Macroeconomic compulsions: Of course, it's not entirely an altruistic spirit that underlies Chidambaram's decision to let you be the master of your investment destiny. It's a more compelling macroeconomic reality: the unsustainable interest burden imposed by artificially high interest rates on small savings. Given their immense popularity—and not just with risk-averse investors—small savings cannot be guillotined with one hack, so policymakers are compelled to resort to the rather more inventive method of killing it by slow poisoning by making it progressively less alluring.
To that extent, Budget 2005 only advances a larger agenda that inspires these moves: to encourage a gradual exodus of investors from small savings to the market, including in stocks and mutual funds. The net result: to lighten the government's interest burden. And to absolve itself of the thankless responsibility of delivering on people's unrealistic expectations of high returns at zero risk.
Accordingly, successive governments have been incentivising investments in equity and equity funds: for instance, equity dividends are tax-exempt in your hands, and so are long-term capital gains. In fact, equity investments today enjoy a distinct tax edge over debt instruments, particularly since Budget 2005 has made interest income taxable in your hands.
It is for the same reason that the government has initiated pension reforms by replacing a defined-benefit scheme (where the pensionary benefits you will get on retirement are predetermined) with a defined-contribution scheme (where your post-retirement benefits are not predetermined and will depend on how well your contributions are managed) and by allowing provident funds to invest in equity directly and through mutual funds.
Budget 2005 has also taken a significant step towards a tax regime that will derail the gravy train where most investments enjoy tax exemptions at all three stages—investment, accumulation and withdrawal. This EEE system, as it is called, will eventually give way to an eet system (where exemptions will continue at the first two stages, but withdrawals will be taxed) to bring it in line with global tax systems. The abolition of the tax break on interest income kicks in this regime by default, but Chidambaram has said he will set up an expert committee to work out the roadmap for the transition to a full-fledged eet system on all investments. This will mean that even withdrawals from the Public Provident Fund and the Employees Provident Fund will be taxable.
Look beyond tax breaks: As a taxpayer and an investor, Budget 2005 will require three things of you. The first is to learn to look beyond tax savings when you're charting the money course of your life. You'll still do well to cynically exploit these tax breaks till they are around, but it's important to not let the tail wag the dog—or let the tax savings influence your investment decisions. In the following pages, we've outlined a hierarchy of investments that might serve you optimally given the new rules of the tax-saving game.
Court risk or perish: 'Risk' isn't quite a four-letter word, so don't run scared of it. Instead, learn to embrace the risk of equity investments. The harsh reality is that however well 'risk-free' fixed-income instruments may have served you in the past, you can no longer depend solely on them to finance long-term financial goals such as retirement, particularly since in the new tax regime, their post-tax returns will barely beat inflation. Understand, however, that whereas high returns come with high risk, the inverse doesn't necessarily hold: you cannot expect high returns simply because you take higher risks.
It has been well established that over the long term, equity investments offer the best returns. The stockmarket is currently at an all-time high, but everything points to sustained buoyancy. Get some equity exposure, even if not directly. For a start, there are ways of gaining indirect exposure to equity investments—through top-performing equity-linked savings schemes from mutual funds, which additionally qualify for tax breaks. Over the past one year, the best of these funds have offered returns in excess of 70 per cent.
Get financially literate: It's important that you acquire a wider, deeper understanding of money matters. In a broad sense, the liberating feeling of having greater flexibility in making your investment decisions comes with a greater responsibility to understand the fundamentals of investments and financial planning principles. Since you are no longer being shepherded into channelling your investments into particular instruments, you are largely on your own. Take charge of your personal finances.
Elsewhere: There is, of course, much else in Budget 2005 that will impact your personal finances. Some of the proposals— such as the fringe benefits tax and the cash withdrawal tax—are ripe for a rollback. In the following pages, we offer you a more clinical understanding of the precise manner in which they will impact you. Yet, in their impact, they are more in the nature of bicycle accidents. It's far more important that you be prepared for the death of an old regime and the birth of a new one.
