How Crippled the MFs with Tax Crutches Gone?

Is Inflation a Bigger Problem Than Tax ?

The union budget-2023-24 was recently passed without any discussions or debate in the parliament. Independent of the government in power, budgets over the years have suffered from poor construction due to the lack of a two-way dialogue between the government and the public. However, the pretensions of a debate before its passing in the parliament provided a synthetic comfort of scrutiny to the public outside. This year may be a unique one with even that process eschewed.

A Finance Bill which is introduced during the budget covers a lot beyond the modifications to the tax rates and the hustle to pass the budget within the permitted time costs the quality of discussions on the detailed amendments or its scrutiny by the parliament which has select committees for such purposes.

Even the government run by the ‘party with a difference’ has not changed this malaise. Worse is the habit of items completely new being smuggled in during the process of approval by the parliament. There have been one too many in the recent years and sets at nought the process of legislation and makes it more like an ordinance.

One such surgical strike in the latest edition, is the felling of the tax benefits to investment in the debt schemes of the mutual funds. Effective from 1^st April,2023, investments in debt schemes of the mutual funds would lose the benefit of classification as a long-term capital gain that entitled both the facility of cost indexation and a lower rate of tax.

To be fair, this subject has been a nettlesome issue for the banks which felt discriminated. An investment in a bank fixed deposit that was akin to an investment in a debt scheme did not qualify for the better tax dispensation. The banks felt that the cheap source of public deposits was being tapped into by the MF industry by dangling the carrot of tax optimisation.

The arbitrage that existed was difficult to justify and continued in the statute book either by default or due to the better canvassing ability of the MF industry. Its removal cannot be seriously faulted. Only the suddenness of the change is the cause for complaint.

MF industry has been burning the midnight oil for the last few days to channelise as much money that it can into debt schemes as the window closes on the midnight of March 31. It is to be seen if the MF industry would seek special permission to keep their shops open late on that day as normally the closure is by 3 PM on any day.

The unkindest cut is laced with some mercy as investments made before the deadline as said above would continue to enjoy the tax benefits irrespective of when the money is redeemed. An investor can keep an investment in a debt scheme technically going for many years and the applicable law on long term taxation would enure. Only if the scheme of taxation for long term assets changed subsequently for the worse would these investments be hit, equally.

Was there sufficient logic to extend the benefit of lower taxation for such debt schemes in the first place? It was a default position whereby growth schemes of mutual funds stood treated like any other capital asset and the gain was subjected to tax as capital gains and the classification of short and long term followed.

There was a point in time, the dividend income from debt schemes that suffered a lower rate of tax was dispensed with presumably on the representation by the banks. Once the dividends from the debt schemes became taxable like normal income, the benefit of lower tax on the gains arising on redemption became untenable.

A lower rate of tax for long term capital gains has no economic rationale at all irrespective of which type of asset it arises from. A return on an asset is an economic outcome based on risk and reward, and market forces. Tax has no role to play at all. The debt schemes are not the last of such cases. Even equity being taxed on its gains at a lower rate has little economic rationale. In fact, the latest law has introduced a new tier of taxation for mutual fund schemes with a partial equity holding of not less than 35%.

If the tax rate should not vary for different types of income, does the concept of indexation justify on economic grounds? This certainly does. Inflation is a more ubiquitous and surreptitious cost than any other form of levy. India, unlike the west has always been a land of high inflation. The west is also caught in this problem now. A fixed return that is not indexed to inflation signifies progressive erosion in the capital giving rise to the return. A four percent annual interest on an investment with a five percent inflation is amounting to a progressive loss of capital.

That is the reality of the bank deposits and other fixed income options in the system. Even banks that have a weak balance sheet tend to have an average interest paid on its aggregate deposits of not more than five percent. Stronger banks have a much lower average cost which is lower than three and one-half percent (350bps).

It is difficult to find any period when the inflation was not more than this figure. Even the inflation index number allowed for tax purposes between 2014-15 and 2022-23, is working out to slightly over four percent annually. The actual inflation would be much higher as the indexation historically covers not in excess of 75% of the real inflation.

Thus, persons eking a fixed income from bank or similar deposits clearly suffer more than the tax they are levied on the income. A detailed analysis may demonstrate that a good portion of the tax may be operating as a wealth tax though not called that!

How could this problem be addressed? A possible solution is to use the index figures given for capital gain purpose to adjust the deposit income and tax only the residual. If a person received say effective return of five percent on investments and the inflation index for the said year was say four percent, the tax should be levied only on the difference.

If such a system could be introduced, it may eliminate the artificial difference between revenue and capital in many instances. Whether the investment is made in a bank FD, debenture or a MF scheme, the indexation of income will eliminate the need to classify assets, artificially as long term and short term and have different rates that have little meaning as these are arbitrarily set.

Some of the tax eagles feel that the change effected in a hurry is incomplete and the indexation benefit has not been explicitly withdrawn for debt schemes though the gains are categorised as short term. This is best left to the tax brains to butt their heads!

To conclude the subject, the investors who are rushing into mutual funds for securing the tax advantage should be vigilant as the funds may tend to hike the expenses slowly given that new accretions will stop post 1^st April and the fixed costs would need to be amortised over a stagnant pool or worse, a declining one.

Note

Those interested can listen in to the discussion that addresses a few more relevant issues.