The government has been generous to big businesses, in this budget. One of the steps to encourage direct investment of businesses and high net worth individuals (HNIs) in government securities is to reduce the tax on the profits in government securities to 15 percent. There are pros and cons of this.

One obvious advantage is to have higher direct investment in government securities which will give competition to banks and may improve yields. However, there are externalities (negative spillover) on investment in mutual funds and banks’ term deposits (TDRs) as the tax on the profit of these instruments is higher. Then the other con is higher incentive for companies to park the cash in government securities over reinvesting into the business they are in.

Prior to the budget 2021-22, for resident individuals, the tax rate on profit on government securities and bank’s TDRs was 15 percent for profit under Rs0.5 million (WHT at 10%) and the tax rate was increasing with higher profits – highest tax is of income tax slab for profits over Rs36 million. Now it is full and final 15 percent for any amount that is investment in government securities (T-Bills, PIBs and Sukuk).

In case of resident companies (other than banks) WHT used to be 10 percent for profits under Rs0.5 million and 15 percent otherwise. The final tax liability was 29 percent irrespective of the investment in banks’ TDRs or government securities. Now the full and final tax is 15 percent on government securities without any slab on profits. Whereas, for bank deposits, WHT is 15 percent and tax liability is 29 percent (corporate income tax rate).

There is clear incentive for both HNIs, and companies is to move away from TDRs to direct investment in government securities. Then, there used to be arbitrage for investors to take position in government securities through investing in cash and fixed income mutual funds –as in these (especially cash funds) mutual funds invest in government securities. The tax rate on mutual funds dividend is 15 percent and 12.5 capital gain tax (CGT). For individuals, CGT on direct investment is also reduced from 15 percent to 12.5 percent in this budget.

Companies and HNIs used to invest in mutual funds for higher net returns (as tax was low) and mutual funds used to invest these in government securities. Mutual funds do not have the incentive to tap retail investor. Then there is a dearth of other products – Term Finance Certificates (TFCs), commercial papers etc. There is no push or pull strategy in it. Now mutual funds must work hard for their money and may push for issuance of new bonds.

Mutual funds earn 0.5-1 percent as fee income on these cash funds. That is too high a number. But companies used to find it attractive (despite the fee) as the tax difference of 14 percent was enough to compensate for the fee. Now that arbitrage opportunity is over. And the funds are not happy. The other shift is to take place from banks TDR to direct government securities. Banks offer similar returns to government securities for companies on TDRs while the tax on TDRs is at 29 percent for profits over Rs0.5 million while the government securities return is taxed at 15 percent. For example, on an investment of Rs100 million in government securities at a hypothetical return of 8 percent, the net return is 6.8 percent while of similar offing in TDRs yields net return of 4.9 percent.

Now companies may take out money from TDRs to directly invest in government securities. There would not be any meaningful impact on system deposits as most of the money eventually falls in banks’ deposits (in CASA). TDRs to be cashed and invested in T-Bills. Then govt will spend that money or put in its bank accounts. And the spending by government will eventually fall in banks deposits – if not lost into the cash economy blackhole.

There might be some loss in deposits in smaller banks which offer better return on TDRs and deposits to increase in bigger banks where CASA is preferred due to wider outreach and low risk. There might be some gain in government-owned banks as usually, higher deposits of government are in its own banks.

The real benefit for the government and perhaps the purpose of this move is to bring competition to banks in government securities market. Whenever the auction target is higher, banks bid at higher rates to milk government. Now with a higher number coming from companies and HNIs, there would be some downward pressure on yields, and this could help in better price discovery.

However, one unintended consequence could be that risk taking appetite for companies may fall. For example, a company getting return of 12 percent on its main business will be taxed at 29 percent to get the net return of 8.5 percent while invested at 8 percent in T-Bills will get net return of 6.8 percent (as compared to 5.7% last year). The marginal investor will move from investing in his business to parking the cash in government securities – the case would become strong in downturn of economy when interest rates would be higher and businesses yield lower real returns.

Nonetheless, it is a no brainer for companies and HINIs to shift from TDRs and mutual fund cash funds to directly investing in government securities.