Is EET the right tax treatment for savings?/ Dec 13, 2005 / The Economic Times
From Indiapensions
Is EET the right tax treatment for savings?
How should tax policy treat the three stages of savings: contribution, accumulation and withdrawal? The government proposes to move from the present Exempt-Exempt-Exempt system to Exempt-Exempt-Taxed. Three experts weigh the pros and cons.
The finance minister made an announcement in the budget speech on the constitution of a committee for making recommendation on Exempt-Exempt-Taxed (EET). This would mean that the maturity proceeds would become fully taxable as against the current exemption under Section 10(10D).
It is important to understand the basic nature of insurance contract and its significance as an important social security measure. It is equally important to realise how insurance is different from other investment options before the insurance is brought into the ambit of Exempt-Exempt-Taxed.
The following points are noteworthy in this regard.
The primary objective of a life insurance is to provide life cover and long-term savings. The proceeds generally help the dependents in the unfortunate event of demise of the person and is a very powerful social security tool.
The proceeds also help the individuals to meet other commitments in life, for example education and marriage of children, providing financial support during old age.
Insurance contracts are generally long-term in nature and are not meant for channelising short-term investments of the individual. This is supported by the fact that there is generally lock-in clause in insurance policies and the policy acquires surrender value only after few years for which one has insured.
The last budget announced the exemption of Rs 1 lakh applicable to all taxpayers irrespective of their income brackets. This opens a high potential target segment for the insurance industry. As stated above, the importance of insurance as a social security measure should not be undermined especially when there exists constraints with the government in terms of access of public funding for medical and old age needs of the public.
The earnings of the insurance policy should continue to remain tax-exempt. It is important to note that the surplus of the life insurance fund is taxable and therefore to avoid any double taxation impact, the earnings should remain tax free in the hands of the policyholder.
Further, in order to provide level-playing field vis-à-vis equity mutual funds, where the earnings of the fund are exempt from tax and no distribution tax on the dividends, the income of life insurance fund should also be made exempt vis-à-vis 12.5% currently. In this regard, a threshold limit of investment in equity markets can be prescribed.
Insurance products are distinct and different from other mode of savings, for example public provident fund, mutual funds, fixed deposits, bonds and shares. While insurance is long term in nature and provides social security, the other modes of savings are generally short term and are made only with the intent of generating income without any social security mechanism.
In most countries, the maturity proceeds are exempt from tax. In India, in case the maturity proceeds are taxed, it will adversely impact the nascent insurance industry and will lead to diversion of funds into short-term avenues and therefore defeat the purpose of privatisation of insurance industry to provide alternate and innovative social security option to the public at large.
Further, there already exists a restriction in the Income-Tax Act, prescribing that the maturity proceeds would be taxable if the annual premium exceeds 20% of the sum assured. Thus, the insurance policies taken with the intent of short-term investment by certain customers is already taxable.
It is therefore important for the government to recognise the importance of long-term savings and encourage the same by ensuring that the taxation policy on long-term savings is Exempt-Exempt-Exempt.
In India, at present, with a view to extending tax support to savings a wide variety of savings and insurance instruments enjoy EET treatment. This is most likely on the assumption that in the absence of incentives, individuals will fail to make sufficient provision for their non-working years, and also, since small savings have been a convenient source for governments to access public funds.
However, the empirical evidence shows that there is no clear nexus between the level of taxation and the other factors affecting the rate of return and the level of savings. Rather than encouraging savings by the vulnerable sections of the population, tax incentives on savings instruments in developing countries have been found to benefit only the upper echelons, who have the capacity to generate surpluses.
However, to ensure that there is no double taxation of savings, first at the point of contribution and again at the point of maturity, as would be the case under a comprehensive tax on income, there is reason to extend preferential treatment to savings. Worldwide, the alternative to comprehensive income tax is the expenditure tax model, which taxes the returns from savings at the point of consumption.
This takes the form of an EET system (exemption at the point of saving and accrual of interest and taxation at the point of consumption),or a TEE system (taxation at the time of investment and exemption on accumulation of interest and on withdrawal at maturity).
EET is normally preferable, because under TEE, which taxes at the point of investment, an individual is generally employed and falls within a higher tax slab, compared to the tax rate applicable to him when he is no longer in active employment, at which time withdrawals from savings, though taxable under EET, can be calibrated in such a manner that he is not pushed into a high tax bracket.
With the introduction of taxation of employer’s contribution to superannuation fund under the fringe benefit tax through the Budget 2005, in the interest of avoiding double taxation, a view will have to be taken as to whether the private employer’s contribution to such a fund will suffer TEE taxation under FBT or EET taxation, along with other savings instruments which may be recommended to be brought under the EET umbrella.
As of now, with a few exceptions, like contribution in certain pension funds of LIC or central government, which get EET treatment, most savings instruments get the entire tax holiday through EET. With the migration to the new system, according different tax treatment to savings instruments having almost similar terms of maturity would result in different effective yields, resulting in confused signals for investment decisions.
It is hoped that a harmonious treatment of savings instruments having similar returns (whether they be pension funds or others) is extended. Under Section 80C, in its new avatar since the Budget 2005, contributions like repayment of principal for house building advance, expenditure for education of children were also accorded EEE treatment. It is difficult to see how EET can be extended to these forms of investments!
While migrating to EET, the salient features of a cap (presently of Rs 1lakh) should be retained from the EEE system, for without a cap on the quantum of contribution, high-income taxpayers will have the opportunity to accumulate an unlimited amount of capital in specified instruments.
At present, round-tripping of investments from funds like the GPF are possible, as the EET system is not able to catch this. A minimum maturity period needs to be introduced through the EET, to plug this loophole.
As the overly liberal EEE has distorted economic choices and impacted on equity and revenue efforts, the transition to EET, if managed with sensitivity to the vulnerabilities of the low income groups, should be considered as a step forward in tax reforms. The “grandfathering” of the previous schemes, (letting savings made under earlier schemes on the premise of EEE treatment remain as EEE), will be a step to make the migration to EET smooth.
Consumption expenditure, rather than income, serves as the most efficient form of tax base under an ideal tax system. Under comprehensive income-tax system, all sources of income are explicitly taxed while the expenditure tax only taxes consumption. EET system is a classic example of expenditure tax and is considered a better international practice relating to taxation of financial savings.
In most countries, it is mandatory for individuals to contribute towards social security (saving for old age, invalidity, unemployment protection, etc). There is a strong case for tax support to savings for social security. However, the OECD study of taxation and savings concludes its survey by observing that “there is no clear evidence that the level of taxation along with other factors affecting the rate of return does generally affect the level of savings.”
EET-based taxation is not new in India. The National Savings Scheme introduced earlier and more recently the annuity plans of insurance corporations and defined contribution plans of the central government follow this method. Savings are also taxed under the TEE method, where contribution to a saving plan/scheme is out of post-tax income and accumulations and withdrawals are tax free.
However, most of the small savings instruments in our country come under EEE category where the contributions, accruals and withdrawals are exempt from tax. These include contributions to Provident Fund, superannuation fund, post office savings, central government securities, NSCs, equity and debentures of infrastructure companies etc.
Under income tax, chapter VIA providing for deductions from gross total income was introduced in 1965. Designed to serve various social and economic objectives, it replaced the system of rebate. This deduction method was more or less abandoned in favour of tax rebate system in 1991-92. The Budget 2005 has done away with Sections 80L and 88 and has substituted the same with 80C providing for income deduction of Rs 1 lakh replacing a system of tax rebate.
Experts say that the psychological impact of EET would be greater in promoting financial accumulation. Almost 2/3rd of the OECD countries follow the EET system. The Kelkar Committee recommendations have categorically suggested a move to EET system for all saving instruments including receipts for life insurance policies, PPF, EPF, GPF, approved superannuation funds, etc from the current EEE system.
The recommendations provide “grandfathering” of these instruments whereby employees would be requested to open new accounts and contribution, accumulation and withdrawals would be subject to EET in the new scheme while the old scheme could continue to enjoy exemption on all of these. A judicious mix of both EEE and EET schemes in the system would be a desirable alternative.
Savings are encouraged to augment capital formation in the country for accelerating economic growth. The funds remain in the economy and help reducing wasteful expenditure. As per the economic survey, our household savings as a percentage of our GDP is around 24%. This can be increased significantly if there are no ceilings on savings eligible under EET. However, exemption for unlimited savings on the EET would not meet the ends of ‘vertical equity’ and revenue loss could be substantial.
The concept of savings is usually long-term oriented. In an ideal scenario, there should be no reason for differential treatment for long-term and short- and medium-term maturity. Again, a judicious balance of long-term and short-term maturity would be welcome.
Kelkar’s recommendations for introduction of a new scheme called “Individual Savings Account”, is a step in that direction. Considering the demographic shift in India where more than 70% of today’s population was born post-1970, a balance ought to be followed for rationalisation of tax system on savings instruments in a manner that the interests of lower and middle income groups are protected.
