Small Savings Schemes are more of social welfare schemes. Recently govt mooted idea to cut interest rate of small savings schemes. Any revision in the interest rates of such schemes faces opposition from various quarters. The worst part is that this protest is without any logic and reasoning. As a citizen of India, we should understand the mathematics behind the decision. After thorough understanding, we can debate and discuss the merits or shortcomings. Also, we should review each and every decision 360 degrees. Any myopic view of the same will give biased approach. This post is not a political post. The objective of this post is to share the benefits of any potential interest rate cut in small savings schemes and why it is necessary.
For the benefit of readers, small savings schemes are the govt run schemes that provide higher interest rate. These are meant for small investors backed by a sovereign guarantee and tax benefits. Some of the small savings schemes are Sukanya Samriddhi Account (SSA), Public Provident Fund (PPF), Post Office Monthly Income Scheme, Senior Citizen’s Savings Scheme etc. The tax benefits are not available on schemes like Kisan Vikas Patra, Post Office Monthly Income Scheme, Recurring Deposit etc.
The goal based small savings schemes enjoy EEE status i.e. Exempt, Exempt and Exempt at all three stages. For example, SSA is for the welfare of Girl Child and PPF is for retirement planning. First exemption is at investment stage. The deduction is allowed at the time investment u/s 80C i.e. investment is tax free. Second exemption is on returns i.e. returns from these schemes are tax free during the accumulation phase. Last exemption is at the time of withdrawal/maturity. The income or (investment + Return) at the time of maturity is tax free in your hand i.e. there is NO TAX. This is the biggest draw for these small savings schemes as we should check post tax returns rather actual interest rate offered.
Small Savings Schemes – Why Govt should cut interest rates
1. Post Tax Interest Rate: Normally investors compare the returns of small savings schemes with the returns of FD that is taxable. Even the interest of 5-year tax free FD is taxable on maturity. Therefore, it is not right to compare the 8.7% tax free return of PPF with 7.75% taxable return of FD. Depending on the tax slab, 8% tax free returns means double-digit returns. Currently, all the small savings schemes offer a return of more than 8%. The highest interest rate is offered on Senior Citizens Savings Scheme at 9.3% and Sukanya Samriddhi Account at 9.2%.
On the other hand, the FD returns are in the range of 7.25% to 7.75%. Therefore, the post-tax return of FD should be around 5.5% to 6%. On the other hand, for apple to apple comparison 8% tax free returns mean 10% plus taxable returns. At the macro level, small savings schemes offer almost 25% to 40% extra returns compared to similar investment options. Of course, the exact calculations will depend on the type of small savings schemes and the tax slab of the investors. It may vary for different tax slabs. It makes a perfect case study for govt to reduce the interest rate. Even after reduction of 100 basis point or 1%, the small savings schemes will offer superior post tax returns to investors.
2. Inflation: The biggest concern of any investor is to beat the inflation. The inflation eats into your returns, as i discussed in my post Impact of Inflation. As the small savings schemes are for small investors. Therefore, in my opinion, small savings schemes should provide a tax free return of 1% more than inflation. In this case, a small investor should be more than happy. Therefore, assuming inflation to be on the higher side at 6% this year. The tax free return of 7% should be good enough for small savings schemes. It makes the case for a cut of 1.25% to 1.5% interest rate cut on small savings schemes.
3. Reduce Lending Rates: In my opinion, the only reason why banks are not able to pass the benefit of repo rate cut to borrowers is due to a higher interest rate of small savings schemes. The FD interest rate plays an important role in the cost of funds for banks. If the difference between the interest rate of FD and small savings schemes is wide then FD will become non-competitive. Currently, the FD interest rate is 7.75% and PPF interest rate is 8.70%. The PPF is EEE status. An investor who doesn’t want to lock for a long period will not mind settling at 1% lower interest rate. Now assume, to decrease the cost of funds, banks decrease FD interest rate to 6.5%. In this case, there will be a huge impact on the FD business of the bank. People will prefer small savings schemes. Therefore, it is important to cut the interest rate of small savings schemes so that bank can reduce FD interest rate. It will decrease the cost of funds for banks. It will, in turn, reduce the lending rates of loans like home loan, personal loan etc. The lower lending rates are beneficial for borrowers. It is also critical for the revival of the economy and sectors like real estate, auto etc.
4. Consumption Cycle: India is a nation of savers. As per information available on the web, Indians save approx 30% of their income. In short, out of 100 Rs, Indians spend 70 Rs. This savings fig for developed economies is around Rs 20. For the revival of the economy, it is important that people should spend. A decrease in small savings schemes interest rate can increase the spending. Obviously, in the long run, it should accompany an increase in income levels. Basically, it’s a cyclic process. If people will spend, it will increase consumption. The increase in consumption means more demand. More demand means more jobs thus increase in income. It is a complex and long process.
I am not saying that investors should not save but increased spending may mean an increase in saving in absolute terms. For example, my income is Rs 1000 today. I save Rs 300. I will not mind reducing my savings rate from 30% to 20% if my income will increase to Rs 2000. In this case, i will be savings Rs 400 but i increased my spending from Rs 700 to Rs 1600. This will boost the economy to next level. This point is very subjective and my personal opinion.
Words of Wisdom: According to news reports, Govt may not cut the interest rate of truly social welfare schemes like Sukanya Samriddhi Account and Senior Citizen’s Savings Scheme. It is a welcome step. The other schemes that are used for investment purpose, the tax free return of 7% in the current scenario is quite reasonable. I hope all the experts and economists will welcome this step. It will be the indirect contribution of all the investors towards acceleration of economic growth. Lastly, it will benefit everyone in the long run.
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