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An unfriendly tax treatment makes the inflation-indexed bond less promising than it could have been
The Reserve Bank of India has finally come out with the consumer-price linked Inflation-Indexed Bonds that it had promised when Raghuram Rajan had taken over as Governor. Formally called the Inflation Indexed National Saving Securities- Cumulative (IINSS-C), the bonds are roughly as the RBI had promised. However, the details released now at the actual launch show that the tax treatment is less than fair and this limits the actual utility of the bonds to far less than what we had been led to assume earlier.
Inflation-indexed bonds are issued in many countries and the general structure is that the face value of the bond keeps increasing in line with an inflation index while a small interest rate is paid to the investor on the face value. This kind of a structure means that whatever the investor gains from the increase in face value is compensation for inflation and counted as capital gains from the taxation perspective. The interest rate is the actual income.
However, the RBI's IINSS is not like this. It's simply a bond that pays an interest rate that is set with reference to the Consumer Price Inflation. This means that the entire earning gets added to the investors income and gets taxed at the marginal rate. If the inflation-compensating part had been capital gains, it could have benefited from indexation, which would have been fair.
As things stand, the IINSS is a mixed bag. It does have a high rate of return than currently as inflation is very high but has the above disadvantage as well as that of a long lock-in period of ten years. Early redemption is available only after three years on payment of a penalty. Then there's also a limit of Rs 5 lakh per investors which put a cap on the utility of the scheme.
The IINSS is fine by itself but it was supposed to be a big deal, announced by the RBI Governor himself as the kind of thing that would lure Indians to financial savings. By that standard, it's a bit of a damp squib. Like many government schemes (the Rajiv Gandhi Equity Scheme comes to mind), it's an example of a little too much bravado at the time of the initial announcement and constant backtracking after that.
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