(photo credit: http://www.gettyimages.com)
For the small, timid investor and retirees, Provident Funds and Postal Savings were the investment vehicles of choice till 2000. Interest rate liberalization resulted in a progressive decrease in interest levels on long term deposits from 12% to 8.5% per annum.
The reform was sensible. Government could not afford to subsidize the growing gap between what Provident Funds assured investors and what they earned from investments-mostly in Government debt. This strategy also aligned with the objective of growing stock markets by incentivizing small investors to divert their savings to equity.
THE AGED BORE THE BRUNT OF INTEREST RATE REFORM
What the government forgot or disregarded, was that fixed return investments are the natural and appropriate choice for the aged, small investor, who treasures liquidity; safety and simplicity in transactions; characteristics typical of deposits and debt investments. Not everyone can be like Warren Buffet-the Sage of Omaha, who remains an equities guru, at age 83.
Consequently the negative impact of financial reforms has been borne by those who were least capable of doing so- the aged, retiree without an inflation indexed pension. There were two reasons why this happened.
First, high inflation, higher than the nominal interest earned, has reduced “real (inflation adjusted)” returns from interest to negative. If the interest earned is 8% per annum whilst retail inflation is 9% per annum, the investor is earning no “real” return at all. Instead she is paying an “implicit”, additional 1% on her investment to the government as “Inflation Tax”
Second, even on such negative real return, “explicit” income tax is levied at the applicable rate on the nominal return further reducing the real return to the investor and enhancing the “Inflation Tax” paid to the government.
What hurts even more is that dividend income is tax free but interest is taxed. There is a theoretical logic to this asymmetry. Dividends are paid out of the post-tax profit of a corporate. Since tax has already been paid by the corporate, on this value stream, it need not be paid again by the shareholder. Unlike dividend, interest paid by a corporate to a depositor is a “cost” and is set-off against revenue to reduce its taxable profit. Since no tax is paid by the corporate on this value stream the taxman is right to charge tax on interest in the hands of the receiver
Notwithstanding the soundness of this general principle, a solid case exits for exempting interest from income tax.
First, timid, small savers, particularly the aged, have no alternative financial instruments for investing their savings.
Financial pundits may counter that such investors should invest in the risk averaging, Mutual Funds available in the market. But Mutual Funds (MF) themselves tend to shift from equity into debt based investments in a stock market downturn, as happened during 2008 to 2013 (SEBI Annual Report 2013-14). After deducting administration costs, the returns available to MF investors, are not significantly higher that what they could get themselves from deposits.
It does not help that the Indian Stock Market, like other emerging markets, is highly volatile. In 2013 volatility in the Indian stock market was 17% as compared to 11% for the DOW and 12% for the FTSE (Bloomberg-2014). Volatility dissuades aged, timid, small savers from such stock market based instruments, since they have a strong preference for certainty of nominal return.
Second, Inflation management in an open, developing economy, hugely dependent on energy import is tricky. Our record, whilst much better than Latin America, is nevertheless worrisome for an aged person dependent on a fixed income. The government has demurred in offering inflation indexed, real interest rate, saving instruments for retail investors. Possibly the financial risks associated in offering such an investment are considered too high. How then can one expect an aged retiree to bear the inflation risk?
NARROWLY TARGETED TAX BENEFITS
Clearly, the universe of aged Indians are not all under privileged or timid or naïve investors. The cynical could well ask why should the likes of Rahul Bajaj- the illustrious, Indian industrialist, age 76 need special exemptions on interest income or for that matter senior government pensioners or retired senior employees of the formal private sector.
We hold no brief for them since they can look after themselves. In any case it is unlikely that this set allocates a significant proportion of their savings to fixed return deposits. They don’t need to since they have their inflation indexed pensions as a fall back.
Our plea is for the junior level retirees from the formal sector and all retirees from the informal sector. Assuming that 90% of the 62 million aged (5% of population above the age of 65-2011 census) are retirees from informal employment and further assuming that 30% of these-mostly in urban areas- have no income other than from savings, the target beneficiaries would be around 17 million aged people. Most of these may not even be income tax payees. Those who are taxable would probably pay tax at the lowest tax bracket of 10%.
Consequently, the exemption is narrowly targeted at the deserving and is unlikely to result in significant loss of tax revenue.
There is widespread expectation that the FM would raise the tax free income level from Rs 3 Lakh (for senior citizens) towards Rs 5 Lakhs per year. This is a welcome but generalized benefit and not a specific benefit for the 17 million aged, lower middle class, urban retirees – all of whom are voters.
The BJP has been unfairly targeted for being tardy on social protection. The 2014 national election generated heated debate between “callous growth” and “virtuous equity”- a falsely projected zero-sum choice.
Expectedly, the FM will seek to correct this impression in the 2015 budget. But it is tough to implement efficient social protection schemes on a tight budget. Even efficient, rich, developed economies struggle to walk the thin line between providing perverse incentives to beneficiaries to become economic drop-outs and ensuring the adequacy of social security.
In the meantime, please Mr. FM, spare a thought for the average, pension-less, retiree from the informal sector. Save her from the perils of sinking her savings in unregulated “high return chit funds” in desperation, just to make her two ends meet. Exempting interest earned by individuals from Income Tax is a good way of doing this. There is no better “win-win” than this.