TAX HAVENS, SHELL COMPANY, ROUND TRIPPING

 

TAX HAVENS:

• Tax havens, or offshore financial centers, are generally countries or locations with low or no corporate taxes enabling outsiders to set up businesses there.
• Information is not easily provided by Tax Haven countries about these financial transactions and hence they are also be referred to as secrecy jurisdictions. 
• Examples of Tax Havens are countries like Panama, the Netherlands and  Maurititus etc. 
• Business is being executed in these tax havens through the legal entities ie shell company. 

                         

HOW TAX HAVENS EARN INCOME:

• Tax havens charge a lower tax rate than other countries and usually charge high customs or import duties to cover the losses in tax revenues. 
• Tax havens mostly charge a fee for new registration of companies, and individuals have to pay renewal charges every year which is the source of earning for these countries .
• By attracting foreign individuals or businesses, even if they pay a nominal tax rate, the nation may earn substantially more in tax revenues than it would otherwise. 
• The country also benefits from corporate investments in business operations as they offer jobs to the country's residents.
• In 2016, a report by Citizen for Tax Justice-a US-based think-tank , stated that more than 370 companies out of Fortune 500 operate subsidiaries in such countries.

• Obama in 2009 says Tax Haven is the largest tax scam in the world. 
• Topmost countries acting as tax havens are Bermuda, Netherlands, Luxembourg ,Cayman Islands ,Singapore and Switzerland etc.
•  Top cos. Benefitted from tax havens are apple, Nike and Goldman Sachs etc.

SHELL COMPANY /OFFSHORE COMPANY/ SPECIAL PURPOSE ENTITY:

• A shell company is a legal entity created in a tax haven. 
• Shell company typically exist only on paper, with no full-time employees, and no office. 
• The single most objective of shell companies is to avoid taxes by manipulating the tax laws.

ROUND TRIPPING: 

• Round tripping of FDI refers to the capital belonging to a country, leaves the country to the TAX HAVEN and then is reinvested in the parent company in the form of FDI.
• This money in most of the cases is used for share market manipulations.
• There can be multiple forms of Round Tripping like an entity transferring money to another entity only to receive it back later to create a false impression of sales or revenue.
• For instance, Company A can transfer $100,000 to Company B, which then returns the same amount to Company A. Company A can then record this as $100,000 in sales even though no goods or services were exchanged.
• Round-tripping can also be used to hide financial losses or debt by creating the impression of cash flow.
• For instance, a company can transfer money to an offshore account, which then transfers it back to create the impression of incoming revenue.

TAX AVOIDANCE vs TAX EVASION, Income-tax Act and Tax Evasion ,BLACK MONEY

 

TAX AVOIDANCE:

• Tax avoidance is the use of legal methods to minimize the amount of income tax to be paid by an individual or a business. 
• This is generally accomplished by claiming as many deductions /manipulating the law and credits as is allowable under the law. 
• As it is not illegal so this method is used by individuals to manipulate the tax payments  without any legal implications
• As per law, it is not illegal so Governments across the world are planning to adopt legal provisions to check this. 
• GOI has institutionalized General Anti Avoidance Rule (GAAR) to check Tax Evasion. 
• At global level , countries are adopting Base Erosion Profit sharing (BEPS) to tackle Tax Evasion.

TAX EVASION:

• Tax evasion is an illegal activity in which an individual or organization deliberately avoids paying a true tax liability. 
• It is a criminal activity for which the assesse is subject to punishment under the law of the land. 
• It involves acts like deliberate misrepresentation of material /income, Hiding important documents, Not maintaining complete records of all the Economic transactions, Making false statements to hide economic transactions, Smuggling and Using fake documents to claim exemption. 
• Tax Evasion leads to generation of Black Money.

Income-tax Act, 1961 and Tax Evasion:

The Act defines certain activities as illegal which can attract hefty penalties and even land you in jail. Following activities under IT act are said to be illegal :

• Not filing Income tax return, 
• Not providing PAN or quoting wrong PAN ,
• Not paying taxes as per self assessment and 
• Concealing income to avoid paying of taxes.

BLACK MONEY:

• The money that is hidden from tax authorities which can be either money earned from illegal activity or unaccounted/unreported money from legal activity. 
• Black money may be generated either by illegitimately drug trade, terrorism, corruption, or legitimate failure to pay the taxes to the government. 
• Different terms are used for black money in an economy like unaccounted income, underground income, black wealth, or in economy terms it is known as parallel economy, black economy, shadow economy and unofficial economy.

Seigniorage ,All about currency notes and coins , Time/Demand Deposit,Currency in circulation vs Currency with Public

 

Seigniorage: 

• Seigniorage is the difference between the face value of currency/money and the cost of producing it. 
• Seigniorage is essentially the profit earned by the Government   by printing currency. 
• If the cost of printing a Rs 500 note in India is Rs 2, then Rs 498 is the profit made on the production of the note and it is Seigniorage.

Seigniorage Formula: 

Face value of currency/money -Cost of producing Currency 

Issue of currency Notes:

• In India, monetary authority is RBI .
• All the currency notes except One Rupee Note  are issued by the Reserve Bank of India (RBI),under Section 22  of RBI Act 1934.

Issue of Coins and One Rupee currency Note:

• The Government of India is responsible for the designing and minting of coins in various denominations as per the Coinage Act, 2011.
• One Rupee Note are signed by Finance Secretary, GOI.
• The role of RBI is limited to distribution of coins that are supplied by Government of India. 
• Coins and one rupee note are the liability of GOI. 

Currency Chests: 

• Currency chests are storehouses where bank notes and rupee coins are stocked on behalf of the Reserve Bank. 
• Deposits into the currency chest are treated as reserves with the Reserve Bank and are included in the Cash Reserve Ratio.

Different type of deposits:

●        Demand deposit

●        Time deposits

Demand deposits: 

Deposits in the form of saving accounts are called demand deposits as they are available on demand of the account holder and the bank is mandated to pay it as and when demanded by the depositor.

Time Deposits:

• Deposits which are having a fixed period to maturity are referred to as time deposits. 
• Deposits like fixed deposits are examples of Time Deposits.

Money in circulation:

In a modern economy money in circulation comprises mainly of currency notes and coins issued by the monetary authority of the country. In India, term money includes

●        Notes and Coins,

●        Balance in savings, current  and demand  deposits

Currency in circulation vs Currency with Public: 

• Currency with Public is the money in the hands of public exclusively and is the most liquid in the economy as it is at the disposal of the individual.
• Currency in circulation comprises of currency notes and coins with the public and cash in hand with banks or DD. 
• Currency in circulation is more than currency with public. 
• Currency in circulation is a major liability component of a central bank’s balance sheet. 

Proportional Reserve System, Minimum Reserve system, fractional reserve banking system

RESERVE SYSTEMS:

These are the mechanisms and policies that regulate the money supply in the banking system and hence liquidity in the economy.

Proportional Reserve System:

• This system was prevalent before 1956 .
• RBI has to maintain certain amount in the form of reserves as proportional reserve against the issued currency .
• This reserve consist of not less than 2/5th of the Gold or sterling securities, and the value of  Gold was not less than Rs. 40 Crores in value.
• Remaining 3/5th of the assets might be rupee coins. 

Minimum Reserve system:

• In 1956, Proportional Reserve System was replaced and Minimum Reserve system was adopted by RBI.
• In Minimum Reserve system, RBI is supposed to maintain a Gold and Foreign Exchange Reserves of Rs. 200 Crore of which at least Rs. 115 Crore should be in Gold.
• It simply means that issuance of currency is not backed by any asset.
• This system continues till date.

The fractional reserve banking system:

• Banking method in which only a fraction of the deposits are kept as reserves by the banks as a mandatory requirement.
• Rest of the amount is given to the people as loans.
• Disbursement of the loans expand the money supply and facilitate economic growth.
• Fractional Reserve system results in Money Multiplier

MONEY MULTIPLIER,Money Multiplier process,Money Multiplier vs Money velocity

 

MONEY MULTIPLIER:

• The phenomenon in which reserve money (M0) got transformed to another form of money supply  ie M1,M2 and M3 is referred to as the money multiplier .
• Money Multiplier  is based on the fractional reserve banking system.
• The size of the multiplier depends on the percentage of deposits that banks are required to hold as reserves. 
• Money multiplier effect is most commonly seen in commercial banks since deposits are accepted by them and a part of deposits is being disbursed as loan after keeping part as reserves.
• Money Multiplier results in creation of liquidity in the economy .

• Money Multiplier is inversely proportional to the Reserves 
• Money Multiplier is directly proportional to the Liquidity in the economy.
• When the reserve requirement decreases, the money multiplier increases, increasing the liquidity in the economy.
• When the reserve requirement increases, the money multiplier decreases, decreasing the liquidity in the economy.
• Lower Cdr-----------------------------------More demand deposits available to bank------------------more credit creation in economy -------------------Higher Money Multiplier .
• Lower Rdr ----------------less reserves with RBI –More money available to Bank ----Higher Money Multiplier 

FACTORS AFFECTING MONEY MULTIPLIER :

• Banking habits 
• Financial inclusion 
• Nature of loans

UNDERSTANDING THE MONEY MULTIPLIER THROUGH FIGURES :

The money multiplier – the ratio of M3 and M0 – has broadly remained stable at an average of 5.1 over April – December 2022 period compared to 5.2 in the corresponding period of the previous year. It has been in the range of 5.46 in feb 2024.

MONEY Supply and Money Multiplier process:

RBI issues /creates certain amount of money ie M---------------------Customer deposited this cheque of Rs M in bank A :

M-----------------M deposited in bank A  as demand deposit.

• Bank A------------Reserve M*.2 and M*.8-------Given to firms and Households as Loans and this M*.8 deposited to bank B.
• Bank B------------Reserve M*.8*.2----------------- M*.8*.8--------------Given to firms and Households as Loans and this M*.8*.8 deposited to bank C.
• Bank C-----------M*.8*.8 is deposited and again process of loan started and it goes on and on.

This process of deposit and its reserve continues in economy forever .

•        Total money supply ----------M+.8M+M*.8*.8+………………………+..{.8}.

•      Value of total money supplied in the economy comes out to be 5M/3 and this money supply 5M/3 is greater than Monetary base ie M.
•         This creation of 5M/3 out of M is because of the process of fractional reserve banking.

IS MONEY MULTIPLIER APPLICABLE ALL THE TIMES:

No, If all depositors withdraw and if money multiplier fails then it will lead to bank run 

                                                     but 

 It is assumed that all depositors will not withdraw deposit at the same time.

                                                    

Money Multiplier vs Money velocity  (RBI):

• MONEY velocity is not the same thing as money multiplier. 
• Money multiplier explains the process in which the “base money ie M0” multiplies in the banking system to the stock of broad money (M₃) at any point of time. 
• Money Velocity refers to the number of times the available money stock change hands in an economy to create nominal GDP.
• While money multiplier could be derived as “broad money/reserve money”, velocity is derived as “nominal GDP/broad money”.

PYQ in UPSC :

Q. The money multiplier in an economy increases with which one of the following? [2019]

a) Increase in the cash reserve ratio

b) Increase in the banking habit of the population

c) Increase in the statutory liquidity ratio

d) Increase in the population of the country

Ans: b) Increase in the banking habit of the population

Q. The money multiplier in an economy increases with which one of the following? [2021]

a)  Increase in the cash Reserve Ration in the banks

b) Increase in the Statutory Liquidity Ratio in the banks

c) Increase in the banking habit of the people

d) Increase in the population of the country

Ans: c) Increase in the banking habit of the people

Different Monetary ratios: Currency Deposit Ratio, Cash Deposit ratio, Credit Deposit Ratio, Reserve Deposit Ratio

 

DIFFERENT TYPE OF MONETARY RATIOS:

The Currency Deposit Ratio (cdr):

The currency deposit ratio (cdr) is the ratio of money held by the public in currency to that they hold in bank deposits.

Significance of Currency Deposit Ratio (cdr): 

• It reflects people’s preference for liquidity. 
• It is a purely behavioral parameter which depends, among other things, on the seasonal pattern of expenditure. 
• For example, cdr increases during the festive season as people convert deposits to cash balance for meeting extra expenditure during such periods.

Cash Deposit ratios (CDR):  

Cash-deposit ratio of scheduled commercial banks is the ratio of cash in hands and balances with the RBI as percentage of aggregate deposits.

                                 

Here, cash in hand is actually physical currency available with bank to be given as loan 

Balance with RBI is nothing but CRR balances with RBI. 

Significance of Cash Deposit Ratio :

• It indicates how much cash banks maintain for each rupee of deposit they accept. 
• Cash Deposit Ratio will always be higher than CRR as settlement balance is also included. 
• The use of plastic money, Internet payments, electronic funds transfer, and so on, reduces this ratio near to CRR.

Credit Deposit Ratio: 

• The credit-deposit ratio is the ratio of assets in the form of loans disbursed and liabilities of the banks in the form of deposits.
• Credit-deposit ratio  is used for measuring a bank’s liquidity.
• The  ratio helps in assessing a bank’s financial health.
• Higher credit-deposit ratio indicates that there is strong demand for credit in the economy.
• Lower credit-deposit ratio indicates that there is poor credit growth in the economy.

The Reserve Deposit Ratio:

• When the money is deposited with the bank ,certain amount of that deposit is kept as reserves, giving rest of the amount in the form of loans.
• Reserve money consists of two things – vault cash in banks and deposits of commercial banks with RBI. 
• Reserve deposit ratio (rdr) is the proportion of the total deposits commercial banks keep as reserves.
• For illustration: CRR+SLR ie 4.5 % +18%=22.5 ie out of 100 Rs deposited with bank ,22.5 Rs are to be reserved with the bank and rest 77.5 Rs are to be given to the customers in the form of loan.
• Higher the Reserve Deposit Ratio, lesser is the money with bank to give in the form of loans and hence less liquidity in the economy.

Monetary Base,Correlation between M0, M1, M2 and M3,Money Supply vs Monetary Base

                                 

Monetary Base / Reserve Money Monetary Base (M0):

• Monetary base is the total liability of RBI which is actually the money created /printed in the economy by RBI.
• As per the RBI Act, the only liability of the Issue Department is 'Notes in Circulation' but If we analyse the balance sheet of RBI, the major liabilities are :

Monetary base formula:

Notes in circulation + Reserves with RBI .

• So, the monetary base (or M0) is the total amount of a currency that is either in general circulation or in the form of commercial bank deposits held in the central bank's reserves.
• This measure of the money supply is not often cited since it excludes other forms of non-currency money that are prevalent in a modern economy.
• It is also said to be High powered money or powerful money as it refers to the currency that has been issued by the Government and Reserve Bank of India.

WHY  M0 (Monetary base) is LIABILITY ON RBI :

• If citizen produces a currency note to RBI the latter must pay her value equal to the figure printed on the note. 
• Similarly, the deposits are also refundable by RBI on demand from deposit-holders. 
• These items are claims on RBI and hence are considered to be the liability of RBI.

Correlation between M0(Monetary base), M1, M2 and M3:

• In a modern economy, M0 is transformed to M1, M2 and M3 through the process of Money multiplier (explained in blog) which is more relevant to common man.
• Money supply ie M3 can be higher than monetary base as the M0 is transformed from M0 to M3 through the process of money multiplier.

For understanding purposes :

M0-Reserve money as on Feb 2024 is 45 trillion while value of M3 is approximately 246 trillion .

Image: RBI Website

Money Supply vs Monetary Base :

• MB is the total value of the currency in circulation and reserve balances, whereas the money supply refers to the quantity of currency with public  and checkable or demand deposits.
• Reserve balances are not included in the money supply calculation, showing that the money supply concept is more about the money available for immediate use. 

MONEY SUPPLY: M1, M2, M3, M4, Narrow Money vs Broad Money

 

                               MONEY SUPPLY:

 

Monetarism (also referred to as “monetarist theory”):

• It is a fundamental macroeconomic theory that focuses on the importance of the money supply as a main driver for economic growth. 
• According to the theory, monetary policy is a much more effective tool than the fiscal policy for stimulating the economy or slowing down the rate of inflation. 

MONEY SUPPLY: 

• The money supply is the total amount of money—cash, coins, and balances in bank accounts—in circulation among the public at a particular point of time. 
• The money supply determines the health status of an economy.
• Any change in the money supply directly affects and determines production, employment, and price levels in the economy.

Different Measures of Money Supply:

• Money supply is classified into various measures on the basis of its functions.
• To adequately capture the variety of assets, Post 1998,  the RBI publishes figures for four alternative measures of money supply, viz. M0, M1, M2 and M3 etc
• Different class of Money has different impact upon the Economy so effective predictions can be made about the likely effects of changes in the different components of money supply. 
• For example, if M1 is increasing firstly it can be reasonably expected that people are planning to make a large number of transactions. On the other hand, if  M3 is increasing , it can be validly concluded that people are planning to save more and accordingly consume less.

01.

M1 = CU + DD +other deposits with RBI, 

where, 

CU = Currency (notes plus coins) held by the public and

DD = Net demand deposits held by commercial banks.

The word ‘net’ implies: Only deposits of the public held by the banks are to be included in money supply. 

Other’ deposits with RBI comprise mainly: 

(i) deposits of quasi-government and other financial institutions including primary dealers, 

(ii) deposits of foreign Central banks and Governments, 

(iii) accounts of international agencies such as the International Monetary Fund, etc.

(IV)Deposits of the Reserve Bank of India Employees' Provident, Gratuity, Super-annotation and Guarantee Funds. All these accounts are maintained with RBI.

M1 excludes:  

1. India’s deposits with IMF, World bank, Foreign Government etc. 2. Interbank deposits.

*******************The interbank deposits, which a commercial bank holds in other commercial banks, are not to be regarded as part of money supply.

02. 

M2 = M1 + Savings deposits with Post Office savings banks

• The reason why money supply M2 has been distinguished from M1 is that saving deposits with post office savings banks are not as liquid as demand deposits with commercial and cooperative banks as they are not chequable accounts. 
• However, saving deposits with post offices are more liquid than time deposits with the banks.

03. 

M3 (Money aggregate) = M1 + Net Time deposits with commercial banks (Fixed deposits, Recurring deposits).

NOTE: M3= M1+time and NOT M3=M2+time.

• M3 captures the complete balance sheet of the banking sector and it is the broader form of money.
• M3 is the most commonly used measure of money supply in an Economy. 
• It is also known as aggregate monetary resources. 

04.

M4 = M3 + Total deposits with Post Office savings organisations *(excluding National Savings Certificates)  *meaning those Post Office “time deposits” and “recurring deposits” also but excludes national savings certificate etc.

• M4 is least Liquid Money.
• It is the broadest money in the economy comprising of almost total money components in the economy.

NARROW MONEY :

• M1 and M2 are known as narrow money . 
• These are the most liquid 

BROAD MONEY:

• M3 and M4 are known as broad money. 
• These are the least liquid money.

In terms of Liquidity ,

•  M1 is most liquid and easiest for transactions whereas M4 is least liquid of all. 
• M2 and M4 that include post office savings banks deposits are not very widely used. 
• The reserve money and M3 aggregates are presented both for the components (liabilities) and sources (assets).