- Wealth PMS (50L+)
My latest column at Yahoo is about how taxes muddle our investment decisions:
Nothing is certain but death and taxes, an old saying goes. The man who said those words went on to die, and no longer needs to worry about taxes. But you and I do — and I sometimes feel that taxes are a more painful choice. Anyway, from an investor’s point of view, taxes impact our returns and complicate our investment choices.
Consider for instance, the average bank Fixed Deposit (FD) at 7% a year. If you invest Rs 10 lakhs you will receive an income of Rs 70,000 a year. If your net income, including this interest, is greater than 5 lakhs, you’ll end up paying 30.9% as taxes, reducing your income to Rs 48,370 – a post-tax return of just 4.84%.
You might invest the same amount in a Fixed Maturity Plan (FMP) or a “Growth” plan from a mutual fund, which delivers the same 7% in a year. As a “long-term capital gain”, you pay a lower 22.66% tax after “indexation” – a method that lets you account for inflation. If the announced inflation figure was 5%, you pay tax only on the “excess” 2% you earned as interest, or Rs 20,000 out of the 70,000. The total tax outgo? About Rs 4500, and the post tax return is approximately 6.5%.
Put another way, FDs taxed your income 30%, while you paid just 6-7% of your income as tax with debt mutual funds or FMPs.
Sounds straightforward, right? The post-tax return for the FMP is much better, so is there really a choice to be made? The answer depends on who you are.
If you’re a high-earning, high-tax-paying individual, the above applies to you. But if you’re a retiree or a person with no other source of income, the Rs 70,000 is less than the minimum taxable income slab, and you pay zero tax. In that case, the fixed deposit is better – you get to keep the whole 70,000 versus the FMP where, regardless of who you are, you’ll pay the 4500 as capital gains taxes. 
Another factor you need to consider is tenure. Assume you invest in a dividend-paying debt mutual fund instead. A long-term debt fund will pay you dividends ever so often, and pay the government about 16% as dividend tax – you pay no tax on dividends received, but indirectly bear the tax as your fund depletes in value by the taxes paid. Is that more efficient for you? If you plan to hold for less than a year, you will no longer get the benefit of indexation or long-term capital gains tax reductions, and the income gets taxed at the highest level – so dividend funds are better for high tax-payers who want some short-term interest.
In case you are wondering why people don’t rush into mutual funds, remember they cannot guarantee returns or even capital, so the 7% return is hindsight, even if they invest in ultra-safe instruments. In an FD, the bank can guarantee the same 7%; many people feel a known devil is better than an unknown angel.
What’s amazing here is that an FMP or a debt mutual fund can in turn invest in the very same fixed deposit by the bank! The tax differences have changed your returns, while it was really the same investment – the bank deposit.
Taxes distort our returns by changing incentives and behavior as well. Ever since our finance minister made long-term equity capital gains non-taxable, investing in equity has taken off in a big way. Yet, ask a person if he would sell shares that have moved wildly beyond his ambitions, and he’s likely to tell you he’ll wait till a year has passed, so he can avoid paying taxes. But just a 10% fall in the stock price could obliterate any tax savings made.
Tax-based behavior changes are territory-agnostic. In China, there have been no property taxes, so people have bought third and fourth homes; a recent proposal to introduce a property tax is said to have cut real estate sales by 70% just because of the uncertainty. On tax-avoidance, Business Week reveals a complex maze of regulatory loopholes tapped by Forest Laboratories to avoid US income taxes by routing transactions through Amsterdam, Bermuda, New York and Dublin. Back in India, the zero-tax on software exports has built a huge IT industry; yet, the market for local software for the Indian market, in local languages, has hardly developed – there is no tax incentive.
Back to personal finance: In Insurance, Provident Fund and certain tax-saving mutual funds, there’s a tax saving on the investment made, and the returns are tax free! These incentives make such products exciting, especially in March every year, when most people salivate at the very mention of “tax-saving” — to the extent they would prefer a product giving lousy investment returns just because it could help them save tax today – a today saved, for a tomorrow wasted. (In my last article, I mentioned a “tax-saving” insurance firm being able to quote a 5.4% yield on a ULIP being superior to a 7% fixed deposit – it indeed may be so because of the tax distortions!)
Taxes are an enormously important part of our investing habits, and it’s all about to change.
Enter the Direct Tax Code (DTC). The DTC will be effective next year, and in its current draft changes the tax distortions substantially. Tax slabs are relaxed, and most deductions have been removed. Any investments made to save tax – under section 80C – will attract the tax when you exit, not just on the returns, but on the principal as well (since you’re assumed to have saved tax on the principal). Equity investments are no longer untaxed in the long-term; they will be taxed just like other asset classes such as debt or gold, by allowing for inflation through indexation.
While the DTC flattens tax structures by removing most exemptions and leveling the playing field, it hurts decisions made today. Buying insurance this year has no tax saving in reality – whatever tax you save today, you pay in subsequent years when you exit. Taken in isolation, this concept is still favourable to you because as you put in pre-tax money today, the power of compounding applies on a larger sum. But it is negative relative to a position a few years ago, when your investment saved you tax on entry and if you exit today, you’re not taxed. Also, the old concept of taking on bad investment returns because, post-tax, they saved you some? That will no longer apply.
It’s impossible to predict long-term taxation changes – how could someone who bought an insurance policy in 2002 for 10 years ever predict that he would be taxed on his entire return on exit? After all, in 2002, there was no such tax; but the Direct Tax Code, in its current form, doesn’t “grandfather” such contracts, so the tax will have to be paid.
What do we do then? It’s illogical to try and predict tax changes, and we will have to assume that what is not taxed today will be taxed at some time tomorrow. In a world where governments have borrowed through their noses, the only way ahead is to increase taxes, and to make them level. When taxes are taken out of the picture, investments might be easier to analyze and compare.
Investing today, for instance, on “Special Economic Zones” on the basis that a tax-free status is a given is fraught with peril – the rules can change to their disfavor. Instead, a better bet would be a company that has greater productivity and more transparent management: the tax-free status is just a kicker. Buying insurance as an investment today, or a “tax-saving mutual fund” has the disadvantage that the Direct Tax Code will tax returns on exit after the three-year lock-in period; instead, invest in a fund that’s had better long-term performance. (Most diversified funds seem to have beaten tax-saving funds handsomely in the last few years.)
Tax considerations are useful in the short term when there is visibility on changes such as the DTC. But in the long term, we would do better by taking on investments on individual merit rather than letting taxes distort our view.
 Yes, Taxes may be deducted at at source, but a person without income can use Form 15G/15H to request they aren’t.