lawyers in India

Household Savings - Tax Law in India

Written by: Vasudha Tamrakar and Anoliba Mani - We are IVth Year students from NLIU Bhopal
Army Law
Legal Service
  • Savings is the difference between Income and Expenditure. A high level of savings helps the economy to progress on a continuous growth path since Investment is mainly financed out of savings. Given the importance of savings there have been extensive studies on the behavioral and other factors, which influence savings. This paper traces the trends, composition and distribution of Indian household savings and tries to find out the key determinants of household savings in India. Further it discusses the contribution of household savings in securities market along with the responsibilities of SEBI to create a congenial environment for enhancement of household investments in the market.

    The Former Patterns of Indian Household Savings

    Gross Domestic Savings[1] in India has shown a steady and substantial rise from the 1950s along with the rise in income. As per Indian National Accounts, Gross Domestic Savings includes current transfers from Indian emigrants and net factor income from abroad. The overall savings period in India is roughly divided into five phases based on the careful identification of the distinctive phases starting from the year 1950.The household sector which is comprised of the pure households, non corporate enterprises in agriculture, trade and industry and private non profit making trusts, has retained a high savings rate in comparison to public sector savings and private corporate sector savings in all the phases.

    The savings rate overall and the household savings rate took a sharp upturn in the 1970s[2], marginally increased thereafter, and then again took an upturn from the 1980s.[3] The first upturn is attributed to the decline in the share of agriculture in GDP and the apparent high propensity to consume of the agricultural sector, a theory yet to be corroborated by evidence[4]. Another school of thought suggests that the rapid expansion of banks, after their nationalization in 1969, contributed to increased savings of people by lowering the transaction costs of saving. Another contributing factor was the remittances from the Indian expatriates from the Gulf countries. Moreover, the Green Revolution in the late 1960s substantially contributed to increase in rural incomes. Though it is difficult to quantify, a certain spillover of the increased income into domestic savings cannot be denied.

    The second expansion from the mid 1980s to present can be attributed to the Economic Reforms initiated in 1985 and thereafter accentuated from 1991. 1984-85 to 1995-96 was a remarkable phase of growth of the Indian economy. The jump in savings rate only substantiated the hypotheses that, economic liberalization did promote savings through economic growth.

    Factors Affecting The Indian Household Savings

    The Keynesian theory explains that the prime determinant of saving is income that has withstood the test of time, while empirical evidence does not corroborate the ability of other variables like interest rates, inflation and tax rates to influence savings.
    A. Income
    Gross Domestic Savings in India has shown a steady and substantial rise from the 1950s along with the rise in income (GDP). There is a correlation between the rise in income and the rise in national savings. This proves that the Keynesian theory of income being the primary determinant of saving holds true in India also. Moreover, it was permanent income, which was the critical determining factor rather than transitory income. In the initial stages of development, the level of income is an important determinant of the capacity to save.

    B. Economic Liberalization GDP Growth and Savings Rate
    Economic liberalization measures initiated in mid 1980s (accentuated from 1991) had contributed to GDP growth rate (average growth rate 5.6%) and the savings rate (17%). This was the period 1984-85 to 1995-96. From 1996-97 to 2003-04, we observe that the GDP has continued to rise, albeit at a fluctuating rate, but the savings rate has continued to rise regularly, without any fluctuations. This only enforces the fact that income is the prime determinant of savings and Economic liberalization helps to raise savings by raising income. In fact from independence to mid 1980s the Indian economy was characterized by a slow growth rate of 3.5% p.a. which changed from the mid 1980s. [5]

    C. Interest rates
    Financial liberalization initiated in the 1980s gathered momentum after 1991. Presently, all interest rates, except those on all small savings schemes of Post Office, Provident funds, Government of India Bonds and schemes for Senior Citizens (the instruments with sovereign guarantee), are market determined. In post 1991 period there has been a steady decline in the interest rates in the economy. But overall household savings increased from 17% of GDP in the 1980s to 25.5% of GDP in 2002-03 and 26.6% of GDP in 2003-04. The transformation from an inefficient and sheltered economy to an efficient and a market determined economy have made people more insecure and prompted them to accumulate savings to guard against future job losses, giving limited importance to interest rates. The insecurity prompted to increase the savings rate. Another fact considered by retired people who were pensioners was that since interest rates had gone down to maintain the same income flow they had increased the volume of savings, to the extent possible So it can be concluded that interest rates do not influence savings much.

    D. Tax incentives
    The Government of India, till March 2005, offered a slew of tax incentives. All these tax rebates were available from instruments backed up by State Guarantee, barring ICICI Bank. People invested heavily in these instruments because of the double benefits of tax avoision (not evasion) and State Cover. The funds raised from these instruments continued to feed the ever-yawning Fiscal Deficit of the Government of India.[6] The underlying logic behind all these changes is to make it compulsory for people to arrange for their own retirement needs (which the bankrupt exchequer cannot provide) in line with the global trends and gently nudge people towards the Stock Market.

    The Composition of Indian Household Savings

    In the post independence era, Indian financial system was characterized by poor infrastructure and low level of financial deepening. Savings in physical assets constituted the largest portion of the savings compared to the financial assets in the initial years of the planning periods. While rural households were keen on acquiring farm assets, the portfolio of urban households constituted consumer durables, gold, jewelry and house property. Strengthening of the cooperative credit institutions, taking over of the banks associated with the former princely states and transferring them into the public sector (1954), strengthening and consolidation of the banking system in India (1950s and 1960s), nationalization of the insurance companies, establishment of Unit Trust of India , major term lending institutions for agriculture and industry (1964) and nationalization of the major scheduled commercial banks (1969/1970) in India, had a cumulative effect in raising the financial savings in the country (RBI, 1998).

    The household financial assets include broadly currency, deposits, net claims on government, share and debentures, insurance, pension funds and provident fund. The share of financial saving in the total saving increased from 23.7 per cent in early seventies to 44.5 per cent in late nineties. During the same period, there has been a downward drift in the share of physical saving from 48.4 per cent to 33.3 per cent, which resulted in a corresponding rise in the share of financial saving from 51.6 per cent to 66.7 per cent. Within household sector, bank deposits turned out to be the most popular abode of saving, whose share improved from a 8.1 per cent in early seventies to 16.3 per cent in late nineties. During the same period the share of shares and debentures also increased from just 0.8 per cent to 3.9 per cent in late nineties. Similarly, the share of contractual savings increased during the same period from 10.3 per cent to 14.5 per cent of the total gross domestic saving.

    An instrument like deposits has been a preferred instrument largely by fixed income households since the three types of deposits, current, saving and fixed deposits combine the various advantages of liquidity as well as returns. In the recent years, with the development of capital market, there has been an increasing preference by households for saving in market-related instruments, such as equity or shares. Such instruments offer the possibility of higher returns, however, with an element of risk attached to it. Households prefer the other market-related instrument, debentures, as an instrument with relatively low risks and fixed returns. More importantly, claims on Government, which comprise Government bonds and small savings, such as saving in National Saving Certificates (NSC) have emerged as the most secure or safest instrument by households given the state backing to these instruments. This has been particularly true in the case of the risk-averse investors, such as fixed income or salaried households, who may shy away from market risks but wish to have a stable return over time. The overall trend vividly brings out the shift in preference to bank deposits, capital market instruments, small savings and contractual savings whose combined share increased from about 19.0 per cent in early ‘seventies to about 40.0 per cent in late nineties[7].

    Contribution of Household Savings In Securities Market

    The share of financial savings of the household sector in securities (shares, debentures, public sector bonds and units of UTI and other mutual funds and government securities) is estimated to have gone down from 22.9% in 1991-92 to 3.9% in 1997-98, which increased marginally to 4.3% in 1998-99. The disenchantment of household sector with securities is confirmed by the SEBI-NCAER survey, which found that only 2.8% of investment of all households were in securities (1.4% in equity shares, 1.3% in mutual funds and 0.4% in debentures), while the remaining 97% in non-securities, indicating low priority of investor for securities. Despite the expansion of the securities market, a very small percentage of households savings is channelised into the securities market. What worries further is the intention revealed in the survey that majority of existing shareholders are unlikely to invest in the securities market in the next year. 56% of urban and 72% of rural households are unlikely to make fresh investments in equity shares.

    This trend indicates lack of confidence by the existing investors in the securities market. Though there was a major shift in the saving pattern of the household sector from physical assets to financial assets and within financial assets, from bank deposits to securities, the trend got reversed in the recent past due to high real interest rates, prolonged subdued conditions in the secondary market, lack of confidence by the issuers in the success of issue process as well as of investors in the credibility of the issuers and the systems and poor performance of mutual funds. The lack of awareness about securities market and absence of a dependable infrastructure and distribution network coupled with aversion to risk inhibited non-investor households from investing in the securities market.
    According to the same SEBI-NCAER survey, safety and liquidity are the primary considerations that determine the choice of an asset. Ranked by an ascending order of risk perception, bank fixed deposits were considered very safe, i.e., least risky, followed by gold, units of UTI-US 64, UTI- other schemes, fixed deposits of non-government companies, mutual funds, debentures and equity shares. Higher proportion of households invest in instruments with a lower risk perception.
    Distribution network is also an important factor. Banks and post offices have wide network of branches and are in a better position to garner a large chunk of savings of households. Difficulties faced by households in investing through secondary market lack of easy access to the market, inadequacy of the market infrastructure, problems in locating the right intermediary, lack of guidance and advice inhibited the households from investing in the secondary market. The number of broker related problems are higher than the number of issuer related problems.

    Recent Trends In Indian Household Savings

    An economic climate that favours the concept “spending beyond means”, creating an environment that pampers the consumer, should have resulted in a drastic reduction in household savings. But the last decade’s savings figures show that Indian households have proved otherwise. Indian household seems to secure its interest through adequate and prudent savings in a most conservative manner, notwithstanding the systematic discouraging policy initiatives, aping the West, to compel the household to blow the money. In the last decade, the interest rates on savings have been drastically cut, the tax incentives for savings have suffered from serious instability, and both the capital market and the non-banking finance companies administered rude shocks to investors. Consumerism is being consciously promoted by making available loans/credit cards with increased options to prospective buyers.

    The surprising reality is that while the `spending beyond means' as a main driver of economy no longer seems to be working even in the West, which in relative terms has in place an adequate social security system in our country, with no credible social security, the policy-makers seem to favour aggressive consumerism. Such an environment, punishing savings and pampering spending, should have resulted in drastic reduction in savings by households. But the figures of the last decade's savings prove that our households think otherwise. Household savings have been channeled over the past 11 years — from 1993-94 to 2003-04. The majority of the savings flowed into bank deposits, claims on government (comprising government securities and savings), insurance and provident and pension fund, in that order.

    Bank deposits seem to be the preferred choice, consistently, despite the drastic reduction in interest rates, from 12 per cent for a three-year term in April 1997 to 5.75 per cent in January 2005, that is halving in this period. Safety, liquidity (including availability of loan against deposits), tax concessions (that increases the effective rate of interest) and, more important, absence of other investment avenues are the reasons for the rise. Investment in government securities and small savings has increased from 12.3 per cent in 1999-00 to 17.7 percent in 2003-04. Though most of these savings lack liquidity, as they are long-term investment, and offer the highest safety to the depositor (government guaranteed) with tax incentives. The current rate of return offered by these schemes also negate the basic rule in financial investment — `higher the reward' the more `riskier' the investment. This government guaranteed savings offers returns, which together with their tax effectiveness are 2-3 per cent higher than the unsecured private company deposits, placing return and risk in inverse proportion.
    Life insurance and provident/pension fund investments have also seen a rise. Life insurance funds growth could be for two reasons: Increased realization about the need to insure, and the increased competition from private players in the last decade. Investment in capital market suffered the same fate as risky company deposits. Barring the first two years (1993-94 and 1994-95) and the dotcom boom year 1999-2000 (where investment peaked to Rs 18,118 crore), the savings has come down to a third in the decade to Rs 5,699 crore in 2003-04. These include investment through mutual funds (with the exception of UTI). The risk-averse household has kept away from this avenue, although, the Comptroller of Capital Issues has been replaced by SEBI (Securities and Exchange Board of India), and from 1993-94 on, the capital market regulator has been framing regulations on various issues connected with capital market. As the regulation became tougher and more stringent, investment came down, aggravated by the investing community taking a beating with such mega scandals as, Harshad Metha and Ketan Parekh. Similarly, after the crisis in UTI, the country's single largest mutual fund, the investors remained net sellers only.

    The private sector saves marginally and the public sector spends more or savings are in the negative. About 85 per cent of our national savings comes from households only. Thus, shedding risky avenues, ignoring policy flip-flops, the household is conscious of the fact that they have to mind their business — that is, financial security of their next generation, depending on their own conservative saving techniques. They are aware that the cost of living, medical, education (remember LKG is costlier than chartered accountancy) are all progressively increasing, which could be met, if only they create and sustain financial security. By blowing up the existing kitty, they would end up enriching the business of shoppers, corporates and banks and that will not be minding their business. They cannot afford to think like our policy makers who plan to promote consumerism, but just the opposite — that is, save more money, to sustain same interest income when interest rate is reduced.

    Current Trends In Indian Stock Markets: BSE Sensex

    On May 22, 2006, the Sensex plunged by a whopping 1100 points during intra-day trading, leading to the suspension of trading for the first time since May 17, 2004. The volatility of the Sensex had caused investors to lose Rs 6 lakh crore ($131 billion) within seven trading sessions. When trading resumed after the reassurances of the Reserve Bank of India and the Securities and Exchange Board of India, the Sensex managed to move up 700 points, still 450 points in the red. This is the largest ever intra-day crash (in points terms) in the history of the Sensex. The Sensex eventually recovered from the volatility, and on October 16, 2006, the Sensex closed at an all-time high of 12,928.18 with an intra-day high of 12,953.76. This was a result of increased confidence in the economy and reports that India's manufacturing sector grew by 11.1% in August 2006.

    On July 23, 2007, the Sensex touched a new high of 15,733 points[8]. The index touched the 15,828.98 mark the very next day[9]. On July 27, 2007 the Sensex witnessed a huge correction because of selling by Foreign Institutional Investors and global queues to come back to 15,160 points by noon[10]. Following global queues and heavy selling in the International markets, the BSE Sensex fell by 615 points in a single day on August 1, 2007, the third such biggest fall in its history[11]. Following the same trend, the BSE Sensex fell by 643 points in a single day on August 16, 2007, which is the biggest fall since April, 2007 and the second biggest ever (absloute terms) in history[12]. It is predicted to fall by about 1000 points for the first time on 25 december 2007.

    These trends speak of an increased responsibility on one of the important components of the mechanism responsible for servicing investors i.e. institution of stock exchange. But business trends and other available evidences (as mentioned above) indicate that the performance of stock exchanges, particularly the major ones (Bombay, Delhi, Ahmedabad, Calcutta and Madras) did not prove to be in correspondence with the increased level of responsibilities that resulted from important changes in new issues market. Besides poor level of liquidity in most securities, at times the functioning and business trends of stock exchanges tend to be influenced heavily by the forces detrimental to the interest of large number of those investors, who put their money in corporate securities. In other words, market influenced by these forces, prove to be detrimental to the interests of healthy saving and corporate financing activity. Recent crash of stock exchanges is a case in point. Unrealistically high prices at one point at time and sudden crash thereafter indicate only the weaknesses of the functioning of the market.

    In other words, these developments underline the need to improve the overall mechanism, of which stock exchange is a part, responsible to service the increasing population of corporate securities' holders. Efficiency of this mechanism should play an important role in serving better the investors' base, which can prove to be a consistent source of finance for private corporate sector. Recent happenings in capital market (like securities scam) only highlight that lack of an adequate framework to monitor the various developments that are determining the fate of our financial sector at large. A comprehensive examination of the role, expectations and need of increasing corporate security holders and evolving the suitable responses thereto at various levels (like new issues market, stock market, corporate sector etc.) should form the part of the attempts necessary to evolve this desirable framework.

    [1] GDS: (Gross Domestic Savings) Total savings in the country as percent of GDP.
    [2] Termed as Phase 1 to Phase 2.
    [3] Termed as Phase 3 to Phase 4.
    [5] Though officially the Indian Economy was liberalized in 1991, reformatory steps had been initiated from 1985 by the then Prime Minister of India, Rajiv Gandhi.
    [7] Excerpts from the Report of the Working Group on Savings for the 10th 5YearPlan Government of India, Planning Commission (2002)
    [8] Sensex hits new high of 15,733.
    [9] Sensex crosses 15, 828 mark
    [10] Sensex plunges by 542 points
    [11] Sensex takes nose dive, plunges by 615 points.
    [12] Sensex dives 643 points on global meltdown

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