Problematic proposal

The finance ministry has set up a committee to suggest a way to ensure that tax-saving investments made by individuals get taxed at the end of their life cycle—under what the finance minister referred to in his Budget speech as the exempt-exempt-tax (or EET) system. Today, taxpayers get a rebate on funds invested in certain schemes, the interest accrued on the savings is also tax-free and there is no tax on the withdrawals either. So the idea of taxation at the end point in the cycle seems fair, except that implementing such a scheme promises to be problematic—even after assuming that all legacy savings will not be subjected to the new tax (without such an exemption, there will be a run on the Life Insurance Corporation!). Perhaps one indication of how problematic things can be is the fact that the committee set up to suggest a method has failed to submit its recommendations on the scheduled date last month.

There are political economy issues involved, for starters. How do you get someone to pay taxes on investments in long-term schemes if the original investment was itself directed there on account of the tax advantage? For instance, in the case of premium payments on life insurance policies, people may have committed to an annual payment of (say) Rs 30,000 when it was tax deductible; if they now have to pay taxes on the final accrual, they may wish to re-evaluate your options, but cannot—unless they foreclose the policy, which usually involves financial loss. A similar problem exists with the employees’ provident fund, where exit options don’t really exist for salaried people. Taxing withdrawals from the fund could be a minefield if you try to separate the initial deposit from the interest component in order to ring-fence legacy deposits.

Then, there is the problem that the tax benefit on exempted savings would have varied, depending on income slabs. Will that be recognised if and when tax is applied on the savings that are encashed? If so, it could become an accounting nightmare. If not, and a uniform tax is applied on all withdrawals from specified savings schemes, then there is unfair treatment of different individuals in different situations.

Since other countries have worked such taxation schemes, some solutions must exist for these problems. But few countries will have the plethora of tax-savings schemes that India does, and the same political sensitivities. Devising acceptable solutions will therefore be more challenging in India. It may therefore be worth considering two possible options. One would be to scrap all tax incentives on savings, so that the problem of taxing exemptions does not arise at all. This raises the question of whether individual savings levels will drop if tax incentives are withdrawn. There have been arguments on both sides of this debate—that savings will in fact be affected, and also that tax incentives merely influence the specific savings instrument chosen, not the absolute level of savings.

The other option would be the more ambitious step of moving to a straightforward expenditure tax scenario. This is what public finance theorists have advocated for long, since it taxes an individual for what he or she takes out of the system (through expenditure), not what is put into it through wealth creation. But that becomes a much bigger issue for the government.