Column : Why EET’s an important tax reform

Aug 15 2009, 22:36 IST
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SummaryThe proposed exempt-exempt-tax model in the draft tax code will produce an equitable and inclusive long-term savings environment and improve retirement incomes.

The proposed exempt-exempt-tax (EET) model in the draft tax code will produce an equitable and inclusive long-term savings environment and improve retirement incomes. The EET model will create a level playing field between tax preferred instruments and focus both product providers and savers on investment performance as the driver of product choice.

For most countries that have adopted a similar model, the policy choice has really been between the classical expenditure tax (EET) and the pre-paid expenditure tax (TEE). While TEE is certainly an attractive option since it causes immediate revenues for the government, and which are deferred until retirement under an EET model, the pre-paid expenditure tax has a major drawback.

The front-end tax relief under an EET model is normally perceived as more “valuable” and is less vulnerable to policy risk. For example, a future government may not feel bound by its predecessor’s commitment not to tax pensions or long term savings in a TEE model.

In the EET model, everyone would have identical rights and choices and face an identical tax treatment on exit. And if there's a threshold beyond which withdrawal is taxed, it would simply motivate people to annuitise their pension corpus, and hence ensure that they don’t run the risk of outliving their retirement savings. Importantly, by simply keeping their withdrawals below the prescribed threshold tax-free limit, individuals will be able to enjoy a healthy replacement rate without being subjected to tax even when they exit.

Importantly, the draft tax code does not discriminate between employee and employer contributions and provides an identical tax preference below a prescribed limit. However, it’s not obvious yet how this will work in practice in the context of legislated pension and provident funds. For example, as things stand, salaried employees in the formal private sector would be forced into the EET house and packed into the ‘EPS and EPS’ room. Unless the EPFO’s vesting, withdrawal and investment rules are modified, the population in the EPFO room would find their door bolted from the outside. Ditto for PPF, superannuation plans and NPS. Hence, implementation of a uniform EET model across retirement savings options would require full portability across employers as well as across various eligible product options.

Easy portability would cause a dramatic improvement in retirement incomes for two reasons. First, salaried workers in private firms would no longer be forced to open new EPF and EPS accounts when they move jobs. Their EPF and EPS account would simply move with them (as they indeed should) and grow over time.

Similarly, civil servants moving to private jobs or salaried workers turning entrepreneurs would be able to “roll-over” their savings to any other permitted intermediary without any tax burden. And second, since workers would also have an option to move their savings, in part or full, to any other “permitted savings intermediary”, it would automatically motivate each permitted intermediary (approved PFs, superannuation funds, insurers and the NPS) to compete to attract the individual's savings. Importantly, in addition to the rights and choices regarding savings providers, individuals will also have the ability to choose between investment options based on their age, risk appetite, income and investment horizon.

Portability across intermediaries and investment choices will require unique individual accounts issued through a centralised administration and recordkeeping facility of the type already created by PFRDA for the NPS. While this process will need to start pretty much from scratch for individuals covered by the EPFO, PPF or superannuation funds, setting up a CRA for EET is unlikely to be a challenge for India based on our experience with the securities depositories, the tax information network (TIN) and the CRA established recently by the PFRDA for NPS. Importantly, the initiative to issue unique IDs to everyone in India through the UIDAI should further strengthen India’s capacity to implement the EET model.

The proposed EET model is the first important step towards a convergence across all long term savings options and could simultaneously help bring all retirement provisions under a single statutory regulator—the PFRDA.

In the coming months, many will undoubtedly argue against EET and defend the merits of an EEE (fully tax exempt) treatment for retirement savings—especially for the middle and lower income segments. For these workers, a phased withdrawal under an EET framework may not result in any tax upon exit.

In order to achieve this also in real terms, the finance ministry could consider an inflation indexed tax-free threshold so that such workers are able to increase their consumption over time in step with inflation.

The author is director, Invest India Economic Foundation

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