Saturday, 27 February 2016

Extract from Economic Survey 2015-16 : Bounties for the Well Off

Subsidies for the poor tends to attract policy attention. But a number of policies provide benefits to the well-off. We estimate these benefits for the small savings schemes and the tax/subsidy policies on cooking gas, railways, power, aviation turbine fuel, gold and kerosene, making assumptions about the definition of “well-off” and the nature of neutral policies. We find that together these schemes and policies provide a bounty to the well-off of about Rs 1 lakh crore. We highlight that policies that are based on providing tax incentives will, in India, benefit not the middle class but those at the very top end of the income distribution.
For example, the average income of those in the 20 percent tax bracket places them roughly in the 98.4th percentile of the Indian income distribution, and the corresponding figure for the 30 percent tax bracket is the 99.5th percentile.

6.1 The government spends nearly 4.2 percent of GDP1 subsidising various commodities and services. Public discussion of these subsidies focuses on their importance in the economic lives of the poor. This chapter shows that the Indian state’s generosity is not restricted to its poorest citizens. In fact, in many c

ases, the beneficiaries are disproportionately the well-off. In at least one area – corporate taxes – the government has recently taken decisive action, by identifying and quantifying exemptions amounting to about R62,000 crore2 and announcing a clear path for phasing them out. A move to GST would also eliminate leakages due to rationalisation of indirect tax exemptions estimated to cost R3.3 lakh crore.3 These commendable efforts could be extended to other areas where the poor and vulnerable are not exposed.
6.2 The aim of this chapter is to document some of this largesse, in areas that often attract policy attention. Our list is neither exhaustive in scope, nor precise in its estimates. But it nonetheless allows a broad understanding of how much government subsidises the betteroff.
6.3 We focus on seven areas: small savings schemes, kerosene, railways, electricity, LPG, gold, and aviation turbine fuel (ATF). In each case, we highlight salient facts and estimate the subsidy’s magnitude. 
“SMALL” Savings
6.4 “Small” savings schemes were initially created to mobilise saving by encouraging “small earners” to save, and offered above market deposit rates in accessible locations like post offices for this purpose. Recent discussions have focused on one efficiency cost of “small” savings schemes – how they hinder monetary policy transmission. Because small savings schemes offer high and fixed
deposit rates (within year) and compete with banks, it is difficult for banks to reduce their
own deposit rates and hence pass on policy rate cuts to consumers in form of lower lending rates. Recently, the government has reduced rates on some small savings schemes to make them more responsive to market conditions.
6.5 But questions also arise about the equity of small savings schemes: what is the rate offered on these instruments, who benefits from them, and how large are these implicit subsidies? These findings are highlighted in
Tables 1 and 2.
6.6 It is misleading to characterise these savings schemes as “small”, because in fact there are at least three types of schemes, only one of which can really qualify as “small.” This first set of “actually small” schemes ranges from postal deposits to schemes for the elderly and women. The second set is of “notso-small” schemes, which includes the most important of all – the Public Provident Fund
(PPF). And the third category is “not-small-atall” schemes, which includes tax-free bonds issued by designated public sector companies like IRCL, IIFCL, PFC, HUDCO, NHB, REC, NTPC, NHPC, IREDA, NHAI and others, supposedly to finance infrastructure projects.
6.7 The interest rates on most of these schemes are fixed (for year), but they vary in magnitude and periodicity. Whatever the terms, the key determinant of their real return is their tax treatment. Ideally, savings schemes should be taxed according to the “EET principle”. The first “E” stands for tax
exemption of the contribution, the second E for exemption of interest income, while T stands for taxation of the principal (and interest) when it is withdrawn. The logic of this principle is explained in the Box 1 at the end of this section.

6.8 Most schemes in the “actually small” category are TTT – neither the interest nor the contribution to the scheme are exempt from tax under Section 80C4 of the Income Tax Act. By contrast, the PPF, which is a “not-so-small” scheme is EEE: the interest is tax exempt, contributions are tax exempt, but
up to a limit of R 1.5 lakhs, and tax exempt at the time of withdrawal. Finally, schemes in the “not small at all” category are TET – the contribution is taxable but the interest is tax exempt and there are no limits (unless otherwise indicated at the time, they are issued) on the permissible subscription to
these bonds. 

6.9 The effect of all these special treatments can be summarised into one metric—the effective rate of return on these instruments compared with the return on a comparable savings instrument, say saving account deposits in the case of post office savings, and 15-year G-Sec in the case of PPF and
tax-free bonds. Table 2 shows that the return on PPF contributions and tax-free bonds are particularly high (Table 2). 

6.10 We can indirectly infer how well-off beneficiaries of the PPF scheme are. Roughly 62 per cent of total 80C deductions in FY 2013-14 were accounted for by taxpayers with gross taxable income more than R4 lakh (47 per cent by those earning more than R5 lakh). These individuals are at the 97.3rd and 98.4th percentiles of the income distribution respectively – hardly “small”.
6.11 While not all 80C deductions are PPF deposits, they appear very sensitive to 80C contribution rules. In 2014-15, when the limit for the 80C deductions was increased by R 50,000 there was an almost a one to one increase in 80C claims for those in the 20 and 30 per cent tax brackets (Figure-1A and B). From independent data from State Bank of India, we found that this increase was
associated with increases in PPF deposits. 

6.12 In sum, the effective returns to PPF deposits are very high, creating a large implicit subsidy which accrues mostly to taxpayers in the top income brackets. The magnitude of this implicit subsidy is about 6 percentage points – approximately R12,000 crore in fiscal cost terms.
6.13 The interest subsidy on tax-free bonds is slightly smaller—about 3.7 percentage points—but because there are no limits on permissible contributions (other than that dictated by the supply of such instruments), the main beneficiaries are large savers who can set aside large amounts. For example,  the average size of the investment in tax-free bonds by the individuals was nearly R 6 lakhs
in FY 2013-14, which was six times the total exemption limit under Section 80C.
6.14 In light of a number of tax incentives for savings given to individuals it is worth asking how wealthy they are in relative terms. So, we identify the tax thresholds for the 10, 20 and 30 percent tax bracket which were 2, 5, and 10 lakhs, respectively in FY 2013-14. We then compute the average
incomes of the people in these tax brackets were and see where they stood in the overall income distribution (Figure 6.2). The results are striking. In 2013-14, the average income in the 30 percent threshold was R24.7 lakhs and these earners were roughly 25 lakhs in  number (1.1 percent of all taxpayers) and placed in the top 0.5 percent of the overall Indian income distribution. Similarly, the
54 lakh income earners in the 20 percent tax bracket represented the top 1.6 percent of the Indian income distribution.
6.15 These numbers are striking and have one policy implication: any tax incentives that are given, for example, for savings, benefit not the middle class, not the upper middle class but the super- rich who represent the top 1-2 percent of the Indian income distribution. Now, it is by definition true that top taxpayers will be beneficiaries of tax incentives. However, in most countries, they will range
from being middle class to very rich. In India, they are the super-rich.

Box 6.1: Tax Treatment of Savings
Income tax is inherently biased against savings; it leads to double taxation in so far both the savings and the earnings are taxed. In general, the tax system provides for a mechanism to eliminate this bias and promote savings in the economy. This mechanism takes the form of a tax incentive by way of a deduction for contribution to specified savings instruments. In India, savings in several instruments are further incentivised by exempting fully, or partially, the earnings at the accumulation stage as well as the withdrawals from tax (both the contribution and the earnings). In effect, savings are subject to exempt-exempt-exempt (EEE) method of taxation i.e. they are exempt at all three stages of contribution, accumulation and withdrawal.
The case for concessional tax treatment of savings is built on the consideration that a tax concession for savings leads to higher post-tax return for the investor. The higher returns, in turn, create a positive substitution effect whereby, in favour of savings rather than current consumption. However, what is missed out is the fact that it also creates a disincentive for savings (income effect), since the higher returns now require lower savings to meet the lifetime savings target.
There is some empirical evidence to suggest that the positive and the negative effects are neutralized at the economy level. Further, the tax incentives for savings, as designed in India, do not encourage net savings (contribution plus accumulation minus withdrawals) since withdrawals are also exempt from tax. In addition, national savings comprise of household savings, government savings and corporate savings. To the extent, tax incentives for savings lead to fiscal loss, government savings are adversely impacted, thereby partially neutralizing the increase in household savings.
Further, tax incentives for savings distort the interest structure and choice of saving instruments, and merely help mobilize funds to specified savings instruments. They also increase the interest rate at which households are willing to lend funds to banks (i.e., make deposits) , thereby adversely affecting investment. They are also regressive in as much as they provide relatively higher tax benefits to investors in the higher tax bracket; in fact, the real “small savers”, who are largely outside the tax net, do not enjoy any form of tax subsidy on their savings.
Overall, tax incentives for savings, more so as designed in India, are economically inefficient, inequitable and do not serve the intended purpose. Hence, there is a strong case for review of the design of the tax incentives for savings schemes.
While there should be no tax incentive for savings, the question is what should be the tax treatment of savings so as to eliminate the inherent bias under income tax. The emerging wisdom is that savings should be taxed only at the point of contribution (TEE) or withdrawal (EET); the latter being the best international practice on several counts.
First, savings (contribution) reduce cash flow and therefore, the ‘ability’ to pay. Therefore, taxation at the point of contribution would create hardship and act as a disincentive to save. However, taxation at the point of withdrawal (principal or earnings) occurs when the ability to pay is greater and  therefore,  justified on principles of taxation.
Second, under the TEE method, taxation at the point of contribution does not provide any immediate incentive to save nor does exemption of withdrawals discourage dissavings. However, under the EET method of taxation of savings, full deduction from income at the point of contribution and accumulation acts as an incentive for savings while taxation at the point of withdrawal penalizes dissavings. The combined effect is that it encourages the saver to build a self-financing old age social security system. Third, under the TEE method, there is no incentive for consumption smoothening  since withdrawals are exempt irrespective of the amount. However, the EET method allows for consumption smoothening particularly in old age since taxation of withdrawals incentivizes postponement of consumption. Under a progressive personal income tax rate structure, there is an in-built incentive to restrict withdrawals to meet necessary consumption only since lower withdrawals imply taxation at lower marginal tax rate and hence, lower tax liability. Consequently,
the potential for old-age poverty is minimized.
Fourth, the EET method provides discretion to the saver for tax smoothening and minimize the tax liability arising from any bunching of gains. Fifth, because taxation is at the last point in the savings process, there is no uncertainty about the potential tax liability unlike in the case of TEE method where the saver is uncertain whether the Government would impose a tax at the point of accumulation or withdrawal to raise revenue to overcome the fiscal crisis.
Sixth, the EET method is extremely simple in terms of compliance and administration since it can be
operationalized by opening an account with a designated fund which, in turn, can invest in a mix of a broad range of debt and equity instruments depending upon the risk appetite of the saver. All earnings are required to flow into the same account and withdrawals, if any, can be subject to withholding tax. It does not require any complex tracking mechanism to prevent leakage of revenue. It is not necessary for the saver to maintain details of savings and earnings to claim tax benefit.
Finally, most developed countries and many developing countries are implementing the EET method of taxation of savings.
In view of the foregoing, India should move, in a phased manner, to the EET method of taxation of savings. Interestingly, the New Pension Scheme (NPS) is already being subjected to the EET method of taxation.
Therefore, deductions under Section 80C and 80CCD should be re-assessed to move toward a common EET principle for tax savings.

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