Did proposal on tax treatment of savings lead to row in direct tax panel?

The government announced that it would exempt from tax all New Pension Scheme withdrawals

The finance ministry recently reconstituted the task force to draft a new direct tax law, appointing Central Board of Direct Taxes (CBDT) Member Akhilesh Ranjan convener of the committee.

This comes after reports suggested that the previous task force, headed by Arbind Modi, had failed to reach a consensus on a number of issues.

A possible sticking point could have been the Modi committee’s proposal on the tax treatment of savings, which entailed putting all long-term savings on exempt, exempt, tax (EET) mode as opposed to the exempt, exempt, exempt (EEE) category currently, Business Standard has learnt.

This politically contentious proposal is in line with Chapter XII of the first draft of the erstwhile Direct Tax Code, which dealt with tax incentives for savings. Arvind Subramanian as chief economic advisor had advocated shifting to the EET method of taxation and savings.

Most developed and developing countries also follow the EET method of taxation. 

EEE vs EET

Most long-term saving instruments in India such as the Employees Provident Fund and the Public Provident Fund are subject to the exempt-exempt-exempt (EEE) method, wherein they are exempt from taxation at all three stages — contribution, accumulation and withdrawal.

On the other hand, under EET, the withdrawal of funds is subject to taxation in accordance with the individual's tax slab, while contribution and accumulation are not.

The government announced on Monday it would exempt from tax all New Pension Scheme (NPS) withdrawals. 

Currently, the NPS is subject to EET, by which a portion of withdrawals — 20 per cent — is taxed.

The rationale for shifting from EEE to EET is straightforward. Having some instruments in the EEE category and some in the EET category distorts investment decisions. It creates opportunities for tax arbitrage, say experts Business Standard spoke to. Further, tax incentives tend to be regressive in nature "as they provide relatively high tax benefits to investors in the higher tax bracket", noted the Economic Survey 2015-16. 

Also, by not taxing withdrawals, EEE reduces the incentive for individuals to save more. 

“The EET method allows for consumption smoothening particularly in old age since taxation of withdrawals incentivizes postponement of consumption,” the Survey said.

“The combined effect is that it encourages the saver to build a self-financing old age social security system,” it added.

Therefore, it argued that deductions under Section 80C and 80CCD be re-assessed shifted to the EET principle for tax savings.

However, when the shift to the EET method of taxation was proposed by the first draft of the Direct Tax Code, it was vehemently opposed on grounds that most countries that followed this approach also had a social security system in place for its citizens.

“The EET savings accounts which operate for individuals in these countries are over and above the mandatory social service payments received by them. It has been represented that in India, in the absence of a universal social security system, the proposed EET method of taxation of permitted savings would be harsh,” it was noted.

There are also additional revenue gains for the government to be considered. Taxation of savings (EET method) could augment the governments resources, which could be spent to create the social security required in the coming decades as the old-age population rises.

The population in India aged 60 and above is expected to rise from 116 million in 2015 to 190 million in 2030 and further to 330 million in 2050, according to the United Nations World Population Ageing Report 2015.

By 2050, three decades from now, the population above 60 will account for roughly a fifth of the total population, up from 8.9 per cent in 2015.