Tax sops to go -- Lower returns for tax savers

Suresh Krishnamurthy

THE scrapping of tax incentives on small savings instruments barring PPF that has been recommended by the Y. V. Reddy committee does have important implications for investors. It will not lead to an increase in the incidence of taxation.

This is because there are other tax-saving instruments such as ICICI Bonds, Insurance schemes, PPF, that will continue to offer tax savings. However, it can and will lead to a reduction in yields on other tax savings instruments.

What the removal of tax incentives on small savings instruments would do is reduce the number of schemes that offer such incentives.

When the number of schemes that offer tax rebates comes down, the other players in this market would reduce the coupon rate offered by their instruments. This will bring down the total return on investments made with an intention to reduce tax.

There are two reasons to believe that this would happen. One, small savings instruments set the upper limit for the yields on all tax savings instruments. Other tax saving schemes cannot afford to peg their return at a level significantly lower than what is offered by tax savings schemes. That would reduce the number of investors who seek such schemes.

Given this backdrop, if the tax incentives on small savings schemes are removed, it is likely that the return on other instruments, such as ICICI Tax Savings Bond would be reduced. It confers unintended and undeserved (as these entities carry a higher) risk benefits to companies allowed to offer instruments with tax benefits.

In addition, consider the schemes that provide tax savings on capital gains. The schemes that offer such incentives are Nabard Capital Gains Bonds and NHAI Bonds. The coupon rate on these instruments is only 8.5 per cent.

The return on these instruments in many cases is only around 11 per cent, even taking into account the tax incentives. Overall, the lack of competition in this market has ensured that the return on these investments are now down significantly from the time when mutual fund schemes and ICICI Bonds also offered such tax incentives.

In this backdrop, it is certain that scrapping tax incentives on small savings schemes may create a situation where the return on these investments decline further. Policy-makers should be aware of this situation and take steps to ensure that the number of schemes that offer such incentives does not come down.

In a way, the situation can be utilised to encourage long-term savings. For instance, tax rebates should be made available only on long-term instruments. Given that the practice of saving for retirement is absent in India, encouraging long-term savings may actually be the need of the hour.

For a small section of investors, removal of tax incentives on small savings schemes would deliver yet another blow. However, if a large section of investors in small savings are retired persons, they are not going to grudge the loss of tax savings. In their case, incomes are seldom that high to suffer taxation. Besides, there are also other instruments that offer tax-free income.