New Delhi: Annual Budgets should normally be a statement of Government finances. However, customarily, in our country, the Budget has become a forum where the government also declares its intended taxation and fiscal policy for the year.
Stability of tax rates and fiscal policy is the key to growth, compliance and investment. Tinkering with and varying the same every year, year in, year out achieves just the opposite purpose.
Be that as it may, the Budget is indeed upon us in less than a month from now. With the markets doing so well and the general feel good factor all around, all fingers and toes are being crossed that the Budget doesn’t bring in its wake any dampeners.
Most probably it will not. The question however is whether it will seek to dry out the damp spots that it left last time?
Tax-free Bonds Discontinued
On 9.7.04, one day after presentation of the Budget-04, the 6.5 per cent tax-free bonds were discontinued. As there was no limit on the amount that could be invested, in the highest tax bracket (ignoring surcharge), this resulted in an equivalent rate of 9.52 per cent p.a., a rate that is not available on any other instrument except the Post Office Monthly Income Scheme (PO MIS). But there too, there is a cap. More on that a bit later.
Sec. 80L discontinued
Simultaneously, a move that hit the all time favourite Bank Fixed Deposits (FDs) and 8% Savings Bonds the most was the omission of Sec. 80L. Rs. 12,000 worth of FD interest used to be tax-free on account of Sec. 80L (The other Rs. 3,000 was for the Savings Bonds). However, the abolition of the same has resulted in all interests from all avenues becoming fully taxable.
The Threat of EET
This was, in my opinion, one of the most astounding -- even bizarre aspects of Budget 05. The government basically announced that it was going to implement the EET (Exempt Exempt Taxed) regime of taxation. But that’s it. After that, there is total silence. Consequence? Wide spread confusion and doubt amongst taxpayers. This is not a discussion on the nuances of EET but suffice it to say that what the government has done is to tell us that:
1. So far your tax saving investments such as insurance, PPF, NSC, ELSS etc. were tax-free. However, now we are going to bring these into the tax net.
2. We can’t tell you when.
3. We won’t tell you to what extent each instrument will be taxed.
4. We cant even say for sure whether existing investments made already, prior to this announcement will also be taxed or not.
5. If you have invested in any of these instruments but not claimed the tax deduction, will the proceeds still be taxed? We prefer to stay silent.
Investors don’t deserve this uncertainty. So even if the committee that has been constituted to look into the implementation of EET is not yet ready with its recommendations, the public at large at least deserve some information or update from the government on this topic.
For though no word is coming from the government, there have been routine reports in the media about how EET could manifest itself. One such disturbing news is that perhaps the Sec. 80C deduction on housing loan installments will be cancelled. Which means that between husband and wife, the family will lose a tax break on up to Rs. 2,00,000.
This translates into a direct tax outgo of Rs. 66,667 per year. Not an insignificant amount for past and potential house buyers. For a long term decision like buying a house, it is critical for me to have an exact fix on my yearly outgo.
It could be the difference that could range from abandoning the idea of buying a house to opting for an extra bedroom. Incidentally, over a 15 year period (which is what the average housing loan tenure is), Rs. 66,667 that you may spend extra @8 per cnet works out to over Rs. 19 lakhs.
Hanging such significant sums in balance does not behoove a responsible government.
Rates
This was as far as tax incidence is concerned. Now let us turn to the actual return. Over the past few years, interest rates were on the decline. This has hit the common man where it hurts the most. The average rate of interest offered by banks to their fixed deposit holders is in the range of 5.50% p.a. to 6.50% p.a. depending upon the tenure of the deposit.
Again, this is fully taxable. If you factor in the tax, the rates work out to 3.8% to 4.5% p.a. Inflation as declared by the government currently rules at 4.7%. Which means that today, the common fixed deposit holder is earning a negative return on his fixed deposits.
Moreover, we all know that the actual inflation rate should be much more than what is officially declared. The official price index based on which the rate of inflation is compiled is misleading on account of various factors such as under-representation of the services sector, erroneous selection of the commodity basket as also the allocation of weightages.
Consequently, the results are not going to be accurate. Want to know the more accurate rate of inflation? Ask the Indian housewife and home maker. She will tell you what she has been contending with year in year out. However, suffice it to say, real returns on FDs are in the negative, regardless of whether you consider official inflation or not.
While the current rates on small savings provide some kind of succour, the more popular amongst them such as Post Office MIS or PPF or even the newly instituted Senior Citizens Savings Scheme comes with their own ceiling beyond which an investor cannot go.
Equity – Here we come
There are four factors that every investor considers before investing even a rupee. These are:
1. Return from the investment
2. Safety of the investment
3. Liquidity of the investment
4. Tax efficiency of the investment.
There was a time when Bank FDs used to provide the most optimal mix of the above four parameters. A reasonable return, adequate safety, satisfactory liquidity (albeit at a small penalty) with an associated limited tax efficiency used to be the ideal formula for risk averse conservative investors.
However, all that has changed now. Negative real returns with no tax advantage has made the very same investors instead fall headlong into the volatile swirls of the stock market.
Observe the glaring discrepancies.
Rates on fixed income – Fully taxable.
Any deductions – Zilch.
Dividends from equities – Fully exempt.
Long-term gains – Exempt.
Short-term gains – Taxed at only 10 per cent.
Luckily for the government and the investors at large, the past few years have been kind to the stock market. However, as they say, when something seems too good to be true, chances are, it is. Let’s get a perspective.
A market that took all of thirteen long years to move from 4000 levels to 7000 has scaled the next 2500 odd points in around six months time.
Great news, but the sobering thought here is that this pace cannot be maintained. They say, when money pours in, fundamentals are brushed aside --- which is precisely what is happening in the market today. One is worried that it could be a "Too much --- Too soon" kind of a phenomenon."
In fact, the annualized growth rate from 7000 to 10000 points works out to over 91 per cent.
A correction is market euphemism for a downturn. A correction will come. Its not a question of “if ”, rather it is “when”. Which is not such a bad thing. Markets by definition will rise and fall. However, with the kind of tilt that the average asset allocation has in equity, when the correction arrives, we investors will basically be in no man’s land.
Wrong treatment for the wrong disease
According to some media reports, possibly Budget 2006 may extend the Sec. 80C deduction to bank deposits. I don’t get it. This is like treating malaria with the medicine for jaundice. Any kind of tax saving presupposes a lock-in. The minimum currently is 3 years on ELSS. PPF, NSC etc. entail an even higher one. This lock-in cannot be exited from, even with a penalty. Also there is a limit of One Lakh, remember?
It is the regular interest that requires a tax deduction, not the capital. And more importantly it is the interest rate that requires a boost, not the tax rate.
Apparently, the Left is putting pressure on the Finance Minister to tax the rich more as an alternative to resource mobilization. I hope our FM knows that you cannot make the poor rich by making the rich poor.
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