Some tax exemptions act as powerful incentives to convert non-savers into savers. This has an outsize impact later in life
05-Feb-2020 •Dhirendra Kumar
Here are two ways of describing the impact of the new optional tax deal on personal savings behaviour. One: it's good to have the option of paying less tax by not using exemptions, but taxpayers who do so will have less of an incentive to save. Two: in the new optional tax regime, taxpayers will face a reduced incentive to save, but the higher disposable income will leave them better off.'
Which one do you lean towards? It's often said that when there's a 'but' in a sentence then the part that comes before the 'but' means nothing. My take on this matter is unequivocal - the reduced incentive to save in the new optional tax regime will mean less savings and later in life, more financial problems for most people. An obvious defence of the scheme is that it's better to give people financial freedom than put them in a straitjacket of rules that guide their behaviour precisely. That's an admirable approach and absolutely correct. Different people have different financial needs and for the government to specify where they should save is pointless. In this view, it's better to put a larger sum of money into the hands of a taxpayer and let everyone save what they need to.
Except that many, especially those who are younger and have lower incomes, will not save at all. Our whole consumerist environment is designed to encourage (even coerce) people to spend, not save. The tax rebate that one gets for saving money is literally the only place that the reverse is true. Actually, it goes beyond just the actual saving that is used for tax-saving. The tax investment becomes a gateway that eventually encourages savers to save more. I've seen this happen countless times with young people whom I know, including almost everyone who works at Value Research.
I keep advising them to invest in ELSS funds to save tax. They end up investing in these funds because the tax-savings are attractive and of all the options, ELSS funds have the shortest lock-in. However, the three-year lock-in ensures (most of the time) that investors get good returns even if their timing and choice of funds is less than optimal. This experience converts a certain proportion of these investors to investing in equity mutual funds over and above their tax-saving needs. Once you have a taste of long-term equity returns, then you end up trying other types of equity investments as well.
This also happens with other forms of tax-saving investments like PPF also, even though the impact is slower to be felt. Once savers get a taste of the compounding magic, they get converted to becoming investors. Tax saving investments are that little nudge that they need to get started, but the actual financial impact over a lifetime is far more than just the tax-saving investments by themselves would have. Of course, this is not true for everyone, but it happens to enough people and eventually enhances prosperity and financial security later in life, especially beyond retirement. Once the default financial choice of your life becomes saving rather than spending, it lays the foundation for a lifetime of happiness that is not just financial, but spills over to personal and professional aspects of life also. Having enough savings removes one of the commonest sources of misery later in life.
Am I reading too much into what after all is just a change in income tax rules? I have been fortunate enough to watch the financial progress of a large number of individuals over almost three decades and I firmly believe this. Beyond any doubt, that the little annual push to save that is delivered by the tax-saving rules is one of the most important services that the government delivers to citizens. Now that the incentive to use that is so much less, I hope the negative impact is not too strong.