Adam Smith, father of Economics and author of the seminal work “The Wealth of Nations” has propounded four “canons” of taxation. These are:
Equality, meaning tax payments should be proportional to income.
Certainty, meaning tax liabilities should be clear and certain.
Convenience of payment, meaning taxes should be collected at a time and in a manner convenient for taxpayer.
Economy of collection, meaning taxes should not be expensive to collect and should not discourage business.
According to the prevailing income tax law, interest from bank deposits is treated as income, and therefore liable for income tax. To what extent does tax on interest from bank deposits (after, of course, a maximum limit) satisfy the above-mentioned canons of taxation?

Canon of Equality

Who saves in savings bank and fixed deposit schemes of banks? It is predominantly the “fixed income earners”, starting from factory workers to government employees to retired people.
Thus, it covers a wide spectrum of the middle class, which runs the wheels of the economy in more ways than any other. While savings bank accounts are mainly meant for transaction purposes, the entire middle-class puts its savings in fixed deposits for meeting various future (bulk) transaction needs and precautionary requirements.
Barring a miniscule proportion with some sort of risk appetite, the majority does not save for speculative purposes, particularly if the capital market (including mutual funds) is volatile and uncertain. Nowadays, even post offices and insurance companies do not offer attractive rates of return.
In addition, demographic data reveal that people’s longevity has increased, thanks to rising standard of living. However, high cost of living and inadequate social security systems have made old age a painful phase for the middle class. Therefore, taxing the interest income from banks violates the principle of equality.
The principle of equality gains significance when inflation rates remain stubbornly high, be it protein or cereal inflation. It should be noted that the middle class’ propensity to consume is high. Rates of interest offered by banks are too meagre to give an adequate positive real return on their savings.
Thus, the tax dissuades the middle class from saving in banks and promotes current consumption. No wonder, financial savings as a proportion of overall savings have fallen, savings in physical assets have swollen, and we are running an unsustainable CAD.

Some More Evidence

Suraj B. Gupta, eminent monetary economist who, along with Sukhamoy Chakravarty, taught at Delhi School of Economics, draws attention to another factor that goes against equity and social justice. Gupta argues in his book Monetary Economics: Institutions, Theory and Policy that the richer the saver, the higher is his marginal income tax bracket, the greater his tax saving from tax exemption and higher the effective rate of interest to him when tax gain is taken into account.
On the opposite end, there are depositors with no taxable income even when interest income from banks has been taken fully into account. They do not get anything from tax concession. Therefore, the policy of taxation on interest income is highly regressive and as per the principle of social justice should be done away with.
The irony is that the Chakravarty Committee, in 1985, after having recognising the element of social injustice embodied in the aforesaid tax concession policy, recommended the retention of the same in the name of capturing larger financial savings in the form of tax-favoured financial assets, he observes.

Canon of Certainty

Income tax rules have, over time, become less ambiguous and more transparent. This is a move in the positive direction.
A lot of credit goes to P. Chidambaram in his various terms as Finance Minister. However, as far as taxing interest earned from bank deposits is concerned, two ambiguities remain.
First, the interest earned in a year, apart from being taxed in that year, is added to the saver’s deposits under compound interest rate regime and becomes again liable for taxation in the subsequent years.
Secondly, interest earned is taken for taxation on accrual basis, not on realisation basis. This should not be done. For example, before IRAC (prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to advances) norms came into being, the recovery of bank loans used to be on accrual basis, which had serious adverse effects on the health of banks, and therefore, it was later changed to on realisation basis. So why have two different rules for similar objectives?

Canon of Convenience

Obviously, tax on interest income, even though the government finds it difficult to do away with it, should not be collected at economically difficult times such as the recent recession.
This, reprieve, though temporary, should have been given since 2008 when the economic crisis hit our country with its knock-on effects. This also distorts savers’ behaviour who, in order to avoid the tax, indulge in what is known as “bank hopping”, which makes collection of the tax harder.

Economy of Collection

Interest on bank deposits also violates the canon of economy of collection. Both for banks and the Government, a large workforce is engaged in computing these taxes, collecting no-TDS forms, issuing TDS certificates, filing returns, and so on, including a lot of back-office drudgery. This, we believe, must be costing a lot to banks and the government alike, in terms of money, time and manpower.
Against this backdrop, we wonder whether it is economical for the Income Tax Department to collect this tax. Anecdotal evidence suggests that the entire machinery engaged in collection of income tax from the salaried class throughout the country does not even break even!
Taxation of interest from bank deposits should be seriously reconsidered by the Government with the objective of ultimately abolishing it sooner than later. This would promote savings in the banking channel and also indirectly give a boost to the capital market instruments.
(The author is a former senior commercial bank economist.)