The Government Needs To Expand Tax-Free Bonds, Not Eliminate Them. Why R Jagannathan Is Wrong

In his article, R Jagannathan argues that tax-free bonds only benefit the rich, and must be discontinued. Here is why he is wrong.

The basic premise of tax-free bonds is that depositors receive income that is tax free.  This creates a strong incentive, especially among higher-rate taxpayers, to invest in tax-free bonds. In the United States, tax-free bonds represent around 43 per cent of the entire bond market, creating an excellent incentive to save for the investing public, and a pool of capital that is used by government at national, state and even local level.

In India, the total size of the bond market is only $812 billion or 43 per cent of GDP, compared to 50 per cent in China and 90 per cent of GDP in the US.  For a country with almost twice the savings rate as the US (29 per cent in India vs 16 per cent), it is shocking but not surprising that more of our citizens do not invest in bonds.

But you see, the Indian consumer is very savvy! The reality in India is that real interest rates are negative once you pay the tax man.  In other words, long term deposits yield 7.75 per cent gross, or 5.5 per cent after tax, yet inflation is 6.5-7 per cent, so the net real return to investors after tax is -1.5 per cent.  You lose money year after year on bank fixed deposits! It is appalling that the reason depositors lose money is solely because government taxes interest on deposits. In a saner world, the tax would be only on the real return after inflation, and not on the nominal return.

Knowing that you lose money on fixed deposits, Indians prefer to buy gold instead. Gold has the great advantages of being easily transported, of being a proven hedge over the long term against inflation and economic upheaval, of being fully convertible into hard currency, and most of all it is out of the reach of the tax man!

The value of privately held gold is estimated at $1 trillion, with around $50 billion in additional gold imports each year.  This is a direct drain on precious foreign exchange, which can be reduced if there were more tax free bond options.

There are three main parameters that determine the attractiveness of bonds to investors. 1. The months or years before maturity of the bond. 2. The creditworthiness of the issuer. 3.  The taxable or tax-free status of the bond.

Having a liquid market made up of a healthy level of both issuers and investors in all types of these bonds, is very important to the health of the bond market in particular, but also the economy in general.  This is because the pricing of these bonds and their daily movements gives a huge amount of information regarding market sentiments and expectations about the economy.  In the US, a widely shared sentiment among professionals is that in a market-led economy, the Bond Market is no less than a deity!

Specifically, tax-free bonds serve the following purposes, which is why in America not only the federal and state government, but even municipalities are allowed to issue them.

First, they allow local infrastructure projects to be financed and built, which would otherwise need central/state level control and approval. This means that decision-making for tax and spending on infrastructure is devolved to the municipal level in America, which is a wonderful thing in general. Of course, we need to build that ability and skills in Indian states and municipalities, but at the end of the day, the market pricing mechanism will determine whether cities large and small are able to raise money in this fashion.  In America, the size of the municipal bond market is huge, about 20 per cent of the total bond market.  In India it hardly exists.

Second, tax free bonds will reduce gold buying.  This not only reduces the drain of foreign exchange, but will also lower investment in a dead asset, namely gold, and increase investment in a productive asset, namely loans to corporates and governments.  Third, mining of this useless metal causes huge damage to the environment in places like South Africa, which would be reduced. Fourth, the cost of capital in India would meaningfully come down if we stopped buying $50 billion of gold each year, and instead put that in the bond market. This would have a meaningful impact in raising our GDP rate.

Good governance is all about enabling the tools of wealth creation, and a deep and rich bond market is a primary tool of wealth creation.  Calling tax-free bonds a mere sop for the wealthy totally misses the point. As the recent massive oversubscribing of tax free bond issuances by the Railways and other entities show, there is a large unmet demand for these instruments, and government would do well to expand their issuance, and not eliminate what is a legitimate means of savings for citizens.