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Low Inflation Erodes Tax Superiority Of Debt Funds

Last month I wrote an article on how you can enjoy around 57% Tax Cut On Debt Mutual Funds Vs Fixed Deposits.

This is particularly true for the investors in higher 20-30% tax brackets.

And, this tax superiority of debt mutual funds, comes from the indexation benefit. As you know, indexation benefit is a sort of compensation provided under the Income Tax Act, for the inflation that you suffer.

Suppose you fall under the 20% tax bracket and have Rs.1,00,000 to invest for 3 years... either in bank fixed deposit or a debt mutual fund.

Assuming a simple gain of 10% p.a... without accounting for compounding... in both the cases, after 3 years the value of your investment would be Rs.1,30,000.

Now, in case of bank fixed deposit,
your gains will be Rs.1,30,000 - Rs.1,00,000 = Rs.30,000.
On this you will have to pay 20% tax i.e. Rs.6,000.

(NOTE: Bank interest is added to the taxable income and taxed as per your marginal income tax slab rate.)

In other words, in case of bank fixed deposits, your gains are calculated by deducting the ACTUAL amount invested (i.e. Rs.1,00,000) from the final value of that investment (i.e. Rs.1,30,000).

Oh no! I have to now pay MORE TAX on my debt mutual funds.

Tax laws for debt mutual funds are different:

Here, you are permitted to offset the impact of inflation on your investment. This, as mentioned earlier, is known as indexation benefit in the income tax jargon. So, if we assume 5% p.a. as simple inflation... without accounting for compounding, the inflation-adjusted cost of your investment after 3 years would be Rs.1,15,000.

Therefore, in case of debt mutual fund,
your gains will be Rs.1,30,000 - Rs.1,15,000 = Rs.15,000.
On this you will have to pay 20% tax i.e. Rs.3,000. So your tax burden is halved.

(NOTE: Long Term Capital Gains on debt mutual funds are taxed at a flat rate of 20% on the indexed gains.)

In other words, in case of debt mutual funds, your gains are calculated by deducting the INDEXED amount invested (i.e. Rs.1,15,000) from the final value of that investment (i.e. Rs.1,30,000).

As is clear from the above simplified example, inflation is the key.

Higher the inflation, higher is the indexed cost. Consequently, lower are the post-indexation gains and hence lower tax.

Likewise, lower the inflation, lower is the indexed cost. Consequently, higher are the post-indexation gains and hence more tax.

The average inflation during 2009 to 2015 was nearly 10% per annum. This high inflation often resulted in an 'indexed cost' that exceeded the 'investment value'. In other words, there was a NOTIONAL capital loss instead of capital gains.

(In the above example, even a simplified 10% p.a. inflation... without accounting for compounding... would have given an indexed cost of Rs.1,30,000. Hence, ZERO capital gains and ZERO tax).

a. Not only the tax payable in that financial year was NIL
b. But also this capital loss could be carried forward to future years and adjusted against gains in those years.

So high inflation was a bonanza for the debt mutual fund investors.

However, inflation in recent 2-3 years has dropped to mere around 4% p.a. This means no capital loss. So nothing is available to adjust in the future years. Plus, of course, there are some gains in the current year which are taxable. So, with low inflation, the benefit of NIL tax is also lost.

In the worst — and extremely unlikely — scenario, suppose the inflation is ZERO for all the 3 years.

Logically, therefore, the indexation benefit is zero. So the indexed cost is the same as actual cost. Hence, you are liable to pay tax on the entire gains of Rs.30,000. This is the same tax as you would have otherwise paid on the bank fixed deposit.

This is for the person in 20% tax bracket. He either pays the same tax as bank FDs (at zero inflation) or less (as the inflation increases).

Due to 20% tax rate on long term capital gains, the person in the 30% income tax bracket, gets a straight benefit of 33% lower tax when the inflation is zero. And as the inflation increases, his tax benefit increases.

So yes, low inflation is leading to erosion in the total tax saved. But still, something is better than nothing.

... investors in 20-30% tax brackets should continue to prefer debt mutual funds over bank fixed deposits
... but they must tone down their post-inflation return expectations. Else they will be severely disappointed.

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