In the article on fiscal policy (click here to read) we discussed conceptual framework behind subsidies. A good subsidy will be on merit goods (for everyone) and should be well targeted (to poor). If the subsidy is not well targeted, it can result in inclusion error (well offs getting benefits) and exclusion error (poor not getting benefits). We also discussed govt should be most sensitive about exclusion errors as they affect poor directly <poor woman not getting kerosene won’t be able to light up her home>. In the JAM chapter of the economic survey, we read JAM trinity has the potential to weed out ghost beneficiaries and thus minimize inclusion error. In this chapter we shall discuss, subsidies which leak to relatively well off sections of society <above bottom 30% in income distribution>.
Performance of a subsidy programme can be judged on two criteria
- Equity- i.e subsidizing those goods and services that account for a large share of expenditures of poorer households <for instance food account for >50% share of household budget of poor but very little share of rich, subsidisng food or not taxing it at all will be proportionately more beneficial for poor than rich>.> On the other hand subsidizing a good/ service such as airfares/ ATF (aviation turbine fuel) which is mostly consumed by rich will not benefit the poor and thus will not be equitable>
- Effectiveness– depends on how well targeted the subsidy is .Suppose a good is consumed by poor such as kerosene but also used in other industries <adulterating diesel for instance>, not targeting well will result in leakage. Higher the amount used by non targeted goods, lesser the effectiveness of subsidy.
Based on these aspects, let’s discuss the bounties for the well off by the govt.
The government spends nearly 4.2% of GDP subsidising various commodities and services. this data is from last year’s economic survey. This considers all implicit as well as explicit subsidies at both central and state level such as subsidised passenger fares, subsidised electricity etc. This is not how subsidies are shown in the budget. As we discussed in the fiscal policy article, govt budgets about 10% of expenditure as subsidies i.e about 1.6% of GDP (only major explicit subsidies are considered there).
Case of small savings – These schemes were created to mobilise saving by encouraging “small earners” to save, and offered above market deposit rates in accessible locations like post offices.
We discussed that one distortion of small savings rate where rate is decided by govt is incomplete transmission of monetary policy (click here to read more about monetary policy and transmission) by banks but the issue here is are these schemes even benefiting small savers i.e. poor.
First things first, these are not just small. There are three types of schemes-
- “actually small” schemes- Eg. postal deposits, schemes for the elderly and women <poor people deposit small amount>
- “notso-small” schemes- Eg. Public Provident Fund (PPF) <generally tax payers deposit upto 1.5 lakh rs limit i.e not so small amount and tax payers are at the top 5% of income distribution in India i.e not at all poor, not even middle but rich>
- “not-small-atall” schemes– Eg. tax-free bonds issued by Public sector Companies <generally rich people deposit on avg 6 lakh per person i.e not small and poor don’t have 6 lakh rs to deposit>
Moral of the story so far is that we should not grudge first type of small schemes (post office savings schemes) for they are for the really needed i.e equity principle holds true.
But the benefit these schemes confer are much beyond the difference b/w rates of interest. Actual benefit is because of tax concessions and here they become even more iniquitous <poor even middle income groups are so poor, they don’t pay income tax. Only top 5% of population pay income tax>
How are savings taxed
Savings can be taxed at three stages
- Contribution stage <when you deposit the amount>
- Interest accrual <interesting earnings>
- Withdrawal stage<when you take out principal and interest>
Income tax is inherently biased against savings; it leads to double taxation in so far both the savings and the earnings are taxed <taxation of deposits as well as interest earnings>. So to eliminate this bias and promote savings, tax incentives are given. So savings may not be taxed at all in what is known as EEE (exempt exempt exempt) i.e exempt from taxes at all three stages of taxation. Or they can be taxed at deposit and earning stage (TTT). Or tax at the time of withdrawal only (EET) or making earnings tax free (TET)
Note that, TTT or TET does not mean you are tax both at the time of deposit and withdrawal. Same income won’t be taxed twice. Hence taxation at the time of contribution is deemed to be taxed at the time of withdrawal.
Let’s understand this with example
|Scheme||Deposit||Initial Tax savings (30%)||Interest (10%)||Tax on interest (30%)||Tax at withdrawal||Real interest|
|EEE||100k||30k||10k||0||0||10k + 30k in tax savings|
|EET||100k||30K||10k||0||30k + 3k||7k|
Clearly EEE scheme (provident fund) and TET (tax free bonds) give higher returns. Survey calculates that implicit subsidy is about 6% (R 12,000 crore) on Provident fund (not so small savings) and 3.7% on tax-free bonds (not at all small saving and investment by largely rich).
This is based on data that only 5.8% of population earns more than 2 lakh rupees to come under income tax net. Even more starkly, major benefit is reaped by those in 30% tax bracket (income more than 10 lakh) who are among top .5% of population. IN developed countries, greater proportion of population pay taxes and thus these schemes benefit middle class as well.
So how should savings be taxed?
Case for concessional tax treatment of savings -tax concession for savings # higher post-tax return for the investor # positive substitution effect in favour of savings rather than current consumption. <higher savings # higher investment # good for economy esp for a capital starved economy like India>
But problems with the way scheme is designed in India
- It also creates a disincentive for savings (income effect), since the higher returns now require lower savings to meet the lifetime savings target. <If a person needed to save 1lakh rupee for his old age, he now will have to invest less to save equivalent amount>
- 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 <no incentive not to withdraw full amount at the maturity>
- Tax incentives for savings distort the interest structure and choice of saving instruments. They just divert 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.<depositors won’t lend to banks at lower rates hence banks unable to pass rate cuts to consumers>
- regressive 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.
Economic survey suggests EET method of taxation for following reasons-
- savings (contribution) reduce cash flow # the ‘ability’ to pay # taxation would create hardship # disincentive to save.<if I save 100k, consumption decreases by equivalent amount and over that govt taxes me, why would I save>. Taxation at the point of withdrawal (principal or earnings) occurs when the ability to pay is greater and therefore, justified on principles of taxation <after all, now my income is actually increasing>
- TEE # taxation at the point of contribution # no immediate incentive to save # exemption of withdrawals # encourages withdrawal. Under EET # full deduction at the point of contribution and accumulation # incentive for savings # taxation at the point of withdrawal # disincentive for withdrawal.
- TEE # withdrawals are exempt irrespective of the amount # no incentive for consumption smoothening <will withdraw the whole amount in one go>, Under EET # More you withdraw # come under higher income tax bracket # withdraw in staggered manner # consumption smoothening
- no uncertainty about the potential tax liability
- extremely simple in terms of compliance and administration
- most developed countries and many developing countries are implementing the EET method of taxation of savings
Case of Gold-Top 20% consumes 80% of gold yet gold is taxed at rate of <2% compared to standard tax rate of 26% (centre + states)
Railways– Reserved class is hardly used by poor (bottom 30%), yet upto 34% of reserved class fare is subsidized.
LPG-91 % of subsidies are accounted for by the better-off as their share of consumption of LPG is 91% compared to 9% for poor (bottom 30%)
Electricity– Better off are subisdized about 32% of electricity bill while poor about 49%. But since 84% of electricity consumption is by better off, acutual subsidy amount will be pretty high.
ATF- There’s no point subsidizing ATF or taxing it less than diesel for no poor travels by air. Yey ATF tax is 20% compared to 55% for diesel and industry still keep clamoring for lower taxes on ATF.
Kerosene– 50% of PDS kerosene is consumed by better off.plus adulteration etc
If we add it all total subsidy to well off comes out to be more than 1lakh crore i.e 16b$ (.8% of GDP).rupees and we haven’t yet added corporate tax exemptions. Contrast this with expenditure on health, a merit good, social responsibility of govt, just 1.3% of GDP.
Addressing these interventions and rectifying some egregious anomalies may be good not only from a fiscal and welfare perspective <more govt budget for actual needy i.e poor>, but also from a political economy welfare perspective, lending credibility to other market-oriented reforms. <govt is pro rich barbs whenever any market oriented reforms are undertaken> It is also an opportunity foregone to help the truly deserving.
Criticism of this analysis (personal views)
- Higher taxes on gold hurts the jewelers. But most importantly promote black marketing, black money generation and corruption <people will buy gold at cheaper rate in Thailand and smuggle to India>
- People earning 2 lakh rupees or 5 lakh rupees can not be termed super rich by any stretch of imagination.5 lakh per annum for a family of 5 turns out to be kust 1lakh per capita i.e 8k rupees per person per month. Problem is with super rich(top .1%, not even 1%) and high amount og agri income not being taxed(issue addressed in next chapter)
- Political economy argument-Just as govt reduced interest rate on provident funds, barbs of pro rich, pro-corporate started being labelled on govt. Fact is that voice of vociferous minority(salaried middle class, super rich according to survey) is much more than silent minority(poor) as we discussed in chapter on exit problem.