“Money as we know it stands at the threshold of yet another major transformation in its long and storied history,” writes Eswar Prasad in his new book, The Future of Money: How the Digital Revolution Is Transforming Currencies and Finance. In the excerpt below, he explores the advantages that central bank digital currency offers relative to cash.

I obtained my first driver’s license in my home city of Madras (now called Chennai) in South India at the age of twenty. I had a license but did not know how to drive. Therein lies a story.

As I was preparing to travel to the United States for graduate studies, I learned from a friend who had moved there a year earlier that having a US driver’s license would be useful for identification and other purposes. Having an Indian driver’s license, I was told, would make the process of obtaining a US one easier. My parents scrambled to find a driving instructor. We ultimately found a driving school that guaranteed a driver’s license within about two weeks—for a significant fee. Curiously, the instruction involved just a couple of cursory hour-long driving sessions, with multiple students taking the steering wheel for some minutes each. At the end of the second or third session, the three of us in the car that day were told to show up for a driving test on the following Saturday morning. Needless to say, I felt unprepared and told the instructor so; the other students seemed to share my concerns. He assured us that all would be fine.

On the appointed day and hour, I went to the driving test facility. This being India, our instructor showed up fashionably late. About a dozen of us aspiring drivers, in various states of anxiety, quickly clustered around him. He took from each of us a special fee that we had been told was necessary to obtain an expedited license, in addition to the usual cost of a license, and it had to be paid in cash. The money went into an envelope.

The instructor then went into the building and returned with a portly gentleman in tow. This turned out to be the driving inspector who held our fates in his hands. He took one look over our motley group and picked out a competent-looking middle-aged lady. To this day, I do not know if the lady was chosen randomly from our group or if this had been prearranged. In any case, she took the driving school’s car for a quick spin around the parking lot under the watchful eye of the inspector and managed to maneuver the car back to the starting spot. The three of them disembarked from the car. In full view of all of us, the instructor proceeded to hand the envelope with the “special fees” to the inspector. The inspector opened the envelope’s top fold a crack, surveyed the contents with a practiced eye, nodded, and headed back to the building. The instructor turned and congratulated all of us on having passed our driving tests.

Such was life in India. Practically every transaction involving a public official had a specific fee that, through some remarkable process of social osmosis, everyone just knew about, even though none of this was written down anywhere. The public servant who had to sign off on and stamp an official copy of my birth certificate received his envelope. The policemen who came to my home to verify my identity, which was necessary for issuance of a passport, politely requested tea money. My parents had already prepared this in individual envelopes, in addition to cups of tea for the gentlemen (it was always a pair of them assigned to this task). After quietly consuming their tea and snacks, they pocketed their envelopes and left.

The payments in all such cases had to be made in cash, whether in envelopes or not. Public corruption takes many forms and levels, ranging from the petty corruption of local officials to the massive high-level corruption involved in issuing lucrative business licenses and government procurement contracts. And no economy, no matter how rich or high-minded, is fully immune. Sophisticated quid pro quos and laundering of large bribes often involve complicated transactions with compliant bankers, clever lawyers and accountants, offshore bank accounts, and so forth; cash is usually not involved.

“Public corruption takes many forms and levels, ranging from the petty corruption of local officials to the massive high-level corruption involved in issuing lucrative business licenses and government procurement contracts. And no economy, no matter how rich or high-minded, is fully immune.”

Even so, cash has traditionally played a key role in facilitating corruption. India’s dramatic demonetization episode of November 2016, when high-denomination currency notes were invalidated overnight with no warning, was meant to be a strike against corruption. The logic was that anyone with a large stock of currency notes beyond a certain limit had probably acquired those through nefarious means. Given how important cash was, and still is, to the Indian economy, this wrought economic havoc. And it probably hurt only unsophisticated corrupt officials and individuals, those who kept their ill-gotten gains in cash rather than in offshore bank accounts. Kenya’s demonetization in 2019—swapping out old high-denomination banknotes for new ones—at considerable expense and mainly as “a step in the fight against corruption,” likely had similar limited benefits. Undoubtedly, the connections between corruption and cash run deep, as reflected in the trope of briefcases or suitcases full of banknotes, usually US dollars, changing hands in return for illegal drugs, ammunition, or favors of various sorts.

Switching from cash to a central bank digital currency (CBDC) would make every transaction traceable, more transparent, and subject to scrutiny. Undoubtedly, corruption will not be controlled just by adding this feature to bribery-related transactions. Corrupt activities will flourish so long as the benefits outweigh the costs, which in turn depend on the probability of and penalty for being caught, such as the loss of one’s job or even a prison term. Ultimately, public officials, like everyone else, respond to incentives.

Still, if only digital forms of payments were available, it would cause corrupt officials—at least in countries that have a semblance of the rule of law— to think twice or thrice about accepting illegal payments. If bribes could be paid only in forms that can be documented and reported to more upright authorities, the balance of power between public officials and members of the public would be leveled to some extent. This might embolden the public to resist demands for bribes in the first place. Thus, a CBDC might bring at least a modest benefit in terms of hindering petty corruption and perhaps even some large-scale corruption.

book cover for future of money shows a coin that is distorted on a computer

Cash in the Shadows

It is not just criminal activities and corruption that are facilitated by cash. Cash fuels the shadow economy, which might include perfectly legal activities. The term shadow economy typically refers to the full range of economic activities that are not reported to tax authorities. A shadow transaction can be as simple as a toddler’s parents paying their babysitter in cash after a (much-deserved) date night out at the movies. The consequences of a high school student failing to report her income to the government are trivial. She might earn a few hundred dollars over the year by taking care of neighbors’ kids or shoveling their snow. The sums become larger as one thinks about more regular employees such as nannies, gardeners, or housekeepers being paid in cash, with neither the employer nor the employee taking the trouble to report those earnings to the government. Such employees might not owe much in taxes even if they were to report all of their cash income and file tax returns, so one might argue that this is harmless and saves everyone the bother of filling out the requisite forms and reporting such income.

The incentives to cheat on taxes grow as the sums involved and the tax rates on those incomes rise. When the incentives are powerful enough, even people in advanced economies engaged in the most respectable of professions cannot resist the temptation. One study, for instance, looked at underreporting of taxable income by professionals in Greece using data on loan repayments at one Greek bank. The authors of the study found that the reported monthly incomes of many doctors, engineers, lawyers, teachers, and journalists were, rather remarkably, less than the amounts they needed just to make their monthly loan payments. Such well-educated and successful professionals would surely be capable of managing their finances better. Besides, no sensible banker would make a loan to someone who would have no money left for any other expenses after making the loan payment.

This odd situation can of course be explained by underreporting of actual incomes to tax authorities. The researchers noted that Greek banks have their own internal underwriting models for estimating the actual incomes of their clients, implying that tax evasion is an open secret. Using such a model, the researchers estimated that nearly half of the self-employment income of people who had received loans from the bank went unreported and, thus, untaxed. The implication was that, in 2009, these lost tax revenues accounted for about one-third of the government budget deficit.

Sizing Up Shadows

The shadow economy is hard to measure, for obvious reasons. Available estimates are imprecise and depend on a number of assumptions but still serve as a rough guide to the size of the shadow economy in a given country and how that has changed over time. Friedrich Schneider of the University of Linz, a leading researcher on this topic, estimates that, in 2018, the median size of the shadow economy in a group of twenty major advanced economies was the equivalent of 10 percent of gross domestic product (GDP). The United States had the lowest ratio in the group—5 percent—while the ratio was more than 15 percent for Belgium, Greece, Italy, Portugal, and Spain. Thus, some rich economies with high tax burdens have large shadow economies relative to their official GDP. Research shows that a combination of high tax rates, corruption, and weak government enforcement can contribute to a bloated shadow economy. In EMEs such as Brazil, India, and Mexico, estimates of the size of the shadow economy relative to GDP range from 24 to 46 percent, depending on the methodology used.

The size of the shadow economy is not an innocuous matter. Unpaid taxes mean lower government revenues that could have been used for social expenditures, infrastructure investment, and other productive government spending. This reduces a country’s economic growth and the welfare of its citizens. When the average Greek worker sees highly paid professionals blatantly cheating on taxes, it erodes trust in the tax system and the social norms supporting voluntary compliance as well as in the government as a whole. Moreover, the shadow economy can disadvantage honest businesses, lead to worker exploitation, and fuel illegal activities and illicit commerce. The shadow economy can thus undermine state institutions, encouraging crime and reducing support for institutions and ultimately threatening economic and political stability.

How large are the tax losses caused by the existence of the shadow economy? Schneider estimates that in 2013 the shadow economy in the United States resulted in lost tax revenues amounting to about 1 percent of GDP, or 4 percent of actual tax revenues. In other words, total tax revenues would have been about 4 percent higher that year if taxes had been paid on all economic activities. In the case of Greece, lost tax revenues in 2013 amounted to 14 percent of total tax revenues. Other researchers, using alternative methodologies, have estimated that in 2011 tax revenues lost on account of the shadow economy amounted to about 9 percent in the United States and nearly a third of reported tax revenues among lower- and middle- income economies in Africa and Latin America. Whatever the exact numbers, the problem is serious.

Casting Light on Shadows

The use of cash to make payments is crucial for the functioning of the shadow economy. Trying to reduce the shadow economy through punitive fines and tighter controls is generally costly and ineffective. It often just makes corruption more pervasive so long as there are no traces that can implicate the tax evader or the government official who looks the other way. On the other hand, the risk of being caught if all payments could be traced digitally would act as a powerful check on tax evaders.

One study analyzed how policies adopted by a group of central and southern European countries to reduce the use of cash shrank the shadow economy and raised tax revenues. Policies that made a difference include obligations for employers to electronically deposit wages and salaries into bank accounts, making social security payments only through bank accounts, and requiring businesses to use cash registers and point-of-sale terminals for electronic payments. Some countries have passed laws making it illegal for consumer transactions beyond certain threshold values to be conducted in cash.

Adding up the effects of all of the policies that in one way or another increase the traceability of payments for commercial transactions is estimated to raise tax revenues by about 2 to 3 percent of GDP. In a 2018 interview, Swedish deputy finance minister Per Bolund attributed the 30 percent increase in his government’s tax receipts over the preceding five-year period at least in part to the shift away from cash. He noted that “[tax] payments are increasing very much—part of that is due to the digitalized economy. It’s [becoming] harder to hide cash under the counter.”

“Switching from cash to a central bank digital currency would make every transaction traceable, more transparent, and subject to scrutiny.”

Replacing cash with a CBDC can thus put a substantial crimp in the shadow economy. Even if a government promised partial anonymity to users of a CBDC, the fact that the government could—if it wanted to do so— trace all digital transactions acts as a powerful deterrent against its use for unreported transactions. Would making payments through a digital platform such as Venmo or using a cryptocurrency not have the same effect? Payments made using those systems would also leave digital traces. The incentives to self-report income would no doubt be greater if the payment system were a CBDC that gave the government easier access to payment records. But leaving any sort of digital trace could by itself reduce shadow economy activity, even if the transactions were handled by a private payment provider. Thus, the elimination of cash could bring more economic activity out of the shadows and into the tax net.

To sum up, a CBDC would discourage illicit activity and rein in the shadow economy by reducing the anonymity and nontraceability of transactions now provided by the use of banknotes. This point has been made forcefully by Kenneth Rogoff of Harvard University, especially in the context of high-denomination banknotes. A CBDC would also affect tax revenues, both by bringing more activities out of the shadows and into the tax net and also by enhancing the government’s ability to collect tax revenues more efficiently.

As with most other factors, a CBDC by itself will not eliminate the shadow economy. In fact, even if all transactions were handled by private or official digital payment systems, the shadow economy would not disappear. Identity fraud, fictitious invoices and receipts, and forms of tax evasion that do not involve the use of cash will persevere. And other developments could already be affecting tax revenues in ways that do not involve tax evasion. The shift from formal contractual employment to the gig economy has meant that many economic activities escape certain elements of the tax net. An Uber driver in the United States pays taxes on her income. But, since she is not an employee of the company, in many states Uber does not have to make the social security or unemployment insurance fund contributions that it would be required to for its regular employees.

All things considered, a CBDC would be a useful implement in a government’s toolkit to reduce the size of  the shadow economy and the related drain on tax revenues.

Excerpted from The Future of Money How the Digital Revolution Is Transforming Currencies and Finance by Eswar S. Prasad, published by The Belknap Press of Harvard University Press. Copyright © 2021 by the President and Fellows of Harvard College. Used by permission. All rights reserved.

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