As is well known, taxation, in its various forms, affects the ability and willingness of an individual to generate income, save and invest. Depending on the base, rate structure and the level of the tax burden, these effects vary. As the structure of taxation can have an influence on the real sector of the economy, taxation policy is often used as an important tool to promote savings, capital formation and economic growth in both developed and developing economies.

However, there are significant differences in the tax mix and tax structure between countries, resulting in different outcomes of tax policy changes. In the backdrop of the Budget, in India, too, we have some discussions of the use of fiscal policy instruments. But the success of such policy measures is limited, as savings in the Indian economy is dependent on many factors, of which fiscal incentives is only one.

The savings rate in India has witnessed acceleration in recent years. At the aggregate level, there has been an improvement in the proportion of savings to GDP in recent years, which has enabled India to break out from its earlier low levels of savings. Recent data indicates that savings GDP ratio rose to 32% in 2005-06.

Pushing up the savings rate further might be more difficult as it requires sustaining the growth momentum. But what is even more important is to avoid getting into an ?excess savings? situation, which we saw in the earlier part of the present decade. This implies that savings exceed investments in the economy, or indicates the inability of the economy to absorb high levels of savings. Slowing the growth momentum and initiatives to boost savings further could result in such a situation.

The effect of tax incentives on pushing up the savings rate further could be limited due the following reasons: inelasticity of savings-to-tax changes; due to the structural composition of savings; and the demographic profile. In an economy with skewed income distribution and a large proportion of the population in the lower and middle-income categories, the propensity to consume in general would be high. Using Keynesian terminology, ?marginal propensity to consume? would be high for low-income sections.

Overall savings towards which these households contribute are, hence, not affected by changes in direct taxes. With regard to indirect taxes, consumption is more elastic, thus changes in rates, such as a decline, would stimulate further consumption. At the other end of the spectrum, for higher income categories, savings are more elastic to changes in interest rates rather than taxes. A change in tax could only lead a reallocation of portfolios and not a substantial increase in savings per se. So, monetary policy matters more in this case.

Second is the structural composition of savings. A decomposition of the 32% savings rate shows that the improvements have generally been widespread, but household savings remained stagnant at around 69% of the total. Overall, since 2001, while the aggregate saving rose, the household savings rate was stagnant.

Moreover, the composition of household savings has not changed significantly in favour of financial instruments, as the share of financial savings has been more or less stagnant?even falling in some years. So, to boost savings further, we need a blend of monetary and fiscal policies in terms of altering interest rates for households and taxes for non-households, who already enjoy a handful of concessions.

The coexistence of high investment and savings rates is also related to the population dividend associated with a change in the country?s age structure, which usually happens after a ?baby boom?. The outcome of this is that when the percentage of labour-age people in the population increases, youth dependency and aged dependency rates go down. This can increase the savings rate because, first, there will be an increase in the gross incomes of the entire population, which will elevate the level of savings; and, second, it increases in the number of working young people and reduces the population?s tendency to consume, thereby increasing savings. This gives an extra impetus to the rising savings rate, irrespective of the policy regime.

The writer teaches economics at IIT, Chennai