The Budget has also, largely, reduced the tax efficiency of options such as mutual funds and insurance. The proposals do not make these instruments redundant. They now force fund managers to justify their existence, and the costs they charge, by adding value. In a way, direct investing is now more tax-efficient than investing through mutual funds.

This need not be viewed as an anomaly. It only raises the bar for fund managers. If they can deliver value over and above such tax disadvantages, as they have in the past, investors would still flock to mutual funds and insurance.

Favouring equities

The collective reaction of traders to the proposal of turnover tax was negative. They think it would reduce volumes. They thus expect the proposal to push up the prices at which investors buy and push down the prices at which investors sell.

The costs for a short-term trader may have indeed gone up. Such traders may thus demand a higher return from equities and push down stock prices now. For non-speculative investors, however, the costs have just declined, making equities more attractive.

Equities are riskier than risk-free government securities. Investors will, therefore, demand more return from equity investments. The differential between the return demanded from equity investments and risk-free yield on government securities is called equity risk premium.

Investors will now be satisfied with a lower premium because of a more favourable tax structure. The reduction in short-term capital gains tax to 10 per cent and the abolition of long-term capital gains tax would accomplish just that. As costs in the form of taxes have come down, you can now buy stocks even at slightly higher prices. Thus, even if lower liquidity pushes up transaction prices, it should not worry you too much.

That would be so especially if the equity market slips from present levels. The combination of lower stock prices and lower taxes augur well for the longer-term investor. Though the pessimism in the market on Budget day may deter you, this is the right time to step up allocation to equities with a long-term perspective.

Small savings stay attractive

Administered rates on small savings have not been changed. Over the next eight months, this would prove handy to investors. This is because interest rates could move up in that period. As such, if you invest in a debt mutual fund, you could be forced to deal with a loss in value. Alternatively, if you opt for a short-term instrument, then too, you could lose in terms of opportunity lost, if the interest rates do not change much. In contrast, small savings schemes offer yields of 8-10 per cent.

The post-office monthly income scheme combined with post-office recurring deposit scheme offer investors a before-tax yield of 9.3 per cent per annum over a six-year period. The after-tax yield, too, is attractive at about 7 per cent.

For tax savers, NSC offers yields of between 9.7 and 14 per cent.

PPF continues to be an attractive long-term investment, even without any tax savings.

You could invest for the long term in these debt securities and expect to generate post-tax returns of 7-7.5 per cent even if your debt portfolio is over Rs 10 lakh. Even if other interest rates in the economy do go up, small savings rates are unlikely to change. As such, you need not wait for the next Budget and invest for the long-term then.

You need also not worry about putting all your investments in a single basket — small savings. This is because the anomaly of small savings being a high interest island will be corrected over the next two to three years. You could then reduce the proportion of small savings in your long-term debt portfolio.

Rebalancing facilitated

Rebalancing refers to the process of changing the proportion of funds you allocate to equity and debt. If you invest Rs 100 in equity and Rs 200 in debt at the beginning of the year, then at the end of the year, the allocation to debt and equity would not be in the same proportion.

You might, however, want to change the allocation to the original proportion. Until now, the spectre of short-term capital gains would have deterred you from doing so. With the tax rate on short-term capital gains cut down to moderate levels, rebalancing is now less expensive.

You also have more tools to accomplish such rebalancing. For instance, you can invest in dividend options of mutual funds and then utilise the dividends distributed to restore balance in your portfolio.

It is also not necessary to rebalance your portfolio within 12 months if you think you can postpone the exercise and avoid even the 10 per cent short-term capital gains. The fact that you can do it now at lower cost will be of immense use, especially when stock prices rise sharply.

Why rebalance at all? Research abroad has indicated that asset allocation has an important role to play in generating attractive returns. Consequently, any fiscal changes that reduce cost of rebalancing will enhance long-term returns.

Building a portfolio

Low taxes on dividends, low taxes on capital gains and attractive return for longer-term debt investing are factors that allow investors to build portfolios in line with their risk-return-liquidity preferences and generate attractive after-tax returns.

For instance, if you were looking for monthly income, a combination of small savings schemes and high dividend-yielding stocks would deliver what you seek. Allocation of 70 per cent to small savings schemes and 30 per cent to high dividend yielding stocks may deliver annual returns of about 9 per cent.

That would be so if small savings schemes deliver 7.5 per cent after tax and high dividend yielding stocks deliver 12 per cent after tax. A return of 9 per cent after tax would double your money in eight years and beat inflation comfortably. Alternatively, you can seek higher returns. If you seek long-term appreciation in value, then larger allocations to growth stocks and equity mutual funds would be more appropriate.

Consider allocating 50 per cent to growth stocks and equity mutual funds and 50 per cent to small savings schemes. You may earn annual returns of 11.25 per cent per annum. Again, this would be possible if the portfolio of stocks and mutual funds delivers 15 per cent after tax and small savings fetch 7.5 per cent after tax. Investments would double in roughly six and half years and returns would almost be double that of inflation.

Building such portfolios and realising such returns are now much more realistic now. Earlier, because of taxes on capital gains, you would probably need a return of 20 per cent prior to tax to achieve a return of 15-16 per cent post-tax. Now, 16-16.5 per cent before tax may be enough to realise 15 per cent after tax.

Planning and managing investments has become that much less challenging because of the Budget proposals. If these changes to the tax structure are not tinkered with, either in the next few months or in the next few Budgets, investors would have much to cheer Mr Chidambaram's Budget of 2004.

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