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Suresh Krishnamurthy

IN KEEPING with expectations, the Finance Minister has tried to reduce the costs associated with small savings schemes. And initial indications are that he has been considerably successful. With the pruning of the rebate under Section 88 of the Income-Tax Act, and the 50 basis-point reduction in the interest rate, yields on these schemes have fallen sharply. Importantly, the benchmarking of the rates on small savings schemes to yields on comparable government securities has started in right earnest.

Sliding yields

The yields on non-tax savings schemes have also declined after the change, but not significantly. In most of these schemes, the fall in yield is 40-50 basis points. Importantly, the attractive features have been retained. Thus, there will still be no tax deduction at source; there will be 10 per cent bonus on maturity in the Post-Office Monthly Income Scheme (POMIS); there is liquidity at appropriate time intervals in Kisan Vikas Patra. Importantly, the Government Relief Bond continues to be a tax-free instrument, despite two committees advocating that it be scrapped.

The fall in the yields of tax-savings schemes is, however, significant. It varies in accordance with the total income of investors. For those with a gross total income of more than Rs 5 lakh, the fall is the most. This is because they will no longer enjoy any tax concession for investing in instruments such as NSC, NSS and PPF. The fall in yields for this class of investors will be around 5 percentage points in both NSS and NSC. In the PPF, the fall in yield is of the order of 3.2 percentage points. However, the overall impact on their portfolio is likely to be considerably lower. This is because tax-saving schemes are unlikely to have accounted for any significant portion of their portfolio. This investor class is likely to have opted mainly for non-tax saving investment options. As such, the non-availability of these investment options is not likely to matter much to it.

In contrast, the impact on investors with incomes between Rs 1,50,000 and Rs 5,00,000 will be significantly higher. Small savings instruments may account for a significant portion of their portfolios, the dependence in many cases being perhaps close to 100 per cent. These investors have no option but to settle for an extended regime of low interest rates.

Such investors will have to deal with the pruning of tax rebates from 20 per cent to 10 per cent, apart from the reduction in interest rates. The fall in yields, thus, is 1.4-4.8 per cent.

For investors with a total income between Rs 60,000 and Rs 1,50,000, the decline in yield is not significant. This set of investors could continue to rely on small savings investment option with rich dividends. The yield to maturity is still marginally above 15 per cent in NSS and NSC, if their interest income is deductible under Section 80-L.

Benchmarking

Another significant move is the linking of the yields on small savings schemes to those on government securities of comparable maturity. For instance, the interest rate on the POMIS will be linked to yield on a government security with a remaining maturity of six years. Thus, each year on March 1, the coupon rate on small savings schemes is expected to change in a non-discretionary manner.

However, several issues have not been spelt out in detail. First, the interest rate will be linked to average annual yields. But it is not clear of how many days average. The interest rate will vary depending on what average is used. More important, the mark-up over the yield on government securities has also not been outlined. Only when these are spelt out clearly can investors plan strategies.

In any case, there are clear indications that the rates, going forward a year, could be much lower than they are now, especially on long-term options. For instance, the yield on a six-year government security is now 6.6 per cent while the announced interest rate on the POMIS is 9 per cent. Even if the mark-up is 1 per cent, the interest rate on this scheme next March may be around 7.5 per cent. Similarly, as the prevailing yield on a 15-year government security is around 7.4 per cent, the interest rate on PPF one year hence could well be around 8 per cent.

Pruned rebates

The pruning of rebates under Section 88 also calls for a change in investment strategy. Importantly, the reduced tax rebate is applicable not only for small savings schemes but also for other tax saving products, such as insurance, infrastructure bonds and equity-linked savings schemes.

For investors in both the Rs 60,000-1,50,000 and the Rs 1,50,000-5,00,000 total income brackets, it makes sense not to go in for investment options requiring annual contributions. This is because the tax rebate may eventually be done away with over the next few years. This will considerably reduce the return from investments requiring annual contributions.

Investment options such as insurance products and unit-linked insurance plan require annual contributions. In the light of the move to pare tax rebates, investors need to consider these options only if they make sense without tax rebates. For example, a few insurance products may make sense for investors because of a few reasons — insurance coverage and tax-free income on maturity.

Housing loan benefits

Interestingly, it is not yet curtains for investors with large incomes. If they have taken a housing loan, and that reduces their gross total income to less than Rs 1,50,000, they can continue to enjoy considerable tax benefits. While the interest paid will reduce their taxable income, their investment in small savings schemes will provide them a tax rebate of 20 per cent.

This is because the extent of tax rebate under Section 88 depends on gross total income and not income from salaries. As interest paid on housing loan goes to reduce the gross total income, it is quite likely that their income will fall in the Rs 60,000-1,50,000 bracket.

These issues have now considerably increased the advantages associated with housing loans. It makes sense for investors to go in for a housing loan now as the interest rates too are low. Also, this benefit is available only if the housing loan is taken before March 2003. As such, investors have only a 13-month window to reduce the impact of taxes on their income.

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