FM Pranab Mukherjee said on Tuesday that he will consider tax-free status for bonds floated by non-banking finance companies (NBFCs) or other private financial institutions (PFIs) to fund infrastructure projects. The estimated deficit in financing for core infrastructure projects in the 11th Plan (2008-12) is estimated to be about Rs 7,50,000 crore. This deficit is equal to around 35% of the investment planned in the infrastructure sector during the period. It seems that the FM?s ?grant? is to take care of the impending shortfall in funding. Let?s try to understand the merits of financing infrastructure projects through tax incentivised bonds.
One of the key roles of the government is to facilitate infrastructure development, which raises living standards, improves long-run productivity and also bolsters the economy. Broadly defined, infrastructure includes roads, power, airports, railways, irrigation, drinking water, etc, for public use. Building infrastructure costs a substantial amount of money and the monetary returns on these investments accrue over a fairly long period of time.
One way to fund infrastructure development is to facilitate public capital accumulation through NBFCs and PFIs. The government has set an ambitious target of investing Rs 22.5 lakh crore in infrastructure during the 11th Plan period. In the first two years of the 11th Plan, many tendered public-private partnership (PPP) projects did not find bidders due to viability concerns. A major reason the projects were not viable is the low returns on these projects vis-?-vis the cost of capital. Exemption of taxes on infrastructure bonds would mean lower interest rates paid to investors by NBFCs and PFIs who, in turn, will provide low-cost financing for these projects, thereby making them more viable.
In a way, the FM is trying to provide subsidy to the infrastructure sector. The only difference is that instead of giving a grant or a direct subsidy, the FM is providing an indirect subsidy through tax exemption. So, effectively, what the FM is saying is that if you lend money for infrastructure projects to NBFCs, the interest paid to you on the bond would be tax exempted. If the government does not take a share from your interest income, as an investor you would be happy with a lower interest rate from the issuer. The government loses out on the tax revenues. The tax exemption clause helps the NBFC and PFIs tap public savings that would have otherwise reached other intermediaries like banks or mutual funds.
The problem is not that the FM wants to subsidise the infrastructure sector?I believe he should?but that this is not the best way to go about it. While the government would forgo tax collections each year, NBFCs and PFIs would receive only two-thirds of this ?subsidy?. The remaining one-third would be picked up by the high net worth investors who ideally shouldn?t receive any tax benefits.
Let us understand why not all the ?subsidy? would reach the NBFCs and PFIs and eventually the infrastructure developers, and how a good proportion of this subsidy would be shared by the investors. Consider the last popular tax savings bonds that were issued by RBI in 2003. These were five-year bonds bearing a coupon of 6.5%. An equivalent five-year taxable bond then yielded 8%. Assuming a marginal tax rate of 30%, a taxable 8% bond means that an investor makes effectively 5.6% post tax, i.e. he ends up paying 2.4% (30% of 8%) to the government as taxes. However, with a tax-saving bond, the coupon is 6.5%. Of the taxes (2.4%) that the government forgoes, more than one-third (0.9%) is held back by the investor. Another downside to this is that if you allow high-income taxpayers to avoid taxes, it doesn?t do a world of good to the already low tax discipline in the country.
Rajiv Lall, CEO, Infrastructure Development Finance Co, suggests that the government should allow insurance and pension firms to buy debt paper of infrastructure focused NBFCs, instead of allowing tax-free private sector bonds. I think it is a good suggestion. In other industrial countries with good infrastructure, pension funds are often active participants in infrastructure financing. Of the ten largest pension funds in the world, six are public pension funds, and all six are strong players in infrastructure investment. The message is clear. If public pension funds have the opportunity to invest in infrastructure, they do so, sometimes quite extensively. They would recognise it is a good investment that also responds to the needs of a growing economy. Likewise, insurance firms tend to have long dated liabilities. Having long dated infrastructure bonds would be a good fit for the asset liability management of their balance sheet. Both insurance and pension firms will have higher funds available in the future as the country has a young demographic profile. Tapping those resources would be more prudent than creating tax deviations through exemptions. Personally, as an investor, I would welcome the FM?s suggestion. However, I am not sure if it is the best thing for the government.
The author, formerly with JPMorganChase, is CEO, Quantum Phinance