Explained: Does the new tax regime adversely affect household savings?

Critics, including former Finance Minister P Chidambaram, have criticised the Budget's focus on the new tax regime saying it does not motivate people to save. This focus, they say, is not good for developing economies that rely on both corporate as well as household savings to spur growth.

New tax regime does not have tax deductions as is given under various provisions such as 80C or 80D of the Income Tax Act.

Finance Minister Nirmala Sitharaman tried to sweeten the new tax regime by increasing the rebate limit to Rs 7 lakh from the earlier Rs 5 lakh. This meant that those with an annual income of Rs 7 lakh need not give any income tax. The finance minister also reduced the tax slabs to five from the earlier six, reducing the peak income tax rate including a surcharge to 39 per cent from 42 per cent and giving a standard deduction rate benefit for those with an annual income of at least Rs 15.5 lakh. 

The finance minister also made the new income tax regime the default tax regime. However, taxpayers will continue to have the option to avail the benefit of the old tax regime.

Typically, a taxpayer can save Rs 4,50,000 in a year through various exemptions and claim tax deductions that are not provided in the new tax regime. These include Rs 1,50,000 under 80C, home loan interest up to Rs 2,00,000, mediclaim of Rs 50,000 under 80D and savings in new pension system up to Rs 50,000. There are various other sundry deductions such as education loans. However, these are not availed of by everyone. So, let us assume that a taxpayer saves Rs 4,50,000 in a year and claims tax deductions on these schemes.

As many as 58.3 million individuals filed income tax returns for the financial year 2020-21. If everyone saves Rs 4,50,000 a year, the aggregate comes to Rs 26.23 trillion. This sum is 46.90 per cent of total gross savings in the country at Rs 55.92 trillion during the year. This constituted 59.75 per cent of total households' savings at Rs 43.89 trillion. This sum also accounted for 84.37 per cent of a household's financial savings at Rs 31.09 trillion.

However, this sum seems to be too exaggerated. This is so because not every filer saves Rs 4,50,000 a year through tax savings.

Sandeep Sehgal, partner at AKM Global and Ranen Banerjee, partner, economic advisory services at PwC, said typically a taxpayer having an annual gross income of at least Rs 20,00,000 would be able to take advantage of these tax deductions. 

While income tax filers at Rs 20,00,000 and above are not available, there were 6,458 filers above Rs 25,00,000 in the assessment year 2018-19. Assuming this number to remain constant in 2020-21, these many filers would have saved Rs 2.9 trillion. This comes to 5.18 per cent of the total household gross savings of Rs 55.92 trillion for 2020-21. This also constituted 6.6 per cent of total household savings and 9.3 per cent of total household financial savings in 2020-21.

Now, the exact number would be a bit over 5.18 per cent since we have taken filers above annual gross income of Rs 25,00,000 and not Rs 20,00,000 and there would have been savings in the lower slabs as well.

Sehgal said the intention of the government seems to be to encourage the new scheme. "This seems preposterous since there is still a very low penetration of insurance and savings among the masses compared to developed nations. The new scheme seems to discourage that,” he added.

 

However, Banerjee said the majority of households in the lower income tax brackets do not have sufficient disposable income to take advantage of all the savings-related tax rebates.

A household with an annual income of Rs 10,00,000 which translates into approximately Rs 83,000 per month does not have the ability to have savings of Rs 1,50,000 under 80C and also have a house loan, on which they pay EMI and can take advantage of the deductions for interest payment on such housing loan, Banerjee explained.

Majority of them take advantage of the mandatory PF deductions only, he said.

Households that have the ability to take advantage of the tax rebates and deductions through savings have disposable incomes to save or spend. This probably comes in income brackets of over Rs 20 lakh annual income or households where there is more than one earning member, he said.

Such salaried households have generally become more aware of alternative investment avenues like mutual funds that give better returns over a longer period than the life insurance policies that used to get mis-sold as investment instruments.

This is reflected by the large increase in investment folios with mutual fund houses. Continuous financial education and campaigns may be better to raise awareness among the households about the importance of savings and prudent investment instruments for various financial needs than using tax incentives to make them save, Banerjee said.