Home > Uncategorized > Piggy Banks and Political Pork – I

Piggy Banks and Political Pork – I

One rough estimate shows households paid R180,000 crores in hidden taxes to the Government in 2009-10. That is a whopping 40% of R435,000 in explicit direct taxes collected by Government in that year.

 

This sleight of hand is accomplished through negative real rates of interest. If “negative real rates of interest” appear forbidding think of them as the interest that you earn on your savings after taking out inflation. Bankers fudge on the interest they offer us while the Government is keen to hide the true rate of inflation. The real rate of return to us is the actual difference between these two nebulous numbers. This return can actually be negative!

 

Consider saving money in 1 year fixed deposit as an example to analyze. You have given away your money today while it will be returned to you one year hence with interest, say 8% pa. If you saved R1000 , one year from now you would get back R1080.  The key thing to understand, is that the R you receive one year hence are not the same R that you invested.  The value of the R will have diminished depending on whether there was inflation, and if so, by what amount. Assume that inflation in the year was 5%.  Then after one year, while you get back a nominal sum of R1080, it is worth only R1030 because the value of the R in the interim period has diminished by R50. The real return to you is only R30 or 3% pa.

 

Consider the same deposit when interest rate offered is 5% and the inflation rate is 8%. In this scenario you gave away R1000 for one year and at the end of it you get back R1050 in nominal terms. While your money was sitting in the bank for one year, the Government was busy surreptitiously increasing the price of all goods and services by 8%. One year later when the banker returns you R1050 you find you can only buy stuff worth R970 in terms of R you had given to the bank 1 year earlier. Hence, while your nominal return stays 5%, in real terms your return is a negative 3% because the value of the R has meanwhile diminished by 8%. The banker and the Government will disclaim responsibility for your loss. But the loss is real.

 

Your loss is not just “notion” but real. It is not obvious by design, not accident. The powers that be in our system have a vested interest in not telling you of your loss. In the normal course, if banking was in the private sector and not so tightly regulated, your loss would go directly to the bank’s bottom line. However, in India that doesn’t happen. RBI’s regulation of interest rates and things like Cash Reserve Ration [CRR] and Statutory Liquidity Ratio [SLR] are levers that are used to funnel your R 30 loss into the pockets of large bank borrowers of which the Government is the largest.

 

Actually, when you put R1000 of your saving in the fixed deposit for 1 year, about R350 of it went as direct loan to the Government. Of the balance 65% about R600 goes to making loans to commercial borrowers which includes R200 lent to farmers who almost never repay their loans. The balance 5% is cash with the bank and CRR.  So broadly speaking, 35% of your money went to Government, 40% to private borrowers and consumer loans and 20% to privileged farmers who know from experience that their loans don’t have to be repaid. All these powerful people gang up to keep loan interest rates as low as possible in the name of development of the economy. Unable to charge a sufficiently high interest on loans, the bank compensates itself by keeping the return on your deposit as low as possible with active connivance of the Government.

 

Why is this state of affairs so dishonest and problematical? Let us look at it from the taxation angle. The total banking systems deposits amount to 6,000,000 crores in 2009-2010. These deposits would have yielded between 6 to 8% nominal. Let us take the upper end 8%.  What was inflation during the period?  The Government makes that very hard to figure out but here the relevant rate is NOT the WPI nor the so called core inflation. What matters is the real prices you pay for the goods and services you buy, and the best proxy for that is the headline CPI number.  That number was something between 11 to 14% pa. Let us assume 11%.  The negative real interest rate that you faced was about 3%.  A simple calculation shows that you lost 3% of 6,000,000 crores, amounting to 180,000 crores. This amounts to 40% of the total direct taxes collected by Government. Note all of this 180,000 crores of taxation falls on the households and not the corporate sector.

 

Let us assume that your annual income is 600,000 so you pay no Income Tax. Further let us assume you are around 30 to 35 years and that you are basically saving money to buy a house with the help of a bank loan. Roughly, you would need to save about 3 years’ income to buy a house about 10 times your annual salary.  That puts your savings in the range of 1,800,000. Assume you put this away in a 1 year fixed deposit as before where you get 5% while inflation rages at 8%. The real loss per year amounts to R54,000.  In short, even with 0 income tax bracket, the magic of negative real interest rates ensures that you cough up roughly 9% of your gross income as hidden taxes to the Government. And this analysis assumes you hold just 3 years of your annual income in savings.  The more your savings, the more the hidden tax you pay. Closer to retirement, your savings could be 10 times your annual income in which case you would pay 36% of it in hidden taxes to the Government. Remember the tax base for Income Tax is your annual income while the tax base for this hidden tax is your total wealth held in bank deposits.

 

The hidden tax on bank deposits is a gigantic rip off of middle class households who should be rewarded for saving rather than punished for them. The sheer inequity of it is astounding but never revealed to the mugs who are caught and mulcted by the system. We shall see how this burden of hidden taxes can be avoided by households by a number of strategies in an another article.

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Categories: Uncategorized
  1. Rajnish Ahuja
    July 4, 2011 at 1:34 pm

    Sonali,
    I simply love it when you talk about basics of economics.I get 100s of pieces on politics but much less on fundamental economics governing our life. So I would rather have you writing on this:-)

    I argue with people around me almost on daily basis who support all kind of subsidies and cry foul with petrol prices.(even if these increases are fractions of price increases in INTL markets). For example, I got this question again
    “High petrol price will drive up the cost of daily usage items, then how can abolishing subsidies to oil products can be beneficial to poor?”.

    With my limited grasp on the subject, all I could manage was , that

    “At the least, the higher petrol price only affects the middle class or whoever choses to drive such vehicles or use oil products, but these subsidies cost every single individual in the form of higher taxes which may be direct or indirect , whether they chose(or not) to use petroleum products”.

    You can elucidate it further ?

    PS: I would like to assume that you acceded to my request(last week) of writing on this subject .Thank you even if you did not :-).. btw, please link the second part of this also in the blog here.

  2. The Wabbster
    July 8, 2011 at 2:17 pm

    Well written. These things must be written about more often by more people.

  3. July 27, 2011 at 2:22 pm

    Sonali, I would request you to also elucidate super profits being earned by the Banks and astronomical salaries and perks by employess looking at the difference between cost of deposits and interest charged on loans.
    Thanks
    ttthakur

  4. September 5, 2011 at 3:08 pm

    Are bank deposits ever inflation-adjusted? Is it at all practical?

  5. October 16, 2011 at 1:47 pm

    Great thought pls write more and more so that public will be aware.thanks

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