The Hindu Business Line : Budget: Empowering the taxpayer

The good thing about the Budget proposals is that they will increase the quantum of personal savings and give investors a wider choice. Undoubtedly, conditions have been created for promoting investments that will make sustained economic growth rate a definite possibility, says H. P. Ranina.

THE Finance Minister, Mr P. Chidamabaram, has sought to create a new taxpayer-friendly environment. The catalyst of these changes is the package of tax reforms that the Budget has unveiled.

The recalibration of tax slabs will lower the tax burden. However, senior citizens earning income between Rs 1,50,000 and Rs 2,50,000 will incur a higher tax liability beginning 2006-07.

Raising initial exemption limits, widening of tax slabs, and deduction under Section 80C for savings, have created a tax environment that could make citizens of Hong Kong and Singapore envious.

A senior citizen with a monthly earning of Rs 25,000, and savings of Rs 50,000 out of his annual income, would pay tax at 6.66 per cent.

Despite, standard deduction having been removed, a woman earning a monthly salary of Rs 35,000 and saving Rs 70,000 a year, would pay tax at just 12.5 per cent. A man below 65 years earning Rs 6 lakh per annum, with annual savings of Rs 90,000, would be liable to pay tax at 17.17 per cent.

Until now, the large number of tax breaks offered to individual taxpayers encouraged investment in debt instruments — typically, small savings — the return on which had been artificially propped up as a concession to populist sentiment.

The preferential treatment that these investments enjoyed is gradually eroding. The administered interest rates on these have been steadily lowered (from 12 per cent, in 1998, to 8 per cent, at present). In coming years, they will become market-determined, as has been recommended by the Rakesh Mohan Committee on administered interest rates.

The effect of this will be to lower these rates to more realistic levels; for instance, the post-office deposit, which offers 7.5 per cent would, under the Rakesh Mohan Committee formula, fetch 6.25 per cent.

The other pillar of small savings — the tax breaks — is being reduced. The abolition of Section 80L that offered tax breaks on interest income from banks and government securities has at one stroke lowered the post-tax returns on four small savings schemes, rendering them less attractive.

Though the instruments that were eligible for rebate under Section 88 will now qualify for a rather more tax-efficient deduction under the newly introduced Section 80C, the removal of sector caps that directed investments to particular instruments means that the taxpayer is now free to invest according to his portfolio needs, and not based on tax-saving considerations.

As Mr Chidambaram noted in his Budget speech, taxpayers will henceforth have greater flexibility in making savings and investment decisions. Of course, it is not entirely an altruistic spirit that underlies Mr Chidambaram's decision to let you be the master of your investment destiny.

It is the more compelling macro-economic reality of the unsustainable interest burden on small savings due to their artificially high interest rates. Given their immense popularity, and not just with risk-averse investors, small savings cannot be done away with immediately. So policymakers have resorted to the more inventive method of killing it subtly by making it progressively less alluring.

To that extent, the Budget only advances a larger agenda that inspires these moves. The agenda being, to encourage investors to move from small savings to the market which includes stocks and mutual funds. The objective is to lighten the interest burden of the government, to absolve the government of its responsibility to deliver to people's unrealistic expectations of high returns at zero risk.

Successive governments have been incentivising investments in equity and equity funds. For instance, equity dividends are tax-exempt, and so are long-term capital gains. In fact, equity investments enjoy a distinct tax edge over debt instruments, particularly since the Budget has made interest income taxable.

It is for the same reason that the government has initiated pension reforms by replacing a defined-benefit scheme with a defined-contribution scheme, and by allowing provident funds to be invested in equity, directly, and through mutual funds to a limited extent.

The Budget has taken a significant step to end the present tax regime where most investments enjoy tax exemptions at all three stages, namely, investment, accumulation and withdrawal. The Finance Minister wants this to eventually give way to an EET system, in keeping with the global tax regimes.

Abolition of tax break on interest income ushers in this regime by default, and Mr Chidambaram has said that he will set up a committee to prepare the roadmap for the transition to a full-fledged EET system.

This means that even withdrawals from the Public Provident Fund and the Employees Provident Fund will become taxable in future.

The Budget will require taxpayers to learn to look beyond tax savings. Of course, people will exploit these tax breaks as long as they are around, but it is important not to let tax benefits influence investment decisions.

With the removal of the tax bias, it would now be necessary to invest in instruments based on other considerations like liquidity, risk and return.

In terms of long-term direction, tax-breaks will now be linked to end-use and not the instrument chosen. This is evident as Mr Chidambaram has retained tax deductions on interest repayments on home and educational loans, payments on medical insurance premiums, and on medical expenses for dependants of the disabled and for the disabled.

Another important Budget announcement is on pension reforms. Mr Chidambaram has announced the tabling of a Bill in Parliament to set up the Pension Fund Regulatory and Development Authority (PFRDA) to replace the ordinance issued in December 2004. When this bill becomes law, pension reforms will finally kick off. The regulatory body will set up a central record-keeping agency (CRA) to record contributions and retirement accumulations.

The body will select vendors of investment products to be on its panel. These vendors will formulate pension products that can be chosen based on different factors.

This system is expected to provide better services and greater information about retirement savings on a regular basis and ensure that retirement accumulation continues uninterrupted, no matter how many times a person changes jobs.

Once the body is in place, it is likely to bring under its supervision all existing provident fund organisations, including the Employees' Provident Fund, which functions as a pension player and regulates itself.

This is expected to change the way these organisations function. They can be expected to be more responsive to personal needs and be trusted, much like the IRDA in insurance, to redress grievances or to take punitive action against defaulters, including employers, pension companies and intermediaries.

The replacement of Section 88 rebate by Section 80C deduction, for similar investments and payments, benefits taxpayers in the higher tax slabs more than those lower down.

A taxpayer in the 30 per cent bracket will save 30 per cent tax (plus surcharge and education cess) against a rebate of only 15 per cent available earlier. Taxpayers with income above Rs 5 lakh, who were earlier not eligible for the rebate, can now save 30 per cent tax.

The internal investment ceilings — Rs 70,000 for PPF and life insurance premium; Rs 10,000 for mutual fund ELSS schemes; Rs 20,000 for housing loan repayment; and Rs 12,000 per child's tuition fees — have been eliminated.

Instead, there is one consolidated limit of Rs 1 lakh for all investments, making the deduction simpler. This deduction under Section 80C will include deductions under Sections 80CCC and 80CCD for pension plans.

The discount on notified Zero Coupon Bonds issued for financing infrastructure will be taxed as capital gains only on sale or maturity. Such bonds need to be held only for one year to qualify for the 10 per cent long-term capital gains tax.

The long-term capital gains tax on gains computed without cost indexation has been extended to such bonds, besides exempting them from tax deduction at source. These benefits will ensure that such bonds become popular with the investing public, thereby helping raise funds for infrastructure at lower cost.

From fiscal year 2005-06, derivative traders need no longer fear losses being classified as speculation losses and, thus not allowed to be set off against other income.

For this, the broker's contracts must bear the MAPIN Unique Identification Number and the Permanent Account Number of the trader in order that the losses can be set-off.

To conclude, the economy is now moving to a new system where personal portfolio preferences will shape the investment strategies that will be decided not by tax sops alone.

In short, the new regime will liberate investors from low-yielding instruments and propel them towards new products, some of which may be risk-bearing but provide full tax immunity.

The good thing about the Budget proposals is that they will increase the quantum of personal savings and give investors a wider choice. Equity-linked saving schemes will get the same tax breaks as instruments like the PPF. Undoubtedly, conditions have been created for promoting investments that will make sustained economic growth rate at 8 per cent a definite possibility.

(The author is a Mumbai-based advocate specialising in direct tax laws.)

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