CIRCUIT BREAKER. Making financial savings less taxing

The debate on how savings and investments should be taxed seems to be drowning in an alphabet soup. After the Budget move to tax the employee’s provident fund, there has been much erudite discussion on whether EET or TEE is the best regime for savings from a public policy perspective. From the saver’s perspective though, this discussion is wholly academic. Over the years, tax laws for Indian saving and investment products have become so convoluted that they can no longer be slotted nicely into three-letter acronyms.

Take the case of the simple bank deposit, the default option for every retail saver. While your initial deposit is fully taxable in vanilla products, there’s a special breed of ‘tax saving’ FDs that exempt your initial investment from tax (under section 80C). Interest on all FDs is taxable at your income-tax slab, but with a caveat. No matter which tax slab you belong to, you will receive your FD interest only after a mandatory 10 per cent TDS cut. Low-income investors need to submit a specified form to the bank to avoid this tax. Given all these ifs and buts, how would you classify the tax regime for fixed deposits — Optional E, compulsory T and E?

When tax rules for a simple instrument like a bank deposit can be so convoluted, imagine the possibilities for products like stocks, mutual funds and pension schemes.

Tax rules for savings and investment products in India have gotten so complicated mainly because they have been tweaked repeatedly over the years, without any overarching policy objectives to guide these changes.

Therefore, we have had one government, buffeted by a bear market, fancying that retail participation in equities needs a push, and exempting all equities from long-term capital gains tax. Another thought that the economy needed a construction stimulus and granted big tax breaks on home loans. Yet another was sympathetic to bankers and decided to withdraw some tax breaks for debt mutual funds.

This makes the whole process of investing a painful experience for the saver. Not only does he have to maintain impeccable records to compute his tax dues, he also has to keep up with the myriad twists and turns in the tax laws, in every Budget.

The best thing this government can do for savers, therefore, is to embark on a Swachh Bharat-type mission to clean up the messy tax rules for the entire gamut of savings. To do so though, it may have to first decide where its policy priorities lie. Here are three ideas.

Economists in recent years have complained hard about domestic households locking up too much of their savings in physical assets even as they shy away from financial ones.

While entry barriers to financial products, such as the Know Your Customer norms are being dismantled, a level playing between physical and financial assets is yet to be established on taxation.

Today, most Indian investors buy property ahead of every other investment because taking a home loan fetches them a hefty tax deduction, even as the asset appreciates in value. But leave alone a leveraged bet, even a plain vanilla investment in financial products such as pension funds, mutual funds or bonds that a saver makes out of his own pocket, gets only grudging tax breaks. In fact, in recent years, stingy governments have squeezed all of the financial investments that a salary earner may make, under the omnibus section 80C. This is indeed why most savers don’t think twice about taking on hefty EMIs to buy property, but hesitate to commit even small sums to financial products. To really encourage savers to bet on financial assets, either leveraged bets on physical assets must be discouraged, or section 80C limits for financial instruments need to be enlarged.

Most of the existing tax breaks on savings take a product-specific approach, rather than an investor-centric one. This results in an anomalous situation where a high net worth investor (HNI) sitting on a multi-crore equity portfolio enjoys the same tax-free status on his capital gains, as the small saver with ₹500 a month in mutual fund SIPs. The HNI rakes in tax-free interest from infrastructure bonds while the aam aadmi gets taxed to the hilt on his bank deposit.

This argues for two initiatives on the part of the government. One, it needs to clearly define who the small saver is, in unambiguous terms. Currently, Income-Tax laws consider savers holding less than ₹2 lakh in their bank accounts as ‘small’ (going by the ₹10,000 tax break). In the capital markets, investors willing to plonk ₹2 lakh on a single IPO or ₹10 lakh in a tax-free bond, are liberally classified as ‘retail’. In his recent clarifications on the EPF, the Finance Ministry suggested that anyone with a salary income of over ₹15,000 a month is a ‘high income’ earner. Two, once a threshold of investment income for the ‘small saver’ is defined, tax breaks need to be targeted at these investors alone.

A third policy objective on taxation is the need to incentivise long-term instruments as opposed to short term ones. Today, holding a share or equity mutual fund for just one year entitles you to tax-free capital gains. But park the same money in a bond, and your one-year gains will get taxed at your slab rate.

Perversely, a 30 or 40-year investment in a pension fund like the NPS gets taxed at your slab rate. But if you decide instead to buy property, you can even get away with nil tax (if you reinvest it in a second home)!

Instead of this messy structure, why not have a common definition of ‘long-term’ (say, five years) that applies to all asset classes? This way, all short-term investment income/gains can be taxed at the saver’s income tax slab rate. And all long-term income and gains can be taxed at a flat rate of capital gains tax. All long-term investments in financial products, must also be allowed to adjust returns for inflation. Without this, why will any saver invest all? It would make far more sense for him to splurge it.

Finally, while cleaning up the tax regime for savers, the Government should take care not to heed the fervent pleas of any of the financial sector lobby groups.

For too long, skewed 80C benefits have forced small savers to deploy their meagre savings in high-cost products such as traditional insurance plans. Tax-free dividends have forced retirees to bet on risky equities. And tax concessions have made HNIs, who have every appetite for equities, to flock to the safe harbour of bonds.

While it may be the government’s business to encourage citizens to save for the long term, it is really none of its business to micromanage their savings, to take over their financial goals, asset allocation choices or product preferences. So why not stop fretting over EEE and see how savers can be given this financial freedom?