Daily Times

One rough estimate shows households paid Rs 1,800 billion in hidden taxes to the Indian government in 2009-10. That is a whopping 40 percent of the Rs 4,350 billion in explicit direct taxes collected by the government in that year.

This sleight of hand is accomplished through negative real rates of interest. If ‘negative real rates of interest’ appear forbidding, think of them as the interest that you earn on your savings after taking out inflation. Bankers fudge on the interest they offer us while the government is keen to hide the true rate of inflation. The real rate of return to us is the actual difference between these two nebulous numbers. This return can actually be negative!

Consider saving money in one year fixed deposit as an example to analyse. You have given away your money today while it will be returned to you one year hence with interest, say 8 percent per annum (pa). If you saved Rs 1,000, one year from now you would get back Rs 1,080. The key thing to understand is that the Rs you receive one year hence are not the same Rs that you invested. The value of the Rs will have diminished depending on whether there was inflation, and if so, by what amount. Assume that inflation in the year was 5 percent. Then after one year, while you get back a nominal sum of Rs 1,080, it is worth only Rs 1,030 because the value of the Rs in the interim period has diminished by Rs 50. The real return to you is only Rs 30 or 3 percent pa.

Consider the same deposit when interest rate offered is 5 percent and the inflation rate is 8 percent. In this scenario you gave away Rs 1,000 for one year and at the end of it you get back Rs 1,050 in nominal terms. While your money was sitting in the bank for one year, the government was busy surreptitiously increasing the price of all goods and services by 8 percent. One year later when the banker returns you Rs 1,050 you find you can only buy stuff worth Rs 970 in terms of Rs you had given to the bank one year earlier. Hence, while your nominal return stays 5 percent, in real terms your return is a negative 3 percent because the value of the Rs has meanwhile diminished by 8 percent. The banker and the government will disclaim responsibility for your loss. But the loss is real.

Your loss is not just ‘notion’ but real. It is not obvious by design, nor accident. The powers that be in our system have a vested interest in not telling you of your loss. In the normal course, if banking was in the private sector and not so tightly regulated, your loss would go directly to the bank’s bottom line. However, in India that does not happen. The Reserve Bank of India’s (RBI’s) regulation of interest rates and things like Cash Reserve Ration (CRR) and Statutory Liquidity Ratio (SLR) are levers that are used to funnel your Rs 30 loss into the pockets of large bank borrowers of which the government is the largest.

Actually, when you put Rs 1,000 of your saving in the fixed deposit for one year, about Rs 350 of it went as direct loan to the government. Of the balance 65 percent about Rs 600 goes to making loans to commercial borrowers, which includes Rs 200 lent to farmers who almost never repay their loans. The balance 5 percent is cash with the bank and CRR. So broadly speaking, 35 percent of your money went to the government, 40 percent to private borrowers and consumer loans and 20 percent to privileged farmers who know from experience that their loans do not have to be repaid. All these powerful people gang up to keep loan interest rates as low as possible in the name of development of the economy. Unable to charge a sufficiently high interest on loans, the bank compensates itself by keeping the return on your deposit as low as possible with active connivance of the government.

Why is this state of affairs so dishonest and problematical? Let us look at it from the taxation angle. The total banking systems deposits amount to Rs 60,000 billion in 2009-2010. These deposits would have yielded between 6 to 8 percent nominal. Let us take the upper end 8 percent. What was inflation during the period? The government makes that very hard to figure out but here the relevant rate is not the Wholesale Price Index (WPI) or the so-called core inflation. What matters is the real prices you pay for the goods and services you buy, and the best proxy for that is the headline Consumer Price Index (CPI) number. That number was something between 11 to 14 percent pa. Let us assume 11 percent. The negative real interest rate that you faced was about 3 percent. A simple calculation shows that you lost 3 percent of Rs 60,000 billion, amounting to Rs 1,800 billion. This amounts to 40 percent of the total direct taxes collected by the government. Note, all of this Rs 1,800 billion of taxation falls on households and not the corporate sector.

Let us assume that your annual income is Rs 600,000 so you pay no income tax. Further, let us assume you are around 30 to 35 years and that you are basically saving money to buy a house with the help of a bank loan. Roughly, you would need to save about three years’ income to buy a house about 10 times your annual salary. That puts your savings in the range of Rs 1,800,000. Assume you put this away in a one year fixed deposit as before where you get 5 percent while inflation rages at 8 percent. The real loss per year amounts to Rs 54,000. In short, even with zero income tax bracket, the magic of negative real interest rates ensures that you cough up roughly 9 percent of your gross income as hidden taxes to the government. And this analysis assumes you hold just three years of your annual income in savings. The more your savings, the more the hidden tax you pay. Closer to retirement, your savings could be 10 times your annual income in which case you would pay 36 percent of it in hidden taxes to the government. Remember the tax base for income tax is your annual income while the tax base for this hidden tax is your total wealth held in bank deposits.

The hidden tax on bank deposits is a gigantic rip off of middle class households who should be rewarded for saving rather than punished. The sheer inequity of it is astounding but never revealed to the mugs who are caught and mulcted by the system. We shall see how this burden of hidden taxes can be avoided by households by a number of strategies in my next article.

(To be continued)

The writer is a trader. She can be reached at sonali.ranade@hotmail.com