More Than Half of Govt Taxes Will Go Towards Paying Interest on Past Loans

As I keep saying, the union budget at its heart is the presentation of the financial accounts of the government or to put it simply, on what it plans to spend money on, during the course of a year and how does it plan to earn and arrange for that money.

Given this, a lot of analysis happens on the issue of what the government plans to spend money on, during the course of a particular year. A similar thing has happened this time around as well, with journalists, analysts and economists, digging into the budget in trying to figure out where exactly is the government planning to spend money in 2021-22 and where it has spent its money in 2020-21.

The trouble is that like previous years this year as well most analysis has missed out on the biggest expenditure item in the government budget, which is interest payments. Almost every government spends more than what it earns and the difference is referred to as the fiscal deficit. This deficit is largely financed through the government borrowing by issuing bonds. An interest needs to be paid on these bonds every year.

This interest is the largest expenditure in the government’s budget, even though it rarely gets talked about.

Take a look at the following graph, which plots the interest payments on the outstanding borrowing of the union government.

Source: Centre for Monitoring Indian Economy.
2020-21 – Revised estimate.
2021-22 – Budget estimate.

As can be seen from the above chart, the interest payments have been going up over the years and are expected to be at around Rs 8.1 lakh crore in 2021-22 . Now Rs 8.1 lakh crore on its own sounds like a large number, but just looking at the absolute number is not the right way to go about things in this case.

Let’s look at what proportion of overall expenditure of the union government have interest payments formed over the years.

Source: Author calculations on data from Centre for Monitoring Indian Economy.

As per this graph, interest payments in 2020-21 formed a little over one-fifth of total expenditure and this is an improvement on the situation that prevailed before. But this interpretation is wrong, simply because the overall expenditure of the government also includes money that it does not earn.

Hence, a government can always borrow more and spend more in a particular year leading to a higher expenditure number and thus, the interest payments as a proportion of overall expenditure will come down. But that doesn’t mean things have improved.

Let’s look at another chart. This plots the interest payments as a proportion of net tax revenue earned by the union government. Net tax revenue is what remains with the central government after sharing a certain proportion of the gross tax revenue (or to put it simply overall tax collections) with the state governments.

Source: Author calculations on data from Centre for Monitoring Indian Economy.

The above chart gives us a clear picture of the prevailing situation. In 2017-18, the interest payments formed 42.6% of the tax revenues earned by the union government. They have been rising since then and in 2020-21 and 2021-22 are expected to touch 51.5% and 52.4%, respectively.

What does this mean? It means that more than half of the government’s taxes are going towards paying interest on its outstanding loans, leaving very little money for anything else, unless the government earns money through other ways or borrows money or uses other ways to finance the fiscal deficit.

One way for the government to earn more money is through the sale of its stakes in public sector enterprises. In 2020-21, the government had hoped to earn Rs 2.1 lakh crore through this route. This turned out to be a very ambitious target and the government is now hoping to earn Rs 32,000 crore through this route during 2020-21.

The disinvestment target for 2021-22 has been set at Rs 1.75 lakh crore. It is very important for the government to earn this money else it will have to borrow more to meet the expenditure. This will mean higher interest payments in the years to come which will either lead to the government having to cut expenditure or having to borrow even more to meet the expenditure. More borrowing will lead to even more interest on the outstanding debt.

This will have to be paid by implementing higher taxes on the taxpayers and many of these taxpayers will be newer ones, just entering the workforce. This is precisely the way the current generation passes on its liabilities to the next one.

Also, as the outstanding debt matures and needs to be repaid, the government will have to borrow more to repay this debt. Hence, a greater proportion of the borrowing will just go towards repaying debt which is maturing. This will become a debt spiral and needs to be best avoided.

There is another thing that is happening and needs to be brought to notice. The government finances a major part of the fiscal deficit through borrowing. So, let’s take the case of 2020-21. The fiscal deficit for the year is expected to be at Rs 18.49 lakh crore.

A bulk of this deficit will be financed by borrowing Rs 12.74 lakh crore from the market. Where does the remaining money to fill the gap come from? A bulk of it comes from the small savings schemes.

The small savings schemes currently in force are: Post Office Savings Account, National Savings Time Deposits ( 1,2,3 & 5 years), National Savings Recurring Deposits, National Savings Monthly Income Scheme Account, Senior Citizens Savings Scheme, National Savings Certificate, Public Provident Fund, KisanVikas Patra and Sukanya Samriddhi Account.

The money coming into these schemes net of disbursements that happen during the course of the year, is used to finance the fiscal deficit of the union government.

This has been rising at an astonishing pace over the years, as can be seen from the following chart.

Source: Centre for Monitoring Indian Economy.

In 2012-13, the amount had stood at Rs 8,626 crore and it has since risen to more than Rs 4.80 lakh crore. While this amount does not end up as a debt of the government, it is a liability that the government does need to repay over the years.

Also, this is money that is coming from the public savings at the end of the day. In order to ensure that money keeps coming into these schemes, the government will have to continue offering a higher rate of interest on these schemes in comparison to bank fixed deposits.

Hence, the perpetual complaint of the bankers is likely to stay, given that the government needs this money to continue financing its high fiscal deficit. The other option is to borrow directly from the market and increase its outstanding debt figure, which the government wants to avoid beyond a point.

What this tells us is that all hasn’t been well on the government finances front over the last few years, and covid has only made it worse. One reason for this lies in the constant fall in the taxes collected by the government as a proportion of the gross domestic product (GDP), over the years.

The net tax revenue of the union government stood at 8.97% of the GDP in 2007-08. It has since fallen and was at 6.67% of the GDP in 2019-20. In 2020-21, it is expected to be at 6.90% of the GDP. The figure is higher in 2020-21 simply because of the size of the Indian economy, as represented by the GDP, is expected to contract more than the taxes collected by the government during the year.

This fall in tax collections and the dependence of the government on other ways of financing its fiscal deficit, also leads to the question whether the size of the Indian economy or its GDP, is being properly measured. Over the years, the informal part of the Indian economy has seen huge destruction and the question is, does this destruction reflect properly in the GDP figures being published over the years. This is a question well worth asking given that if the GDP is growing why have tax collections been falling?

To conclude, it does seem the government understands the financial situation it is headed towards. Hence, an ambitious target for disinvestment has been set. Over and above this, it also has plans of monetising physical assets including surplus land. Hopefully, this will take off soon. .

PS: Of course, you will not find this kind of analysis anywhere in the mainstream media or even digital publications which charge a fee. Hence, it is important that you support my work. You can do it here. 

Rahul Gandhi Needs a Lesson in Inflation

rahul gandhi

Rahul Gandhi, in his new avatar, as the angry young man (yes at 45 he is still young), has a thing or two to say on most issues. Let’s take the latest decision of the Narendra Modi government to cut the interest rates on the public provident fund(PPF) and the small savings schemes like Kisan Vikas Patra(KVP) and National Savings Certificate(NSC). Interest rate cuts ranging from 40 basis points to 130 basis points have been carried out. One basis point is one hundredth of a percentage.

Earlier the interest rates ranged from 8.4% to 9.3%. Now they are in the range of 7.1% to 8.6%. These interest rates come into effect from April 1, 2016.

Rahul Gandhi’s office tweeted to say that “slashing interest rates on small savings – on PPF and KVPs, is yet another assault by the Modi Govt on hard working middle class people.” He further said that “this Govt has failed farmers, failed the poor & now it’s failing the middle class. Modiji ppl are seeing through your event management politics.”

While the Modi government has taken the middle class for granted on other issues, like not passing on the benefits of the fall in oil prices in the form of lower petrol and diesel prices, or trying to tax the Employees’ Provident Fund corpus of private sector employees, the same cannot be said in this case. Before I get into explaining this, we first need to understand the meaning of inflation and how it impacts investment returns.

What is inflation? Inflation is essentially the rate of price increase. If the price of a product in March 2015 is Rs 100 per unit and it jumps to Rs 110 per unit by March 2016, the rate of inflation is said to be 10%. So far so good.

What does it mean when people say inflation  is falling? It doesn’t mean that the prices are falling. It means that the rate of increase in price rise is falling. Allow me to explain. Let’s extend the example considered earlier.

The price of a product in March 2016 is at Rs 110 per unit. Let’s say by March 2017, the price of the product has increased to Rs 115.5 per unit. This means that the price of the product has risen by Rs 5.5 or 5%. The inflation is 5%. Hence, the rate of price rise has fallen and the price of the product has gone up.

A fall in the price of the product would mean the price of the product going below Rs 110 per unit, by March 2017, which is a totally different thing.

This is a very important point which many people don’t understand and hence, it is worth repeating. A fall in the rate of inflation does not mean lower prices, it just means that the rate of price rise is falling or has slowed down.

Now let’s get back to Rahul Gandhi and the Modi government’s decision to cut interest rates on PPF and other small savings schemes.

The rate of interest on offer from April 1 onwards, ranges from 7.1% (on the one-year post office deposit) to 8.6% (on the Senior Citizens Savings Scheme and the Sukanya Samriddhi Account Scheme). What is the prevailing rate of inflation? Inflation as measured by the consumer price index in February 2016 had stood at 5.18%.

What does this tell us? It tells us that the rate of interest on offer on PPF as well as other small savings scheme is higher than the prevailing rate of inflation. This means that the money invested will “actually” grow and not lose its purchasing power. The real rate of return on these schemes is in positive territory. The same cannot be said for the period when Rahul Gandhi’s Congress Party was in power.

Inflation as measured by the consumer price index was 10% or higher between 2008 and 2013. In fact, the inflation during the period stood at an average of 10.1% per year. What was the interest that the Congress led UPA government was paying on PPF and other small savings schemes?

The rate of interest varied from anywhere between 8-9%. This, when the prevailing rate of inflation was greater than 10%. Hence, the money invested in these schemes was actually losing purchasing power.

This is not the case now. Investors are actually earning a “real” return on their investment. Some people told me on the social media that even with lower inflation, prices are not really falling. As I explained earlier, lower inflation does not mean falling prices. It just means that the rate of price increase has slowed down.

Also, it needs to be mentioned here that investments made into PPF and other schemes like Senior Citizens Savings Scheme, National Savings Certificate and Sukanya Samriddhi Account Scheme, enjoy a tax deduction under Section 80C. Hence, the effective rate of return on these schemes is higher than the interest that they pay.

I guess these are points that Rahul Gandhi needs to understand. Editors of media houses who have run headlines saying how the middle class will be hurt because of the cut in interest rates, also need to understand this. While “middle class hurt” makes for a sexy headline, that is really not the case.

Also, it is worth mentioning here that the Modi government is trying to introduce a certain method in the calculation of the interest to be paid on these schemes. The interest will now be linked to the rate of return on government securities and will be calculated every three months.

Indeed, this is a good move and brings a certain transparency to the entire issue. Further, people up until now have been used to interest rates on PPF and small savings schemes remaining unchanged for long periods of time. But now with a quarterly reset in these interest rates coming in, they need to get used to the idea of these interest rates changing on a regular basis.

This is something that needs a change in mental makeup and will happen if the government persists with this. Also, it is important in the days to come the government ensures that the rate of interest being paid on PPF and small savings schemes is higher than the rate of inflation. That to me is the most important thing than the current rate cut.

The column originally appeared in the Vivek Kaul Diary on March 21, 2016

Hold your fire! Govt cutting rates on PPF, small savings schemes is a good move; here’s why

rupee

The Narendra Modi government has cut the interest rates on offer on the public provident fund(PPF) and other small savings schemes run by the post office.

The new interest rates will come into play from April 1, 2016 and will be in effect until June 30, 2016. The interest rate on PPF has been cut from 8.7% to 8.1%. The interest on the Senior Citizens Savings Scheme has been cut from 9.3% to 8.6%.

InstrumentRate of interest w.e.f. 01.04.2015 to 31.3.2016Rate of interest w.e.f. 01.04.2016 to 30.6.2016
Savings Deposit4.04.0
1 Year Time Deposit8.47.1
2 Year Time Deposit8.47.2
3 Year Time Deposit8.47.4
5 Year Time Deposit8.57.9
5 Year Recurring Deposit8.47.4
5 Year Senior Citizens Savings Scheme9.38.6
5 Year Monthly Income Account Scheme8.47.8
5 Year National Savings Certificate8.58.1
Public Provident Fund Scheme8.78.1
Kisan Vikas Patra8.77.8 (will mature in 110 months)
Sukanya Samriddhi Account Scheme9.28.6

 

This decision to cut down interest rates hasn’t gone down well with the middle class. This has come soon after the Employees’ Provident Fund(EPF) fiasco where the government tried to tax the accumulated corpus of the private sector employees on contributions made after April 1, 2016.

While trying to tax EPF was incorrect, the hue and cry being made out on interest rates on PPF and small savings schemes being cut, is uncalled for. This is happening primarily because most people have become victims of what economists call the money illusion.

What is money illusion? As Gary Belsky and Thomas Gilovich write in Why Smart People Make Big Money Mistakes: “[Money illusion] involves a confusion between ‘”nominal” changes in money and “real” changes that reflect inflation…Accounting for inflation requires the application of a little arithmetic, which…is often an annoyance and downright impossible for many people…Most people we know routinely fail to consider the effects of inflation in their finance decision making.”

Hence, money illusion is essentially a situation where people don’t take inflation into account while calculating their return on an investment.

How does this apply to the current context? Let’s consider the Senior Citizens Savings Scheme. The interest rate on offer on the scheme was 9.3%. The rate of inflation that prevailed between 2008 and 2013 was 10% or more. Hence, the real rate of return on the scheme was negative. This was the case with other small savings schemes as well as bank fixed deposits.

In fact, the real rate of return was well into the negative territory. The real rate of return for a senior citizen who did not have to pay income tax on the earnings from the Senior Citizens Savings Scheme stood at minus 0.7% (9.3% minus 10%).

For those who had to pay income tax, the real rate of return was even lower. For those in the 10% tax bracket the real rate of return was minus 1.63% per year. For those in the tax 20% and 30% tax brackets, the real rate of return was minus 2.56% and minus 3.49%.

But back then no one complained about the interest rate being low, even though almost everyone who invested in PPF and other small savings, was losing money. The purchasing power of their investment was coming down.

The situation is totally different now. Inflation as measured by the consumer price index stood at 5.2% in February 2016. Given this, the real rate of return is now in positive territory. Let’s repeat the Senior Citizens Savings Scheme example and see how the real returns stack up.

The interest rate on offer on the Senior Citizens Savings Scheme from April 1, 2016, is 8.6%. For those who do not have to pay any income tax, the real rate of return is 3.4% (8.6% minus 5.2%). For those in the 10%, 20% and 30% tax brackets, the real rate of return works out to 2.54%, 1.68% and 0.82% respectively.

Hence, the situation is substantially better than it was in the past. Investor are actually making a real rate of return on their investments. Also, for savings instrument like PPF, where no tax needs to be paid on accumulated interest, the real returns are higher.

But given that the nominal interest rate has been cut, people have an issue and a lot of noise is being made.

Given these reasons, the government was right in cutting the interest rates on offer on PPF and other small savings schemes. Also, it is important to understand that the high rates of interest on offer on these schemes has been preventing the banks from cutting their deposit as well as lending rates at the speed at which the Reserve Bank of India wants them to.

As RBI governor Raghuram Rajan had said in December 2015 Since the rate reduction cycle that commenced in January [2015], less than half of the cumulative policy repo rate reduction of 125 basis points [one basis point is one hundredth of a percentage] has been transmitted by banks. The median base lending rate has declined only by 60 basis points.” Repo rate is the rate at which RBI lends to banks.

While RBI cut the repo rate by 125 basis points in 2015, the banks only managed to pass on less than half of that cut to their end consumers. One reason for this is that many public sector banks have had a huge problem with their corporate loans. Another reason has been the high interest rates on offer on small savings schemes.

The banks compete with these schemes for deposits and given the high interest on offer on post office savings schemes, banks could not cut interest rates beyond a point without losing out on deposits.

The hope now is that the RBI will cut the repo rate further, banks will cut the interest rates on their loans and deposits, and people will borrow and spend. Whether that happens remains to be seen.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on March 19, 2016