Economists have long fretted about the slow pace of capital formation in India and the modest levels of household savings. It is true that gross household savings—financial and physical combined—are hardly buoyant. At around 24-25% of GDP, the ratio has remained largely flat in recent years.
While this could certainly be higher, it also needs to be viewed in the context of rising incomes, growing household wealth, and changing lifestyle preferences over the past few decades. As wealth has increased, the propensity to save appears to have declined.
Net financial savings have weakened as households increasingly borrow—both to meet basic expenses and to finance aspirations. Household debt has risen steadily, crossing 41% of GDP by March last year. As long as banks are underwriting these loans prudently, this by itself is not a cause for alarm.
Shift towards market linked instruments
The real concern lies in the sharp shift in the mix of household financial savings away from bank deposits and towards market-linked instruments. In 2016-17, bank deposits accounted for nearly 60% of household financial assets. That share has since fallen sharply to around 35%. Over the same period, equities and equity-oriented mutual funds have surged in popularity, with their share rising almost four-fold to about 15% in just five years.
A deeper equity market is desirable in a developing economy, as it provides companies with access to growth capital. There is nothing inherently problematic about this shift. The problem is that banks are now facing an acute deposit shortage. The loan-to-deposit ratio is nudging 100%, an all-time high, constraining their ability to expand credit. The primary driver of this shift is the unattractive return on bank deposits. Interest rates have softened—three-year deposits fetch a modest 6.3%—and the interest earned is taxed at the individual’s slab rate, which can be as high as 30%.
Comparative taxation: Equities vs Deposits
Equities, by contrast, enjoy a far more favourable tax treatment. Long-term capital gains on equities and equity-oriented mutual funds are taxed at 12.5% if held for over a year, with gains up to `1.25 lakh annually exempt. Short-term gains are taxed at 20%. With equities also delivering superior returns—often in the range of 8-9% or more—the post-tax comparison overwhelmingly favours market-linked investments.
Debt-oriented mutual funds fare little better, as capital gains are taxed at the slab rate regardless of the holding period, with no indexation benefit. On a post-tax basis, therefore, even modest equity returns often outperform fixed deposits, despite the higher volatility. Economists point out that this skewed tax treatment has materially altered household behaviour.
Bank deposits and fixed-income products have become distinctly unattractive for savers as few countries impose such a wide differential between the taxation of deposits and equity investments. A recalibration is warranted, particularly as weak deposit growth threatens to choke credit flows to the economy.
The argument is not about privileging deposits over capital markets. A vibrant equity market is essential for a growing economy, and policymakers have rightly encouraged financial diversification. The concern is about balance. Not taxing deposit income at the slab rate would entail some revenue loss for the exchequer.
But impairing banks’ ability to lend poses a far greater risk. Credit is the lifeblood of economic growth, and any sustained slowdown in credit expansion would have far more damaging consequences for the broader economy.