Here's an excerpt from the Economic Survey that argues that the tax exemption on withdrawals from savings schemes like PPF and others under section 80C should be taxed:
(from page 99 volume 1 of the Economic Survey)
Tax Treatment of Savings
Income tax is inherently biased against savings; it leads to double taxation in so far both the savings and the earnings are taxed. In general, the tax system provides for a mechanism to eliminate this bias and promote savings in the economy. This mechanism takes the form of a tax incentive by way of a deduction for contribution to specified savings instruments. In India, savings in several instruments are further incentivised by exempting fully, or partially, the earnings at the accumulation stage as well as the withdrawals from tax (both the contribution and the earnings). In effect, savings are subject to exempt-exempt-exempt (EEE) method of taxation i.e. they are exempt at all three stages of contribution, accumulation and withdrawal.
The case for concessional tax treatment of savings is built on the consideration that a tax concession for savings leads to higher post-tax return for the investor. The higher returns, in turn, create a positive substitution effect whereby, in favour of savings rather than current consumption. However, what is missed out is the fact that it also creates a disincentive for savings (income effect), since the higher returns now require lower savings to meet the lifetime savings target.
There is some empirical evidence to suggest that the positive and the negative effects are neutralized at the economy level. Further, the 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. In addition, national savings comprise of household savings, government savings and corporate savings. To the extent, tax incentives for savings lead to fiscal loss, government savings are adversely impacted, thereby partially neutralizing the increase in household savings.
Further, tax incentives for savings distort the interest structure and choice of saving instruments, and merely help mobilize 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. They are also regressive in as much 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.
While there should be no tax incentive for savings, the question is what should be the tax treatment of savings so as to eliminate the inherent bias under income tax. The emerging wisdom is that savings should be taxed only at the point of contribution (TEE) or withdrawal (EET); the latter being the best international practice on several counts.
First, savings (contribution) reduce cash flow and therefore, the 'ability' to pay. Therefore, taxation at the point of contribution would create hardship and act as a disincentive to save. However, taxation at the point of withdrawal (principal or earnings) occurs when the ability to pay is greater and therefore, justified on principles of taxation. Second, under the TEE method, taxation at the point of contribution does not provide any immediate incentive to save nor does exemption of withdrawals discourage dissavings. However, under the EET method of taxation of savings, full deduction from income at the point of contribution and accumulation acts as an incentive for savings while taxation at the point of withdrawal penalizes dissavings. The combined effect is that it encourages the saver to build a self-financing old age social security system.
Third, under the TEE method, there is no incentive for consumption smoothening since withdrawals are exempt irrespective of the amount. However, the EET method allows for consumption smoothening particularly in old age since taxation of withdrawals incentivizes postponement of consumption. Under a progressive personal income tax rate structure, there is an in-built incentive to restrict withdrawals to meet necessary consumption only since lower withdrawals imply taxation at lower marginal tax rate and hence, lower tax liability. Consequently, the potential for old-age poverty is minimized.
Fourth, the EET method provides discretion to the saver for tax smoothening and minimize the tax liability arising from any bunching of gains. Fifth, because taxation is at the last point in the savings process, there is no uncertainty about the potential tax liability unlike in the case of TEE method where the saver is uncertain whether the Government would impose a tax at the point of accumulation or withdrawal to raise revenue to overcome the fiscal crisis.
Sixth, the EET method is extremely simple in terms of compliance and administration since it can be operationalized by opening an account with a designated fund which, in turn, can invest in a mix of a broad range of debt and equity instruments depending upon the risk appetite of the saver. All earnings are required to flow into the same account and withdrawals, if any, can be subject to withholding tax. It does not require any complex tracking mechanism to prevent leakage of revenue. It is not necessary for the saver to maintain details of savings and earnings to claim tax benefit.
Finally, most developed countries and many developing countries are implementing the EET method of taxation of savings. In view of the foregoing, India should move, in a phased manner, to the EET method of taxation of savings. Interestingly, the New Pension Scheme (NPS) is already being subjected to the EET method of taxation. Therefore, deductions under Section 80C and 80CCD should be re-assessed to move toward a common EET principle for tax savings.