How do tax incentives impact household financial savings?

How do tax incentives impact household financial savings

The difference between income and expenditure is referred to as savings. Because investment is primarily financed through savings, a high level of savings aids the economy in its endeavour to continue to grow. Given the significance of saving, numerous studies have been conducted on the behavioural and other factors that influence saving. In this article, we are going to trace the trends, composition, and distribution of household savings in India, the relationship of household savings with tax breaks, and also the primary determinants of household savings in India.

Household Savings

The households with investments in financial products are those households that hold outstanding investments in at least one of the following products:

  • Bank fixed deposits
  • Kisan Vikas Patra
  • Insurance schemes
  • Provident funds and pensions
  • Post office savings
  • National Savings Certificate
  • Mutual funds, and
  • Listed shares

On the other hand, there are many households that make some investments in physical assets. They have outstanding investments in the gold and real estate sector.

Factors Affecting Indian Household Savings

The primary determinants of household savings in India are as follows:

1. Income:

There is a link between increased income and increased national savings. The level of income is an important determinant of the saving capacity of individuals at all stages of development.

2. Economic liberalization:

Economic liberalization measures, which began in the mid-1980s and intensified after 1991, contributed to GDP growth (average growth rate of 5.6%) and savings rate (17 percent). This only emphasizes the fact that income is the most important determinant of savings, and that economic liberalization aids in increasing savings by the means of increasing income.

3. Interest rates:

Currently, all interest rates, with the exception of those on Post Office small savings programmes, Provident funds, Government of India Bonds, and programmes for Senior Citizens (instruments with sovereign guarantee), are market-determined. Such interest rates influence the volume of savings that an individual is willing to make.

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4. Tax incentives:

Until March 2005, the Indian government offered a variety of tax breaks. Because of the dual benefits of tax avoidance (not evasion) and State Cover, people usually invest heavily in these instruments.

Tax incentives to promote financial savings globally

Tax breaks for certain specified financial products have been used in India, as well as other countries, to influence saving into financial markets through the Income Tax Code. The need to incentivize households to invest in long-term saving instruments in order to build assets to finance retirement consumption in old age is often the driving force behind tax breaks. In the United States, for example, new vehicles for individual retirement savings were created as a result of tax legislation in the 1970s and 1980s. In fact, most OECD[1] governments use tax incentives to encourage private retirement savings. The need to promote long-term savings is also a driving force behind the Indian tax incentives. Certain bank deposits, small savings instruments administered by the Indian government, insurance, and pension products are among all the assets that are exempt.

Do tax incentives increase financial savings?

In recent research done by financial experts (Pandey et al. 2018), a study has been made to analyse the effectiveness of tax breaks on financial savings in India. In such research, the aggregate national accounts data was reviewed to see whether financial savings had changed with regard to changes in tax breaks or not.

The findings suggest that tax breaks have no or very limited effect on increasing the level of overall financial savings and, at most, have a “substitution effect,” meaning that they cause households to channel their savings into tax-exempt products rather than increasing overall savings. Tax breaks also provide a subsidy to better-off households that are subject to income tax. This implies that tax breaks in India primarily benefit those who are already at the top of the income scale.

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Non-financial assets such as real estate and gold account for a large portion of Indian households’ wealth. In India, tax policy has been used as a lever to encourage people to save in financial assets and to save for the long term. This is accomplished through Section 80C of the Income Tax Act 1961, which provides tax breaks for specific financial products such as fixed deposits, small savings instruments, pension, and provident funds, and insurance.

Furthermore, international evidence from around the world also suggests that tax breaks for specific financial products only have a substitution effect, meaning that households shift their investments to assets that qualify for a tax break or tax advantage. Several direct tax committees have raised similar concerns about the structure of tax breaks in India, including the Shome Committee in 2001, the Kelkar Committee in 2002, and the Malegam Committee in 2015.

In India, it is seen that tax-incentivized households invest in the financial products that are provided a tax break or advantage, particularly insurance.

In 2016-17, a much higher proportion of taxed households claimed to have outstanding investments in fixed deposits, insurance, small savings, and pensions – all of which are Section 80C instruments. For example, 88 percent of non-taxed households report having outstanding investments in fixed deposits, compared to 96 percent of taxed households. The next most popular instrument is insurance, with 50% of non-taxed households having insurance compared to 90% of taxed households; this is followed by provident/pension funds, where the difference is much greater – 7% of non-taxed households compared to 55% of taxed households.

Household financial savings in India

Household investment in financial assets (or financial savings) had been steadily increasing from around 11% of GDP in 2001 to around 17% in March 2007. Despite the fact that there were no tax breaks between 2003 and 2005, financial savings increased. Since 2007, a tax break has been announced almost every year. Despite this, by March 2013, financial savings had dropped to around 11% of GDP. The conclusion remains the same when looking at the other series of years. Financial savings as a percentage of GDP remained relatively constant from 2012 to 2015, and only slightly increased in March 2016, possibly due to the increase in the overall tax exemption limit from Rs. 100,000 to Rs. 150,000 in the 2014-15 budget. Therefore, the link between tax breaks and financial savings appears to be questionable. This data is according to the research literature on “Impact of Tax Breaks on Household Financial Saving in India” published in India Policy Forum (Pandey et al. 2018).

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What should the Government do to boost the trust of households in financial savings?

Governments are funded in two ways: first, through revenue streams such as taxes, and second, through borrowings, which are primarily made available through financial institutions such as a pension, housing, provident, and insurance funds.

On the revenue side, India’s tax-to-GDP ratio of around 17% is half that of the OECD average (35%) and is low even when compared to other emerging economies such as Brazil (34%), South Africa (27%), and China (22%).

To begin with, banks and NBFCs must gain credibility, but a policy push is also required to promote savings schemes such as provident and pension funds, as well as insurance products, to the general public.

It could be argued that India has all of these, but the reality is that India is largely an informal economy with no social security – such as a provident fund – for 90 percent of the workforce and pensions available only to the privileged few. Pension fund assets as a percentage of GDP in India are 1%, while they are 95% in the UK.


Non-financial assets such as real estate and gold account for a large portion of the wealth of Indian households. However, our tax policy has been used to encourage long-term savings and promote savings in financial assets. To put it another way, tax breaks have influenced people to save for specific products like insurance and pensions. Hence, the Government must take more efforts to educate people on the tax policies that it offers to promote household financial savings.

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