Tax tweaks can promote financial savings

If there is one thing that gladdens the heart of most Indians, it is ferreting out little escape routes that can legitimately trim their tax outgo. Therefore, the Finance Ministry is quite right to focus on tax breaks, in its bid to lure Indian savers back to financial avenues. While the review is on, here are a few ideas policymakers must consider.

Raise the Rs 1 lakh limit

Personal income tax rates have declined sharply over the years. But that has been accompanied by shrinking tax breaks on savings and investments too.

Remember Section 80L, which used to fetch you tax exemptions on interest earned from deposits? Or Section 80CCF, which exempted investments in infrastructure bonds from tax? These tax breaks have been quietly done away with in recent Budgets, leaving you at the mercy of the ubiquitous Section 80C.

Under Section 80C, investment of up to Rs 1 lakh each year in certain avenues gets you a tax exemption on the principal invested. Now, there is a problem both with this limit and the investment options that are crammed into it.

For one, the Rs 1 lakh limit applies uniformly to all taxpayers, with no regard to how much they earn or will need to invest. Whether you are a fresher who has just joined the workforce at Rs 5 lakh a year or a silver-haired veteran who has only five years to retire, the Government somehow thinks that all you save towards your financial future is Rs 1 lakh a year.

Then, it encompasses everything from contributions to pension funds to children’s education expenses to home loan repayments. In practice, for higher income earners, the entire Rs 1 lakh limit tends to get gobbled up entirely by compulsory provident fund deductions from their salary. It is little wonder then that Section 80C offers little incentive for investors to consider small savings, insurance or equity mutual funds.

If policymakers want to create tax incentives for investing in financial instruments, the Rs 1 lakh limit needs to be raised to account for inflation as well as higher income. Maybe, the flat limit can be replaced by a proportionate one which allows tax payers to invest, say, 20 per cent of their yearly earnings in financial instruments.

Dividends vs. capital gains

Though they look good on paper, the tax breaks that equity investments enjoy, often turn out to be ephemeral.

Long-term capital gains on shares are exempt from tax. But with the stock markets averaging barely a 3 per cent (annualised) return over the last five years, most equity investors are sitting, not on capital gains, but on capital losses.

In effect, therefore, the tax benefits on equities come into play only if you make gains on them. If you lose, there isn’t any tax benefit to holding them.

The only regular return that investors make from equity investments is by way of distributed dividends. Yet dividends in India are taxed at higher rates (a flat 16.2 per cent dividend distribution tax) than capital gains (15 per cent for short term, zero for long term). Return of cash through share buybacks is also taxed at higher rates.

Despite India Inc sitting on mountains of idle cash, its dividend payout ratio (proportion of profits distributed) is no more than 25 per cent. The average dividend yield is a measly 1.4 per cent.

Encouraging companies to return more of their surpluses to shareholders will definitely improve the return experience of investors. It will also reduce the perception that stock market investments are pure gamble.

This can be accomplished by trimming tax rates on dividends and extending the capital gains tax exemption to share buyback programmes.

Better deal for debt

Current tax breaks on equities are based on the belief that, to get retail investors to buy risky assets, you need to offer sops. From an investor’s perspective, there is a yawning gap between the tax treatment of equity and debt returns.

Equity shares are exempt from capital gains tax if held for more than one year. Dividends are subject to a flat rate of dividend distribution tax. However, capital gains on bonds are taxed even if you hold for the long term. And interest received from bonds or deposits is taxed at the individual’s income tax rate, which can be as high as 30 per cent.

But this approach of taxing debt returns to the hilt and allowing equity investments to go scot-free, has pitfalls. For one, the unequal tax breaks may prompt investors to go overboard on equities, thus taking on more risk than they can afford. After all, all investors need to have both debt and equity instruments in their portfolio for balance. How much equities one should own should be decided by individual risk appetite, rather than tax breaks.

Two, there is no reason why shares must claim any innate superiority over debt, as financial savings go. If the argument is that stocks redirect household savings into productive uses in business, that holds true for debt too. It is not clear why investing in a Reliance Power IPO is better for the economy than investing in HUDCO bonds or SBI deposits.

Given that investors have been shying away from all kinds of financial savings — bank deposits, bonds and shares — this is not the time to be finicky. It is best to leave the debt/equity mix to the investor’s choice.

Instead, the Government must consider taxing interest from debt instruments at the same rates as dividends from shares. Holding equities for the long term can be encouraged by allowing inflation-indexed capital gains tax ( a la bonds) on shares held for more than 3 years.

Finally, it is essential to make financial assets at least as attractive as physical ones such as land and gold, by subjecting them to similar tax regimes.

Today, though jewellery and property are subject to tax on paper, they escape both capital gains tax and wealth tax due to poor enforcement.

Ensuring better tax compliance on jewellery and property transactions would go a long way in putting financial assets back into the reckoning.

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