Budget 2016 – Is this the first step towards EET?

The shift towards EET is nothing new. It was proposed by the Kelkar Committee nearly 18 years ago but was never taken up seriously as employee unions had resisted the idea of taxing instruments that had been free of tax for a long time. Let us first understand the concept of EET. Take the case of provident funds. They proffer tax benefits at 3 stages. Firstly, you get the benefit of Section 80C for your contribution to the provident fund. Secondly, the interest earned on your provident fund is entirely free of tax. Lastly, the principal received by you on maturity or withdrawal is entirely tax-free in your hands. Since it is exempt at all three levels, it is referred to as an EEE (Exempt, Exempt, Exempt) model.

The logic of converting this EEE model into an EET model is two-fold. Firstly, it ensures that the government subsidy for such investment instruments goes away. This is more important at a time when the government is trying hard to find resources to fund its programs. Secondly, due to these tax breaks, the provident fund as an instrument gets an unfair advantage over other debt products. This tends to distort the yield curve. It is in this background that the government in budget 2016 has taken a small step to move towards the EET model. That essentially means that while your contribution to PF and your interest will still be tax-free, the maturity proceeds will now be taxable in the hands of the individual.

What changes has this budget announced: 

  • To put EPF at par with the National Pension Scheme (NPS), the government has decided that only 40% of the maturity proceeds of the EPF will be tax-free in the hands of the individual.
  • This means that on the balance 60% of maturity or withdrawal, the amount will be taxed as income in the hands of the individual. However, this has been open to various debates and interpretations.
  • The government has subsequently clarified that only 60% of the interest component at the time of maturity proceeds will be taxed in the hands of the individual. Thus the principal contribution of the employee and the employer will continue to be entirely tax-free in the hands of the individual.
  • In addition, the government has announced in budget 2016 that the contribution of the employer to the provident fund will be tax free only up to a limit of Rs.150,000/- per annum. That means any contribution that the employer makes to your provident fund beyond the limit of Rs.150,000/- will be taxed in the hands of the employee as salary and taxed in the same year.
  • This is used by the government to make the high income earners within the corporate sector pay a higher portion of tax each year.

Buy Why EET now?

The question that begs an answer is why the sudden focus on EET now. There are three reasons for the same:

  • The government is moving towards simplification of taxation for individuals and corporates. We have already seen the gradual withdrawal of exemptions for corporates. In case of individuals, any further cut in tax rates will be accompanied by withdrawal of exemptions.
  • There is a huge hidden subsidy that the government is bearing because of these tax breaks. It is estimated that many of the government welfare programs can be funded if these exemptions are withdrawn.
  • As mentioned earlier, the tax breaks on provident funds was distorting the demand for other debt market instruments. Hence these new instruments are not able to develop in this environment. The idea is to provide a greater level playing field.

The message seems to be quite clear. EET is now more a matter of when rather than whether? The government realizes that a large chunk of the benefits of instruments like PPF, Deposit Schemes and LIC policies are going to the wealthy class of India, who can actually afford to manage without these exemptions. In the process, the government can reduce its huge subsidy burden. Then the fiscal deficit management may not really look so daunting in the first place.

Read more about Union Budget 2016 highlights here.

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