This presentation explains the reason behind occurence of Demonetization in India on 8 November, 2016. The presentation uses game theory as a tool to explain the reason behind creation of black money in the system followed by steps to eradicate it eventually leading to demonetization.

1. The Demonetization
Game
Government vs Black Money
Hoarders

2. Why Has Black Money Been Generated?
• A game already existed between government and general public based on existing
income tax rules.
• Strategic environment:
• Players: Government and General Public
• Strategies: Government [Raid, Do not raid] and General Public [Tax evasion, No tax
evasion]
• Payoffs: Government [Profit on income tax collection on amount evaded] and General
Public [Unreported income]
• Rules:
• Income Tax rules as followed under Income Tax Act
• Assumptions:
• Players are rational
• Probability of detection or raid is low

3. Why Has Black Money Generated?
• I = Gross income of taxpayer
• T = Tax rate (in %age)
• E = Amount evaded
• C = Cost of raids
• So, net income of taxpayer,
Y = I – t(I-E)
• Now if unreported income is caught,
then penalty is imposed. Let’s say:
x = net penalty imposed, including tax
rate and penalty on tax (in %age)
• Thus, new net income of taxpayer,
Z = Y - xE

4. Why Has Black Money Generated?
Government
General Public
Tax evasion No tax evasion
Raid xE – C , E(1-x) -C , 0
Do not raid 0 , E 0 , 0
• As per the above analysis, we can clearly see that Tax evasion is the dominant
strategy for the taxpayers which leads to the creation of black money in the
economy.
• Since x is always less than 100% and if E is low, then raid will not be preferred if
C is high. Only if E is high and C is relatively low, will a raid be preferred by
government which also reasons out our assumption as to why probability of raid
is low.
Dominant
Strategy

5. Bringing Back The Black Money
• Strategic environment:
• Players: Government and Black Money Hoarder
• Strategies: Government [{VDIS (Voluntary Disclosure of Income Scheme) and No VDIS},
{Demonetize and No Demonetization}, {Change in rules and No change in rules}] and
Black Money Hoarder [{Declare and Don’t Declare}, {Cheat, Comply and Do nothing}]
• Payoffs: Government [Profit on income tax collection on amount evaded] and Black Money
Hoarder [Outstanding unreported income]
• Rules:
• Dynamic rules set by player 1 i.e. the government during each action taken (timeline of
rules in exhibit 1)
• Assumptions:
• Players are rational
• As and when player cheats, he or she exits the game there and then.

6. VDIS
No VDIS
Declare
Income
Don’t
Declare
Government Black Money Hoarder Government Black Money
Hoarder
Government Black Money
Hoarder
• Players
• Government
• Black Money Hoarder
• Strategies
• Govt – VDIS / No VDIS
• BMH – Declare / Don’t Declare
• Rules:
• Cost associated with administration
of VDIS Scheme is C1
• x1 is the net penalty imposed if
income is declared (in %age)
x1E – C1 , E(1- x1)
- C1 , E
0 , E
Voluntary Disclosure Of Income Scheme Game

7. VDIS
No VDIS
Declare
Income
Demonetize
Don’t
Declare
Don’t
Demonetize
Cheat
Comply
Government Black Money Hoarder Government Black Money
Hoarder
Government Black Money
Hoarder
x1E – C1 , E(1- x1)
- C1 , E
0 , E
- C1 , E
-C1-D1, E-CC1
x*E-C1-D1, E*(1-x)
• Players
• Government
• Black Money Hoarder
• Strategies
• Govt – Demonetize /
Don’t Demonetize
• BMH – Cheat /
Comply/Do nothing
• Rules
• D1 is the cost associated
with administration of
demonetization move
• CC1 is the cost incurred
for conversion of black
money
Do Nothing
-C1-D1, E
Introduction of Demonetization in the Game

8. Cost of Conversion
Cheat
p1C1
p2C2
p3C3
pnCn
pn-1Cn-1
p4C4
CC1= p1C1 + p2C2 + p3C3 + p4C4 + ………. + pn-1Cn-1 + pnCn

9. • Black money hoarder has three plausible options — Cheat (consume goods and
services, leaving the task of conversion to someone else), Comply (confess and pay
the penalty) or Do nothing (Wait and watch for some time)
• The ingenious ways currently being used by hoarders to convert notes (i.e. Cheat)
• Leasing unused bank accounts of the poor;
• using accounts of those exempt from tax (agriculturists, certain sections of the corporate
sector);
• pumping money into sectors which still are allowed to accept old notes;
• backdating sales; and
• making advance payments to employees and vendors who would in turn carry out the
conversion.
Options for the Black Money Hoarder

10. VDIS
No VDIS
Declare
Income
Demonetize
Don’t
Declare
Don’t
Demonetize
Cheat
Comply
No
New Rule
New Rule
Cheat
Comply
Government Black Money Hoarders Government Black Money
Hoarders
Government Black Money
Hoarders
• Strategies
• Govt – New Rule / No New Rule
• BMH – Cheat / Comply / Do Nothing
x1E – C1 , E(1- x1)
- C1 , E
0 , E
- C1 , E
-C1-D1, E-CC1
x*E-C1-D1, E*(1-x)
-C1-D1, E-CC1
Do Nothing
Do Nothing
-C1-D1, E

11. • Strategies
• Govt – New Rule / No New Rule
• BMH – Cheat / Comply / Do Nothing
No
New Rule
New Rule
Cheat
Comply
VDIS2
No VDIS2
Demonetize
Don’t
Demonetize
- C1 ,
E
- C1 , E
Cheat
Comply
-C1-D1, E-CCn
Cheat
Comply
No
New Rule
New Rule
Cheat
Comply
-C1-D1, E-CC1
x*E-C1-D1, E*(1-x)
-C1-D1, E-CC2
Do Nothing
Do Nothing
-C1-D1, E
Do Nothing-C1-D1, E
-C1-D1, E
-C1-D1, E
-C1-D1, E
x*E-C1-D1, E*(1-x)
x*E-C1-D1, E*(1-x)

12. The Two Strategies Available With The Government
• The government has two strategies
• Sequential rollout of VDIS and Demonetization (current scenario)
• Simultaneous launch of VDIS and Demonetization
• One of the main differences in these two strategies, apart from the timing, is that
those who disclose their black money would be subject to much lower penalties in
the simultaneous scheme as opposed to the current scheme in which they lose
90% of their money after the VDIS window is closed

13. Advantages and Disadvantages of both the
strategies
• With the simultaneous disclosure and demonetization scheme, black-money
hoarders would have a much better opportunity to consume or convert their
money
• The consumption would give the economy a demand boost
• The amount disclosed would be low under both schemes because it brings
hoarders into the eye of the income-tax department and places at risk the non-
monetary assets amassed with black money
• Hardly any money would have to be burnt in the simultaneous scheme as is likely
to happen in the current scheme which offers little incentive to disclose

14. Advantages and Disadvantages of both the
strategies
• In simultaneous rollout, the fact that a large amount of conversion would take place
might leave the government open to the charge of colluding with hoarders
• However, in the current scheme the government is open to the charge of putting the
general public to enormous discomfort and, even, peril for no fault of theirs
• The unorganized sector that comprises 45% of GDP and 80% of employment is hard
hit in both formulations as the flow of funds in its supply chain dry up
• This causes large-scale disruption of the kind envisaged in the move to organized
retail
• But the larger time window in the simultaneous scheme enables a few viable
responses to emerge.

15. Finding the Equilibrium (as of now)
• The simultaneous scheme would have resulted in scenes of the rich splurging on
items of conspicuous consumption and created an even greater political backlash
• Hence the equilibrium of the game would involve
• the choice of the sequential scheme,
• strong expressions of outrage from the opposition, and
• a large amount of conversion and consumption by black money hoarders with some
amount of money being burnt

16. Alternatives
• Personal and Corporate Tax slabs should be reduced to inhibit tax evasion. GST
will unify taxes and thus prevent double taxation and prevent people from
avoiding indirect tax
• Simultaneous rollout of VDIS and Demonetization
• Extensive country-wide Income Tax Raids

17. Exhibits

18. Rules
• November 8 (Day 1)
• Deposit Rs500 & Rs1,000 notes till December 30, 2016. No limit on deposit, without KYC -
Rs50,000
• Exchange - up to Rs4,000 & limit to be reviewed after 15 days
• Cash withdrawal limit – own account - Rs10,000, Rs 20,000 – week - till November 24, 2016
• ATMs, cash deposit machines, cash recyclers & other machine shut on November 9 and 10
• Old notes accepted for 72 Hours - government hospitals, pharmacies, Railway ticketing
counters, ticket counters of PSU’s, buses and airline ticketing counters at airports, purchases at
consumer co-operative societies, milk booths, crematoria/burial grounds, petrol/diesel/gas
stations of Public Sector Oil Marketing Companies, for arriving and departing passengers at
international airports and for foreign tourists to exchange foreign currency at airports up to a
specified amount.

19. Rules
• November 11 (Day 4)
• Exemptions extended - November 14.
• Payment for court fees. Utility bills restricted to arrears or current bills. Toll-plazas - Deleted from
exemptions (Road Transport Ministry exempted toll payments completely – as on November 24,
the decision was to extend the exemption till December 2).
• November 13 (Day 6)
• Limits: Cash withdrawal - Rs2500, Exchange - Rs4500, Weekly - Rs24000, Daily limit of
Rs10,000 removed
• November 17 (Day 10)
• Rs.50000 cap for Jan Dhan accounts

20. Rules
• November 17 (Day 10)
• Farmers permitted Rs25000 per week
• Registered with APMC markets/mandis permitted Rs.50,000 per week
• Weddings permitted Rs.250000 (each side) – KYC
• Exchange limit – Rs.2000 from November 18
• Option to draw advance salary up to Rs.10,000 - Some Central Government
employees
• November 21 (Day 14)
• Farmers allowed to buy seeds with old currency on production of proof of identity

21. Rules
• November 23 (Day 16)
• Monthly transaction limits for e-wallets raised to Rs.20000 to promote usage
• November 24 (Day 17)
• Exchange of notes discontinued. Deposit into banks continue
• Foreign citizens exchange limit Rs.5000 a week
• School fees up to Rs.2000 govt. schools, Fees Government colleges, Pre-paid mobile top-
up Rs.500, consumer cooperative stores – Rs.5000, water and electricity bill payment, Toll
payments 3rd – 15th December
• Exemptions till Dec 15 - only Rs.500 to be accepted. Rs.1000 not accepted

22. Prepared By:
Ankur Kalra
Manu
Bhojnagarwala
Nishant Bindraban
Priyanka Jain
Sarthak Jain
Giulia Sabatey