Move towards EET is good, but handle retirement savings with care

The draft direct taxes code unveiled earlier this month makes a beginning towards the EET (exempt-exempt-taxation) treatment of savings, including those relating to retirement. This is consistent with widespread international practices, particularly in the middle and high-income countries.

The draft code implies that the tax treatment of all retirement savings, whether public or private, will receive the same tax treatment. This is a positive step.

For retirement savings, the first ‘E’ refers to the exemption of personal income tax of the contributions to the approved retirement fund. The second ‘E’ refers to the exemption of accumulations of interest, capital gains, and dividends in the retirement account from income tax. The ‘T’ refers to levy of personal marginal rate of income tax at the time of withdrawals of retirement savings.

The implication is that pre-retirement withdrawals such as those permitted under the Employees’ Provident Fund (EPF) scheme will also be subjected to the personal income tax.

The draft code proposes to set up a system of central recordkeeping by an independent agency to maintain the records of individuals with permitted savings intermediaries. This has the potential of developing more empirical based public policies towards savings.
Under Section 66, which will replace the current Section 80C of the Income Tax Act, 1961 of the proposed new Code, the aggregate amount of deduction for investments made in tax-saving instruments is set to increase to a maximum of Rs 3 lakh from the current limit of Rs 1 lakh.

It would be useful to consider including in the final code a provision for increasing the permitted savings deduction every three years or so, according to a formula based on inflation rate, and income growth.

It is envisaged that the change in tax treatment will commence from the 2011-2012 financial year. The code therefore provides for transition provisions, with no tax deduction on withdrawals of any amount of accumulated balance from individual accounts in the Government Provident Fund, Public Provident Fund, EPF and other recognised provident funds until March 31, 2011.

The proposed new tax treatment regime would apply to account maintained with any provident fund, superannuation fund, life insurance and the New Pension Scheme (NPS), approved by the Pension Fund Regulatory and Development Authority (PFRDA).

The importance given to the PFRDA in the Draft Code is significant. It is hoped that the PFRDA will use its authority to increase the number of different types of superannuation funds (including those floated by mutual funds and other financial intermediaries) to increase competition and to provide wider choice.

The possible role of micro-finance institutions which provide savings and pension products will also need to be considered.The above increases the urgency of passing the PFRDA Bill, 2009 before the end of this year.

The PFRDA’s role is essential in providing an environment for long-term retirement savings, in which all stakeholders can have confidence; in enhancing professionalism of the provident and pension fund institutions; and in developing the pensions industry.

The main argument for the EET treatment is that the current practice of EEE (exempt-exempt-exempt) taxation of some types of retirement savings, and for some (but not all) organisations providing retirement income, is neither efficient (as it distorts allocation of
savings between different instruments without necessarily increasing the overall household saving), nor equitable (as exemption of unlimited retirement balances disproportionately benefits the high-income groups).

Moreover, the EEE treatment leads to a loss of revenue from the personal income tax. If this loss is made up by use of a tax which burdens the lower half of the population in terms of income more than the personal income tax, then the equity of the tax system is adversely impacted.

Under the EET treatment of savings, the definition of what constitutes withdrawal is crucial. The draft code states that if the withdrawal amount is transferred from one permitted savings intermediary to another, or to between different accounts of the same intermediary, the personal income tax will not be levied at that stage.

The draft code largely mitigates the tax disadvantages of the NPS in comparison with other providers such as the Employees Provident Fund Organisation.

It is not clear from the draft code whether the second tier of the mandatory NPS or the pre-retirement withdrawals from the voluntary NPS will be subject to personal income tax. The logic of the EET suggests that they should be taxed.

The issue of treatment of commutation benefits under the old civil service pension scheme, the NPS (both voluntary and mandatory), and under other private and public sector pension schemes also needs to be addressed more explicitly. Would such withdrawals be subject to normal marginal personal income tax rates?

If the answer is yes, then the tax burdens for those opting for them will be high. If it is not, then there will be gaps in the EET treatment of retirement savings.

To address this issue, it may be useful to consider the following. At the time of statutory withdrawal, a one-time lump sum payment (periodically adjusted for inflation and income levels) to meet social and other obligations may be permitted without attracting personal income tax. This may be combined with a phased or programmed withdrawal options to be offered by approved entities. The PFRDA should encourage development of such options.

An individual would then be able to turn the accumulated retirement savings into periodic payments (e.g. every quarter) in such a way that the principal plus the interest is exhausted over a period of 15-20 years. If a person dies, the remaining balances can accrue to the nominee. There will thus be no insurance and risk-pooling under the phased withdrawal.

The purchase of annuities, which is currently mandatory under the NPS, can then be made voluntary. Even in countries with well-developed financial and capital markets, the use of annuities is not widespread.

Even if annuities are mandated, the pricing may be an issue as the insurance companies providing them make overly conservative assumptions concerning longevity and investment returns.

These are some of the refinements that merit consideration as the draft code begins the process of a desirable shift towards EET treatment of retirement savings.
 
Mukul Asher (mukul.asher@gmail.com) is a professor, and Amarendu Nandy (amarendun@gmail.com) a PhD candidate, Lee Kuan Yew School of Public Policy,
National University of Singapore. Views are personal.