Gene Roddenberry’s Star Trek had a wonderful concept, one called ‘Prime Directive’. It required outer space explorers from Earth to avoid interference with the affairs of civilisations they came across. This ensured natural progression instead of a nudged progression, biased by Earth sensibilities. Events over the past few years in the Employees’ Provident Fund programme can make one think that policymaking should take a ‘Prime Directive’ break in affairs related to the EPF.
Take, for instance, the recent amendments to tax regulation affecting EPF. For long, taxation surrounding the EPF was simple to understand and easy to execute. If one contributed more than the limit prescribed under Section 80C of the Income Tax Act, they did not get a tax break on the excess contribution. Earnings on contributions rarely suffered taxation since tax laws pegged tax-free earnings to rates higher than that of interest rate on the EPF. One paid tax on their corpus only if they withdrew it within five years of commencing contribution. Rightly so, since the EPF is a retirement product. This taxation framework incentivised employees to use the EPF as their primary retirement saving. Indeed, for many, the EPF remains the sole ‘risk-free’ retirement savings mode given its design, asset allocation and the ‘government-run’ tag.
‘HNI’ individuals
This will change for many because of the new tax regulation that, in effect, labels one “a high net worth individual (HNI) who is misusing EPF” if one contributes more than ₹2.5 lakh per annum to the EPF. The limit is ₹5 lakh in cases where employers do not make contributions to the provident fund. Indeed, the day after the announcement of this change, the media was filled with statistics of a staggering twenty members that had over ₹800 crore in their EPF accounts — just twenty out of the several crore accounts overseen by the Employees’ Provident Fund Organisation (EPFO). The move should be given a rethink because it is flawed in principle and difficult to administer.
Regressive view
The basis of this new tax law reeks of a 1970s’ Bollywood-style narrative where the affluent do only evil and need to be punished. The ‘rich man’s pension vs. poor man’s pension’ divide, that we have seen earlier in policymaking in case of superannuation plans (the Fringe Benefit Tax and the perquisite tax on superannuation contributions), and now in the case of EPF, is regressive. It assumes that the government knows what is adequate for an individual on retirement.
We live in an era of evolving post-retirement aspirations, medical cost inflation, volatile interest rate cycles, credit busts and minimal choices for post-retirement investments. The best bet for employees, then, is to maximise savings via statutory and voluntary contributions. Intuitively, most employees who start to contribute large sums of money to their retirement plan do so when there are surpluses — when mortgages have been paid off and children’s education is funded. This occurs closer to retirement. So, the need to catch up is significant.
While other investment products have grown in popularity, one does realise that for most working Indians, the EPF typifies safety with governance. For the government, therefore, to decide on a common threshold of adequacy is incorrect — it suffers the flaws of a one-size-fits-all approach.
Furthermore, the ‘misuse’ that was used to justify the imposition of the tax is difficult to comprehend. The EPF is solely a payroll deduction and cannot be contributed in any other manner. It, therefore, suffers taxation for amounts exceeding the limit prescribed in Section 80C of the Act. This last point makes the new clause bring the EPF to the borders of double taxation.
Further, close to 65% of EPF is invested in government securities, with the rest being invested largely in PSU bonds and the equity index. Earnings are made available to the employee via an interest credit mechanism. Despite the stickiness of these interest rate declarations and their often being higher than market rates, it is certain that the government does not subsidise this interest rate credit.
Unlike the Employees’ Pension Scheme (EPS), the EPF remains a subsidy-free, pay-what-is-earned retirement fund. The flaws it suffers are related to design and administration and are equally applicable to all segments of its members — the affluent and not-so-affluent. It is accessible to employees on permanent cessation of employment and, thanks to the Universal Account Number (UAN) regime, cannot be accessed easily before retirement. Given all this, the argument of misuse of the EPF by the higher-salaried segment is incorrect.
In addition to flaws in the principle, there can be difficulties in the administration of the new tax rule. Various interpretative inadequacies surrounding the applicability to EPF, especially in light of the changed threshold from ₹2.5 lakh to ₹5 lakh, remain. It is also unclear if the interest on such excess contributions is taxed once during the year of contribution or throughout the term of investment in EPF. The mechanism of tax communication from the EPFO to the member also remains uncertain. One assumes that the systems at the EPFO will need changes and such ongoing taxation of the annual interest rate credit is a first-time measure for the organisation.
The bigger picture
In a wider context, it is important that policymakers reflect on what the EPF has come to signify. While pension funds are seen by governments in myriad policy contexts, they should remain, foremost, the retirement funds of their beneficiaries.
Regulations governing contributions, taxation, investments, administration and benefits should be made in the interest of the beneficiary. But it may seem that other imperatives dominate the agenda in pension policymaking in India. Hence, the resultant outcomes are, at best, sub-optimal from a beneficiary point of view. An example of this is how regulation has obsessed over the coverage of lower-income employees, who have often preferred current compensation over deferred compensation such as retirement funds, while tax laws frown upon other segments of employees increasing voluntary provident fund.
Some of these re-looks are important to execute over time, but an immediate rollback of the tax rules will demonstrate the will of the policymakers to encourage retirement savings. And then, a period of ‘Prime Directive’ adoption will help ‘energise’ the vision of a pensioned society.
Amit Gopal leads Mercer's investment practice in India and has worked with retirement plan funds for over two decades
