Best Recipe to Save Taxes

As we approach the annual tax-saving investment season, the landscape has changed decisively. As things stand, I would expect tax-break investments to be biased heavily in favour of the government’s small savings schemes as opposed to an equity-based tax saving option like ELSS mutual funds.

There’s a push as well as a pull for this. The small savings schemes have got a lot of attention lately when the government raised interest rates on these across the board. Rates were raised by margins ranging from half a per cent to 1.45 per cent. Among the instruments whose returns were enhanced, the PPF (Public Provident Fund) and the NSC (National Savings Certificates) are heavily used as tax-breaks. For PPF, the rate of return has been enhanced from 8 per cent a year to 8.6 per cent. For NSC, it’s up to 8.4 per cent. The government has also introduced a new 10-year duration for the NSC.

On the other hand, equities are getting as bad a press as there possibly can be. It’s now been more than three years since the stock markets have given any meaningful and sustained gains. What’s more, with the shadow of slowing economic growth, declining corporate profits and the threat of economic doom emanating from Europe, it’s hard to consider ELSS mutual funds as a serious alternative. However, I’d like to argue that this is the time to be actually act contrary to instincts. Firstly, the enhancements to the interest rates are not all that there is to the small savings story. What the government has actually done is to switch to flexible, floating rate mechanism for these instruments. The interest rate have been linked to what the government is paying for its debt in the larger market for government securities. Every year in April, the rates will be reset according to what the market yield for government debt is. While the NSC will stay locked at whatever rate was locked in at the start, PPF returns will change every year.

The government’s motive is clear—it would like to collect as much funds as possible while paying as little as possible. Over the last five years, these instruments were less attractive than other products. As a result, inflows had suffered. The current set of changes are aimed squarely at ensuring that the government gets good inflows while holding rates as low as possible and still be competitive. In the new arrangement, interest rates will be automatically lowered or raised every year. Practically speaking, the way these things work, you can expect to always be slightly lower than the real inflation rate. Your money will erode, but very slowly. And that’s the price you pay for a government guarantee.

On the other side of the table, I think this is a good time to be buying equity with the three-year horizon that tax-saving funds have. Investing in equity always makes sense when the markets are as beaten down and pessimistic as they are now. Sure, they could still decline sharply over the next few months, but the solution to that is cost-averaging.

All things considered, here’s the best recipe for this years’ tax-saving investments. Whatever amount you have left over after deductions so far, divided it by four. Invest each part in a good ELSS mutual fund at a one-month gap over the next four months. This will give you a good average entry point no matter what happens in the equity markets during the period.

In fact, this could well be the last year when these savings are possible. If the government manages to pass the new Direct Tax Bill in the winter session of parliament as promised, then this year is the last one when you can save taxes with an equity investment of only three years’ lock-in. From next year onwards, the only way to save tax with equity investments will be through Tier I NPS deposits, which will be locked in till retirement.