Tax Gold, Drive Smuggling

On Friday, 1^st July 2022, the Central Board of Excise hiked the import duty on gold from 7.5% to 12.5%. Gold also attracts GST of 3%, so the effective tax on gold adds up to just over 18% of its value. This action may have been triggered by the drop in India’s forex reserves over the past few months – $16.7 billion down since March[1]. The India move comes just days after the G7 announced tighter sanctions on Russia, including Russia’s gold exports[2].

While the G7 action is likely to be inconsequential, the Indian move may have unintended consequences. Anybody by-passing the official channel (i.e. smuggling gold) stands to make a 15.85% return for a one-time trade over a few days. Even high-flying hedge funds would be hard pressed to match such a return. The government has just raised the incentive for gold smuggling, ignoring in the process India’s own experience from the 1970s, as well as more recent lessons from immediate neighbour Sri Lanka.

India used to have high taxes on gold imports during the 1970s, which directly drove gold smuggling. Indians returning from overseas travel, especially the Gulf, would routinely carry gold jewelry just under the permissible limit. Bollywood legend Amitabh Bachchan became famous for playing a gold smuggler in Deewar. Customs agents, who should have been trying to prevent narco-trafficking, were instead spending time looking for gold. All this began to disappear in the 1990s, after India rationalized its gold import duties.

Alas, India is repeating the same mistakes again, and New Delhi shouldn’t be surprised when it leads to similar outcomes. More smuggling also means more money with the underworld –counter-intuitive as India has been working hard to cut down terrorism finance at home and from abroad. Instead, it is creating new illegal cash flows.

In the present day, India can look to next door Sri Lanka for lessons on governments dictating to markets. Before it defaulted on foreign debt, Sri Lanka’s official exchange rate was LKR 200 to a dollar. But the street rate started inching up during the second half of 2021, reaching LKR 250/US$ but the government didn’t adjust, and kept the currency at LKR200 the dollar. The family of a Sri Lankan worker sending money home would lose 20% of the value of any remittance. Not surprisingly, inward remittances fell by 50% as overseas workers either preferred to hold on to their cash or use informal channels such as hawala. Hawala used to thrive in India during the 1980s, when there was a difference between the official and the market exchange rates. If the arbitrage is high enough, people will find a way around excessive taxation.

Why People trust gold

Indians are amongst the most avid consumers of gold, not just today but for centuries. Gold is one of the very few ways to preserve wealth across generations, and unlike land, it is portable. Gold has fared especially well against fiat currency, or paper money, which originally started as a substitute for gold/silver coinage. The words ‘I promise to pay the bearer’ on Indian banknotes meant that a paper banknote could be exchanged for as many silver rupees. In 1945, the Indian rupee was an 11.66-gram coin, 50% silver – worth Rs 350 at today’s prices. Effectively, the Indian rupee has lost 99.7% of its value since 1945 to now. Bank deposit rates in India have traditionally been lower than the inflation rate – meaning they lose value in real terms, and the interest on these deposits is taxable.

Bullion beats paper, at least in this part of the world. In places such as the U.S. or U.K., where the currency is more stable, the preference for gold is also lower.

Amit Bhandari is Senior Fellow, Energy, Connectivity and Investment Studies Programme, Gateway House.

A longer version of this article was published on the Financial Express, click here to read.

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References:

[1]https://rbidocs.rbi.org.in/rdocs/Wss/PDFs/2T_24062022FD9354623B9747B782FEE58F74824CEE.PDF

[2] https://www.g7germany.de/g7-en/news/g7-articles/ukraine-g7-summit-2057560