Union Budget 2024: Tax-free bank deposits may stifle flow of funds to capital markets
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With another Union Budget around the corner, expectations are high over income tax breaks. This time around, the buzz is over proposed plans to make interest on bank deposits tax-free. But do bank deposits deserve an I-T exception?
Currently, if the total income from salary, rent and interest goes above the tax-free threshold, you have to pay income tax at 5 to 30%, depending on the income slab you fall in.
However, capital gains (profit on the sale of capital assets such as shares and property) are taxed differently. Profit earned from equity shares, bonds/debentures and equity mutual funds are classified as short-term capital gains (STCG) if sold within 12 months from purchase and taxed at a flat 15%. While the long-term gains (LTCG, ie profit booked for sales after 1 year of purchase) of more than Rs 1 lakh are taxed at flat 10% and not on aggregate income. That is, if you have Rs 2 lakh from LTCG and Rs 49 lakh from all other sources, tax is payable only on Rs 1 lakh LTCG at 10% while the remaining will attract rates up to 30%.
Thus at higher aggregate incomes, more is taken from deposit interest than from equity and bond returns as income-tax. A recent report from the SBI economic research department has questioned this special treatment for capital gains from financial assets and proposed equal treatment of both deposit interest and capital gains.
Bank deposits are probably the safest investment in India – there is an explicit guarantee for deposits of up to Rs 5 lakh per depositor per bank and for amounts above that, there is the implicit guarantee from RBI (ie. the apex bank would rescue all troubled banks to ensure that no depositor loses their savings). Thus savers need not worry about the safety and liquidity of bank deposits – all they need to care about is interest rates. This safety ensures that there is a huge chunk of savings freely flowing into banks.
While banks guarantee the safety of your deposits, investments in the stocks have high risk. You can lose all your money due to the vagaries of the market. Thus, is it unfair to offer some tax incentives on such a risky investment?
Another issue raised in the SBI report is the taxation of capital gains only upon sale of stocks whereas deposit interest is taxed even on interest due to the depositor but not paid (in case of deposits with compound interest; also referred to as cumulative deposits). But banks pay you back the amount shown in account statements and deposit receipts and hence what is accrued is guaranteed to be paid. Gains from stocks are realised only when sold and unlike bank deposits whose value can only go up over time, stock prices can go down and end up in losses too.
In other words, in the case of bank deposits accrued gains are fully realised whereas in stocks accrued gains may or may not be realised. Thus the demand is for equal treatment of unequal investments. Moreover, dividends from equity shares (which are not capital gains) are treated on par with deposit interest for taxation. Unlike interest on bank deposits, it's a company's discretion to pay the dividend. Not all companies in profit pay dividends and even when they pay, dividend yield is extremely low. So the only source of gain for most equity investors is the capital gain. Hence, investors would argue that the special treatment is legit.
Currently, loan growth of banks is higher than deposit growth. One of the reasons for this relatively slower growth is personal savings flowing into equity markets. (Technically, when you use your bank balance to buy shares, the amount ends up in the deposit or loan account of the seller of shares with the same or a different bank. If in a deposit account, funds don’t leave the bank, but if in a loan account, the deposit leaves the bank. Thus, that amount either funds or reduces an existing loan, but it cannot fund a new loan.)
Isn’t it fair to ask the bankers to pay higher interest if they want more deposits so that post-tax returns are higher? Why should the government give up on much-needed tax revenue and cut down on government services to citizens? This when bad loans of Indian banks are at multi-year lows and profits and profitability ratios at multi-year highs. Stock markets will eventually turn less bullish and may even crash and at such times savers come back to banks.
Ever since the liberalisation, banks and stock markets have attracted a lot of savings whereas earlier most of the savings were in land and gold. Financial savings circulate in the economy and promote economic growth.
Financial savers get better returns when there is competition for their savings from different players offering a range of returns at different levels of risk. And for the typical risk-averse Indian investor, tax incentives for the riskiest investment are a low-cost nudge.
Tax-free bank deposits may nudge such an investor away from equity markets and will deny her the huge gains equity markets have delivered. And all those gains will be taken away by foreign portfolio investors! India needs a lot of risk capital and our savers too need a slice of gains from such capital. Hence it seems best to maintain the status quo.
(The writer is an ex-banker and currently teaches economics & finance.)