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The key to bringing India's economic growth back on track is to rekindle the animal spirit of entrepreneurs, including the small and marginal entrepreneurs. An economy needs investments to grow, and investments need the savings tap to flow without friction.
The forthcoming Union Budget must address the issue of how to improve the flow of savings to investments, whether in the form of equity or debt. Earlier, only equity capital was thought to take on the risks in business, and hence deserving of preferential tax treatment, which led to differentiated capital gains taxation for equity as against regular income tax for interest income. However, if the experience of the past several quarters has taught us anything, it is that even debt capital takes on business risk, maybe not as much as equity but significant nonetheless.
Several savers (investors) in Co-operative Banks, NBFCs, and corporates have faced the brunt of businesses failing to honour their commitment and repay their dues. It is time that policymakers took another look at the long-standing presumption that only equity investment is about risk-taking while debt investments are risk-averse.
For the Indian economy to grow at rates over 8-10 per cent (which in my view is feasible), we must be willing to address the taxation deterrents to savings and investments. India's savers are hurt less by low real interest rates and more by its taxation. Interest income is taxed at the marginal tax rate, while equity capital gets better treatment under capital gains.
Further, under Section 115BBDA of the Income Tax Act, shareowner returns on equity investments are taxed three times in case of dividend income. Firstly, when the shareowner's profit share (of the profit made by the company) gets taxed as income tax on corporate profit. The second instance is the deduction of dividend distribution tax from profits before the company makes the dividend payment to shareowners (coming after payment of corporate income tax) and the third is when this dividend, having already paid income tax and dividend distribution tax, gets further taxed in the hands of the shareowner when such income exceeds Rs 10 lakh annually.
There is no rationale for taxing listed companies' dividend payments thrice. There may be some logic in the taxation of dividend income from unlisted companies, etc., but certainly none for the regulated and listed corporates. Such tax policies deter long-term investments in the economy besides distorting capital allocation. At the very least, the Finance Minister should revert to the pre-2016 position where dividend income was tax-free for all shareowners.
The second urgent issue is the tax arbitrage in case of interest income. At present, the law offers an unfair tax advantage to debt funds of mutual funds and insurance investment schemes because investments made through these channels get the benefit of indexation. This benefit is not available to bank deposits, postal savings scheme or other direct debt investments, including government bonds.
When the government's fiscal deficit is a constraint to paying favourable interest rate to savers, we can still encourage savings by giving tax-free status to direct interest income, or at least for the interest income received from market-linked products like bank deposits and listed debt investments. After all, why should tax benefit in the form of indexation, etc., be given only when savings are channelled through the mutual funds and not when directly invested in FDs and NCDs? This sort of tax arbitrage is distortionary and must be done away with. Let all interest income be tax-free in the hands of the end-user. Such relaxation will offer banks and financial institutions much needed leeway to raise deposits at a lower cost and will increase credit offtake besides enabling faster transmission of policy rate cuts to spur economic growth.
To further encourage debt investments, it is also desirable to make it easier for savers to invest in debt instruments. Allowing institutions to borrow as and when required through op-tap bond issuance is a good idea. Such on-tap insurances would also help in increasing the liquidity of the securities, further encouraging direct debt investments from savers.
There is also a case to be made for relaxation of external commercial borrowings (ECBs), especially in these times when the international market is flush with liquidity and on the prowl for yield. Policymakers need to re-evaluate the pros and cons of the current restrictions on external borrowings, especially for the fund starved NBFC sector.
NBFCs should be allowed external borrowings even for lower tenure, say, one year (instead of three years), and also be allowed to repay existing rupee debt or refinance foreign borrowings with the proceeds of the ECB.
As NBFCs borrow more from external markets and narrow their dependence on domestic banks, the interlinkages within the Indian financial systems would reduce, making the system more stable and less prone to the spread of contagion, and lowering the "systemic rise" in the Indian financial services sector.
Yes, it would make the task of the RBI a little harder in terms of having to manage the currency risks. But, is it better to have the RBI manage some extra external risks than continuing to have India's NBFCs starved of capital? It would also be a tiny step towards capital account convertibility, a long-cherished desire of industry and policymakers alike.