RQ | Black Money: Stocks and flows

Any physical quantity can be measured in two ways – as a “stock” and as a “flow”. Stock refers to the total amount of the quantity at a particular location at a particular time. Think, for example, of water in a reservoir. “The stock of water at XXX reservoir is 1000 cubic metres” is a “stock measurement” –  it tells us how much water was there at a particular point in time.

The other way of measurement is as a “flow”. This refers to the quantity of the quantity that “changes” or “passes through” between two fixed points in time. For example, we can say that “the flow of the water in my bathroom tap is 20 litres per minute” or “in the last one hour 100 litres of water flowed down my drainage pipe”. Dimensionally speaking, flow has a “quantity per time” dimension while stock has a “quantity” dimension. Flow, unless expressed as a rate of change, also has two points in time mentioned while stock is measured at a single point in time.

Moving from physical quantities (such as water) to financial matters, a company’s balance sheet is the measurement of stock, since it measures the assets and liabilities at a particular point in time (“as of 31st March 2014″). The profit and loss statement, on the other hand, is a measurement of flow, since it tells us about the revenues, costs and profits of the firm in a particular time period (“between 1st April 2013 and 31st March 2014″, for example).

Taking matters more global, any measurement of wealth is a stock, since it is measured at a particular point in time. Measurement of economic activity, such as GDP, on the other hand, is a flow, since it measures the quantity of activity over a period of time. A common fallacy is to compare stocks to flows (this piece in ET is a stellar example of this fallacy), though it must be mentioned that it’s a common practice in financial accounting, analysis and valuation (but there the dimensionality is maintained and recognised. It is common, for example, to divide inventory (a stock) by sales (a flow) to determine “how many days of inventory” a company has on hand). More worryingly, there is sometimes a worrying lack of understanding between stocks and flows when it comes to policy recommendations.

One of the features of the BJP’s campaign over the years, and especially in its run up to this year’s General Elections, is to “bring back black money stored abroad”.

Pop Quiz: Is black money stored abroad a stock or a flow?

During the duration of this “bring back black money” campaign, there have been many fanciful estimates of the amount of black money stashed away abroad and what that can do to India’s deficits if it can be “brought back”. Some of the WhastApp and email forwards estimate, extremely fancifully, what the bringing back of the black money can do to the USD/INR exchange rate even!

The problem with this whole idea of “bringing back black money abroad” is that it fundamentally attacks a particular stock of black money and not the flow (there you have the answer to the pop quiz). Black money stashed away abroad is “harmless” in that it just sits there without being used for any transaction. In that sense the value of that money is lower since it is not being constantly exchanged for something that is more valuable.

What should be of more of a concern to us is the “flow” of black money rather than the stock. Every time a transaction is financed by black money (i.e. without a paper trail or a receipt, and money changing hands in hard cash), the government loses out on the taxes that would have otherwise have to be paid on the transaction. The more the number and value of transactions that can be conduced “in black”, the more the incentive for people to do other transactions “in black” and keep their money in cash, and not accounted for. This has a multiplier effect in terms of number and value of transactions that are unaccounted, and thus help evade taxes.

Rather than one-time efforts to “bring back black money” which attack only the stock of black money, our policy should be geared towards cutting down the flow of black money. A regime of high stamp duties and low property taxes, for example, lead to the perverse incentive for under-invoicing the price of real estate and paying the difference in cash – the “saving” is such that even otherwise law-abiding citizens have an incentive to play along in the black money game and trade in cash. Enabling easier peer-to-peer mobile payments, for example, can have the effect of dramatically increasing the number of transactions that can be conducted without cash, and will be an important step in chipping away at flows of black money. Value Added Tax, with its “input credits” was designed as a system to check under-invoicing within a supply chain, but what if the entire supply chain of a particular commodity runs on cash without written contracts (social capital within business communities allows this, for example)?

Periodic attacks on the stocks of black money (stored either abroad or domestically) can bring in large amounts of money into government coffers and this might make such attacks glamorous. But they are tedious to implement and government resources are much better off employed in cutting off the flows of black money.

DISCLAIMER: This is an archived post from the Indian National Interest blogroll. Views expressed are those of the blogger's and do not represent The Takshashila Institution’s view.