Why The Government Should Discontinue Tax-Free Public Sector Bonds

Are the Tax-Free bonds beneficial to anyone except the rich?

I love tax-free public sector bonds. They give me regular long-term returns that bank deposits and pure debt funds usually cannot match, and largely without much hassle. You can buy and forget, especially if you are a long-term investor seeking income and safety, and not unduly concerned about the ebbs and flows of the debt market. Whenever the opportunity presents itself through a public offer, I invest a bit.

Even at today’s lowered interest rates, retail taxpayers can get pre-tax yields of over 8.5-10 percent, depending on their respective tax brackets. The Indian Railway Finance Corporation’s (IRFC’s) 15-year tax-free bonds that opened today (8 December 2014) offer a coupon of 7.53 percent. If you are in the 30 percent tax bracket, you get simple annual yields of well over 10 percent on a pre-tax basis. And IRFC is a triple A rated bond, with an implicit government guarantee since it is 100 percent owned by the Indian government.

However, what is good for me as a taxpaying individual is not good for India and its public finances. For two reasons: one, tax-free bonds are invested in largely by high net worth individuals and people who are relatively well off; and two, while they help public sector entities save a bit on borrowing costs, this is essentially an interest rate subsidy to them – and a free ride to rich investors.

Tax-free bonds also distort the sovereign debt market. If, for argument’s sake, we take government-run companies and government itself as one and the same effective borrower, the government raises 15-year money at just over 8 percent (pre-tax) when public sector tax-free bonds with the same maturity yield over 10 percent.

This means government and one of its arms are borrowing at two different rates even though their risk profiles are not that different. Wouldn’t it have been simpler for government to just borrow the amount directly at lower rates and lend it further to the public sector? Of course, that would show up in budget deficits, but is hiding it in unlisted public sector account any better?

Tax-free bonds are morally indefensible when they essentially benefit the rich or the better off. Plus they distort the real fiscal situation since what is a form of indirect government borrowing shows up as an off-balance sheet item and does not figure in the exchequer’s borrowing programme. It aids fiscal fudge.

What seems like an easy and cheap way to raise money for infrastructure and other worthwhile causes is essentially a lazy way to offer covert subsidies to the rich and denude taxpayer resources.

It is best to discontinue them. I may love tax-free bonds but that is no reason for the government to love them. I love them for the taxes I can avoid paying; that is precisely why the government should not love them.