India's Savings Experiment: Tax Concessions Are A Double-Edged Sword

With many economies facing the challenge of a rapidly aging population, whether people are saving optimally becomes an increasingly important social issue. Unfortunately, research findings suggest that much of the global population is not saving enough to maintain their living standards after retirement, possibly due to a “living for the present” attitude.

What bothers both policy makers and economists is how to design incentive schemes to get people to make wiser saving decisions to benefit both themselves and society. Among all the policy interventions, an income tax reduction incentive is one of the most commonly used tools worldwide. However, whether such a policy is effective in boosting saving rates remains controversial.

Recent research shows that majority of the people are unresponsive to such stimuli. In more developed economies such as Denmark and the United States, we see citizens actively shifting their money around to take full advantage of the tax benefit. This is problematic because a real increase in savings should be financed by reducing consumption. If people simply move their planned savings from one account to another, there will be no change in the savings rate. In fact, the tax relief will harm the government revenue and reduce the public saving rate.

India as a case study

From both the aspects of the policy effects and understanding human behaviors, India presents an interesting case study.

India's national saving rate experienced rapid growth up to 2007 (38.33% of GDP) but has declined since then. It stood at 28.92% of GDP by 2016. India's economic boom is partially to thank for the high national savings rate, but it should stabilize at a certain level.

In July 2014, India’s Union Budget raised the tax exemption limit by 50,000 rupees ($764.25 USD), as well as the tax deduction limit on accounts that pay interest on housing loans. This means home loan borrowers could pay less income tax by paying down more on their loans. The policy intention is to encourage people to save more. This change in policy allows researchers like us to analyze how India mortgage loan borrowers behave to fulfill the policy maker’s motive in response to the 2014 income tax reform.

Some exciting new findings emerged from existing data:

• About 30% of mortgage loan borrowers pay down more on their mortgage loans with an average of 18,400 rupees ($281.24 USD).
• Mortgage loan borrowers reduced their consumption by about 11,600 rupees ($177.31 USD) on average by the end of fiscal year 2014. This amount is equivalent to 5% of the total annual consumption.
• The reduction in consumption does not reverse back in fiscal year 2015 and remains at a similar level.

The above estimation is conservative which means the actual reduction in consumption vis-à-vis the increase in savings should be larger. The persisting reduced consumption level implies that it is not due to some temporary behavior change but a response to the change in tax benefit.

The next question is whether the policy was effective on the target audience. Our findings suggest that younger, male, single and low-income mortgage loan borrowers reduce their consumption to pay down the loans. This is the exact demographic targeted by the policy who may have suboptimal saving issues and may regret not saving enough as they get age.

The 2014 increase in income tax exemption limit is also applicable for some other long-term saving vehicles such as contributions to the public provident fund and tuition fees. We have no insight on whether non-home loan borrowers also save more. Based on the current limited data, the assumption is pessimistic. While the policy works in reducing the negative savings, it does not mean it also works in promoting the positive savings.

A double-edged sword

The tax concession is also a double-edged sword for home mortgage loans. Incentives for mortgage takers differ depending on their repayment capability.

Potential homebuyers who plan to take a mortgage may be encouraged to buy right now as they can pay less tax. However, they may not have saved enough to make a down payment or may be tempted to take a larger loan than originally planned to buy a larger house. If these people have not done a careful calculation or over-estimated their repayment capability, they may face difficulties meeting the required loan payments on time.

Our data supports the concerns as described above. Within two months of the policy announcement, we found a large increase (250%) in the number of new mortgage loans. Mostly made by younger people, the properties covered under the mortgage are smaller in value, while the loans are in smaller amounts, take a longer time to mature and require a smaller monthly repayment. It suggests that the surge in loan demand is propelled by people who are not financially sound. In one year’s time, these people are more likely to miss the payment timeline and become delinquent.

Can the lenders identify these people? Are they charged with higher interest rate? The answer is “no.” If the banks fail to detect consumers who have a low credit rating and a higher chance of either becoming delinquent or defaulting on their loans, it will bring actual loss to the bank.

Our findings highlight the dark the side of policy intervention. It distorts the incentive and the behavior of the potential market participants. Without adequate guidance, common people may make inappropriate financial decisions and suffer later in life. More needs to be done in terms of educating the public to understand the impact policy changes may have on them.

The opinions expressed are those of the writer and do not represent the views and opinions of NUS.

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