Making financial savings less taxing

Savers in India need a far simpler tax regime for financial products that doesn’t distort their freedom to choose

Published - February 01, 2018 12:02 am IST

Bumping up the household savings rate and nudging savers to park their surpluses in financial assets have always been high on the agenda of Indian Finance Ministers. Fully aware of this, different arms of the financial services industry — insurers, banks, intermediaries, mutual funds — usually present a long laundry list of Budget demands. This year has been no exception.

But it is accommodating such piecemeal demands over the years that has led to such a complicated and inconsistent smorgasbord of tax rules for investors. This does them more harm than good. It may be desirable for the Finance Minister to refocus on the big picture policy objectives on savings, to rework the tax incentives around them. Here are some ideas that may uncomplicate life for savers, if they figure in the Budget.

Omnibus 80C

India is an aspirational economy and this makes deferring one’s consumption a particularly difficult decision for the income-earner. Offering tax incentives to increase the savings rate, therefore, makes sense.


The Income Tax Act, under Section 80C, does create such incentives by allowing savers to deduct up to ₹1.5 lakh upfront from their taxable income each year towards investments. Ideally, Section 80C should have stopped with an omnibus deduction and allowed investors to choose their own instruments.

But in practice, there’s a restrictive list of ‘approved’ 80C investments that has grown over the years to accommodate the whims of different Finance Ministers. In the present section 80C, bread-and-butter contributions towards provident funds and senior citizens’ savings jostle for space with the principal on home loan EMIs (equated monthly installments), ULIPs (unit linked insurance plans), equity-linked funds and children’s tuition fees. There are also separate carve-outs outside 80C for pension contributions, home loan interest, medical insurance premium and, unaccountably, donations to political parties.

The problem with the ‘approved’ 80C list is that it distorts choices for savers. Some savers lock into risky ULIPs or ELSS (equity linked savings scheme) products for 80C tax breaks, when bank fixed deposits would better suit their risk profile. Others buy larger homes than they can afford to avail of home loan tax breaks. The sub-limits on medical insurance and National Pension System (NPS) unduly influence allocation decisions.

Instead of micromanaging savings under 80C, it would be good if the Finance Minister did away with the approved list and offered just one catch-all deduction of, say, ₹2 lakh a year, for financial investments. That would allow savers freedom of choice based on individual goals.

Favour financial assets

That Indian savers prefer to bet their surpluses on physical assets such as gold or property, instead of in productive financial assets such as deposits, bonds and shares, has for long been a sore point with policymakers. It is only recently, in fiscal year 2016 and FY 2017, that there has been a mild shift in this behaviour.


Income tax rules, however, continue to offer handsome tax breaks on property investments, which are denied to many financial investments. For instance, tax laws encourage leveraged investments in property by allowing tax deductions on both the principal (Section 80C) and interest repayments (Section 24B) on home loans. But when it comes to financial investments, forget leverage, many popular avenues (bank and post office deposits less than five years, recurring deposits, bonds) receive no tax breaks even on the actual investment.

Property investments also enjoy more generous capital gains exemptions than financial products. Capital gains earned on selling residential property after three years is not taxed if you reinvest the proceeds in another house. But this reinvestment benefit is unavailable to financial products. What’s more, capital gains tax rules for financial products are complex — shares and equity mutual funds get full exemption after one year, bonds and debt mutual funds suffer tax after three years and returns from cumulative deposits are taxed at stiff rates as income, and not as capital gains.

To establish a level playing field between physical and financial assets, sale proceeds from financial assets, if held long term, should be allowed to be reinvested without capital gains tax. A uniform definition of ‘long-term’ and cost inflation benefits for all financial products, whether they are bonds or bank deposits, would render them more attractive.

Freedom on allocation

Prudent financial planning requires a saver to decide on her relative allocation between safe and risky assets based on her life stage, income, financial goals and risk appetite. Reserve Bank of India data tell us that in FY17, Indian households made a ₹18.2 lakh crore incremental allocation to financial assets. About 60% of this went into bank deposits, 24% into insurance premia, 16% into pension and provident funds, 10% into shares/mutual funds and about 5% into small savings, with other minor allocations.


This tells us that Indian investors have an overwhelming preference for fixed income avenues that safeguard their capital, even if they earn lower returns. This is logical given that the population is dominated by low to mid-income earners.

But present tax laws ignore individual risk-taking ability, and try too hard to push investors towards equities. So, dividends on equity shares are exempt in the investors’ hands (distribution tax is a flat 20% at source). But interest on deposits are added to one’s income and suffer tax at 10-31%. Equity gains are treated as ‘long term’ after just one year and completely exempt from tax thereafter. But for most debt investments, ‘long term’ is three years with gains taxed at 20%.

It would be desirable to tax both dividend and interest income at similar rates in the hands of investors. There is also a case for treating equity gains as ‘long term’ only after three years. These measures above will not just nudge savings behaviour closer to the policy objectives. They will also make financial products vastly more appealing to savers, by uncomplicating the tax rules that presently hamper their freedom of choice.

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