Methods to Estimate Black Money

We need to first define what "black money" means. It includes 2 things -
  • Income earned illegally - betting, extortion, smuggling 
  • Income earned legally but tax not paid 
Estimating this is like hitting in the dark. But anyway, many attempts have been made to estimate the amount of black money in India.
Methods to Estimate Black Money
Following are the commonly used methods to estimate black money:

1] Input-output ratio method

The first method tries to find the difference between how much money should be generated and how much is actually generated. The only trick is to estimate how much “should” be the income. And it depends from industry to industry.

For example -
Count the number of houses built in a city and estimate how much cement is needed to build a house. Make a list of all the cement suppliers in that city and see how much they have sold (as per tax records). You will find a huge gap in what the cement manufacturers have declared as sold and what the customers should have bought. The difference is unaccounted black money.

Look at the quantity of raw material purchased by a manufacturer and see how much output should ideally have been generated as per worldwide norms. Then compare it with the actual output declared by the manufacturer. If there is a huge gap, then the manufacturer is declaring loss where, in fact, he is generating black money.

As you can see, this is a very crude way of estimating the black money and is subject to a lot of assumptions. Normally, this is very accurate if you are estimating the black money in one particular sector, such as real estate, or cement, or bullion. But replicating this for the entire economy is very difficult, time consuming and not much reliable.

2] Circulation velocity method

To understand this, we need to first understand the currency circulation concept. Let us assume that you have a currency note of ₹ 1000. Every time this currency notes changes hands, “income” is generated for someone. The question is - how many times does this money change hand in one year?

Look at the following illustration -
Circulation velocity method

In the above picture, every person has earned ₹ 1000 during the year, but they are all using the same currency note. This is because, on an average, the same currency note has changed hands four times. Each of these people earned the money, and then spent the same money (for the sake of simplicity).

Now, to estimate the black money in an economy, this is what you do -
Count the number of currency notes in circulation (the RBI knows this)
Estimate how many times the currency should change hands (in our example, it was four). In real world, this number is different for different economies. Cash based economies like India have a higher number, whereas economies using plastic money will have a lower number.

Multiply the currency notes with the velocity number. In our example, if ₹ 1000 note is changing hands 4 times, then the total income of the country should be ₹ 4000. This is the estimate of total actual income.

Now compare this with the declared income. This is available with the tax authorities. If the declared income is ₹ 3000, then your black money is ₹1000.

This is a systematic approach and is fairly okay. But the problem is that this number changes drastically depending on your assumption of the currency circulation.

3] Sampling/survey method

As per the statistical survey method, there is a sample population selected from within the country. The pattern of consumption of this sample is found. How much money do they earn? How much money do they spend? What is the amount of money that they declare to the tax authorities?

Based on this focused study of a particular group, their black money is estimated. Then this percentage is replicated to the entire economy. This is a simple method. But, as you guessed, the challenge here is to select the correct representative sample. Can we really assume that the consumption pattern of 100 thousand people will be the same as 1.25 billion people?

It’s a dicey method (just like others)

4] Kaldor’s approach to black money calculation

Economist Nicholas Kaldor estimated the black money in a different way. He first looked at the total GDP of the economy. From this, he deducted all the salary income (assuming that salaried people can’t evade taxes). Now the remaining portion is the income earned through rent, income, profit etc.

If we assume that all people in the country are honest, then these people would pay tax on this total income (subject to a basic exemption limit of ₹ 2.5 lakhs). Using this assumption, he calculated the amount of money that should have been taxed. We compare this with the amount of income actually taxed. The difference is black money.

The problem with this approach is that it is difficult to estimate the income that should have been taxed because each sector has it’s own set of tax rules, exemptions, complications and other challenges. Therefore, Kaldor estimated the “should have been” amount separately for each industry.

It was a complicated approach. Over time, many economists have developed on this model with their own set of assumptions.

5] Other methods

There could be other methods as well. For example, some economists believe that we can separately assume the amount of black money generated by different categories of people working in different industries and then superimpose that assumption to the country’s population.

I can think of another method. Recently, the Reserve Bank of India issued a notification cancelling the validity of ₹ 500 and ₹ 1000 notes. RBI, in it's press release said that total currency in circulation rose by 40% over the last 5 years, whereas the number of ₹ 500 and ₹ 1000 notes increased by 76% and 109%.

This goes to show that these high value notes are not moving. Mostly, this happens because these notes are stashed as black money. Therefore, the number of currency notes declared now (after this scheme) and the currency notes in circulation earlier should give you a fair estimate of the number of notes that were stashed (not in circulation).

Bottom line is - estimating black money is not easy. It involves a lot of assumptions, and anyone can assume anything (like I did in the previous point). Well known economists have a proper basis to assume something, and hence their estimates are likely to be fairly accurate. But who knows!

You may also want to read the White Paper on Black Money in India for a more detailed discussion of how black money works.

[ Source - Quora | Palkesh Asawa ]