms (by way of computerization of records). In Bangalore, a lot of these are already done.But the problem is with 2 – Recognizing market price.Problem is that real estate markets (around the world and not just India) are very opaque. 2 transactions can happen at different prices despite they having happened in a same period of time. The transactions price is based not just on the size (bigger plots command higher prices in most areas) of the property but also the desperation of the seller. A desperate seller will sell at a lower price compared to one who is willing to wait.Recently heard of a property deal where the buyer said that he will pay 32% via bank draft and rest in cash. Assume for a instance that the property is worth a crore, the 68% cash would mean 68 bundles of 1000 Rupee notes. Easy to store despite the enormity and then use it in another transaction. If same is in 100 rupee notes, the bundles will come to 680. Highly cumbersome to store as also to check count the bundles.As I said, this in itself will not solve the problem. Problem will get bit reduced but major reduction can be done if Taxes (Stamp Duty) is brought down since at current rates (12%) its just too much.

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