Demand can be revived by eliminating all tax incentives to save

It is said that things get done in India only when there is a crisis. The government can then undertake reforms that were long overdue but did not have the courage to implement.

Hopefully the current abysmal levels of growth will be considered crisis enough. And Mr Sinha will do everything in his power, and in his budget, popular or unpopular, to help the country ride over this crisis.

One such measure, that may be unpopular, would be a reform of small saving schemes and withdrawal of tax incentives to save. Today there is a general consensus that the current downturn is due to a demand recession.

Thus a step towards reviving demand could include reducing incentives to save. After all when there exists unutilised capacity in the economy and a slowdown in consumption, why persist with providing incentives to save?

Tax incentives for small saving schemes were given at a time when financial savings of the household sector were low and when banking and capital markets were underdeveloped. But now many of these need to be abolished altogether.

Of course, the reason why the Mr Sinha may be reluctant to do so is because resource mobilisation through small savings has become a major source of finance for the government. But not only are interest rates on small savings high, the schemes continue to receive tax benefits.

This not only distorts the structure of interest rates in the economy, but also adds to their cost for the government. For instance, while the interest cost of small savings in 1999-2000 was 32.5 per cent of the gross collection in the year, another 8.6 per cent was added to cost by way of foregone tax revenue.

The Parthasarathi Shome committee on tax policy and tax administration argued that these tax incentives lead to inefficiency and inequity in the tax structure. They result in greater taxpayer compliance burden, administrative costs, loss of revenue and complexity of the tax laws and encourage tax avoidance.

But since tax incentives create a clientele for their continuation and spread, many countries maintain them even after tax reforms. Not because they are considered to be effective, but because it is politically difficult to remove them once they have been introduced.

Consequently, “temporary” measures designed to respond to particular perceived disincentives, remain in force long after the conditions that originally led to their introduction have changed.

Take, for instance, the case of Section 80L. Under this section, existing tax provisions provide for exemption of income upto Rs 12,000 from income tax on specified financial instruments.

This section was introduced by the Finance Act, 1967, “originally with a view to encouraging investments in the shares of Indian companies and, perhaps, also to mitigating the double taxation of dividends for the smaller shareholders”.

The Finance Act, 1970 substantially enlarged the scope of this section by including government securities, debentures issued by specified co-operative societies or institutions, investments in the units of the UTI, deposits with banking companies or co-operative banks and deposits with financial corporations engaged in providing long term finance for industrial development.

The scope of Section 80L was also increased by the inclusion of interest on National Saving Certificates and bonds issued by certain public sector undertakings carrying interest generally at the rate of 13 per cent or more.

However, from assessment year 1998-99, the exemption for dividend income has been taken out of the purview of Section 80L since the whole of dividend income is now exempt in the hands of the shareholders. “Therefore, the very rationale for introducing the provision ceases to exist.” The Shome committee thus recommended abolition of tax incentives under Section 80L.

The rationale for removal of tax incentives for small savings also lies in the short term nature of many of the saving instruments. The Y V Reddy Committee on the System of Administered Interest Rates argues that while there are some good reasons why tax incentives for long term saving instruments may be provided, there are excellent reasons to remove tax concessions on short and medium term instruments.

In its classification long term instruments include the Employees Provident Fund, Public Provident Fund and Public Pension Fund. Financial instruments with short and medium term redemption periods include National Saving Cetificates, National Saving Scheme, Relief bonds, government securites etc.

While the old age security schemes are not marketable instruments and therefore, illiquid, financial instruments like bonds and debentures, shares and government securities should technically be treated as short to medium-term savings for tax purposes because of their high liquidity and marketablilty.

Moreover, the Reddy committee found that tax incentives on financial instruments having short and medium lock-in provisions are being used more as a vehicle for tax avoidance by recycling existing savings, rather than as an instrument for financial accumulation.

It recommended doing away with the plethora of ad hoc exemptions on varied instruments. And, like the Shome committee it has also recommended the withdrawal of tax incentives under Section 80L.

But would this not lead to an additional tax burden for the salaried section? Already there is inequity in the tax structure as individuals with the same income levels but other sources of income are able to avoid paying taxes, while the salaried employee ends up with a higher tax to income ratio.

Yes, but not if along with these changes, the finance minister also accepts the personal tax rate schedule proposed by the Shome committee. Then the change will be tax neutral for the tax payer. The committee has observed that tax slabs have not been changed in line with inflation. In 1973-74 the exemption limit was Rs 5000.

Tax rates of 10 and 20 per cent were applicable for incomes upto Rs 10,000 and Rs 20,000 respectively. The inflation adjusted corresponding income levels are ten times in each case in 2001-02.

The committee has therefore recommended that income up to Rs 50,0000 should be exempt from payment of tax. Rates of 10 and 20 per cent should be applicable for incomes upto Rs 1,00,000 and Rs 2,00,000 respectively, and a rate of 30 per cent for income above Rs 2,00,000.

Why then would Mr. Sinha continue with the tax incentives? The answer would perhaps lie in the investor profile of small savers. In a survey of the ownership profile in UP it was observed that 28 per cent of the invested amount was held by traders. Another 22 per cent was held by government employees!

The question is no longer whether there is a case for a change in the structure of tax incentives to small saving schemes, it is whether Mr Sinha can afford to take a step that will be unpopular with both his party’s supporters and the babus who surround him. But then if he can change the tax rate schedule as well, then Mr Sinha need have no fear. He will make everyone happy.