First there was 10% tax on equity share and equity oriented mutual funds schemes (ELSS is an equity oriented scheme) and now the recent increase in the PPF rates accompanied with meltdown in the equity market has created a perception that PPF has become a better tax saving product than ELSS.  Is it really so? Let us examine it.  

Implications of increase in the interest rates of PPF

An impression is created amongst average taxpayer investors that PPF is a better tax saving product, especially after the changes in interest rates and turmoil in the equity market. But in my opinion the answer cannot be that straight forward. Average investor does not understand the interplay between interest and inflation. In stead of focussing on the nominal rate of interest on PPF the investors should focus on real interest rate which he will earn on PPF account. . A real interest rate is effectively the inflation adjusted rate of interest one earns on his investment. Real rate of interest is the coupon rate of interest officered on an instrument as reduced by the current inflation rate. As the PPF interest rate goes up, the banks have been crowded out and they will not be able to attract deposits at the currently offered  rate of interest. And therefore they will be forced to raise the interest offered by them on their fixed deposits. It will happen  sooner than later. As is evident from the  increase in yield on government securities the interest rate curve has reversed, the nominal interest rates have started going up. It will add to the inflation and thus the ultimate net impact on the real rate of interest will not be as substantial as it is perceived to be.  The increased rate of interest on PPF is applicable only for the next quarter. However if the yield on government securities keeps going up, the PPF interest may also go up in immediate future. It may also be noted that in case the interest rate curve reverses again which is bound to happen sooner or later, the interest on PPF will come down again.

Should you ask whether is it either PPF or ELSS or both

A student of personal finance would under that for goal setting and seeking the same, investor has to follow the principle of asset allocation and asset rebalancing periodically. Based on the old age advice “One should not put all his eggs on one basket” the investors have to choose more than one asset classes for his financial goal. Proper asset allocation is an important principle and an integral part of financial planning process. Debts and equity form two major asset classes for an average investor. The ratio of debt and equity investments in any portfolio would vary from individual to individual and would depend on various factors like age, liquidity requirement, risk profile, income flow  consistency etc.

To reduce the risk and to optimise returns on investments in the long run, investors should adhere to proper asset allocation and ensure that it remains in the same ratio by carrying rebalancing of assess  periodically. The principle of asset allocation should equally be followed while choosing the investment products for tax savings as well. You should allocate all your investible funds, for claiming the tax benefits, between ELSS and PPF rationally unless you are salaried where contribution to employee provident fund (EPF) is proxy of PPF.  Even after imposition of 10% tax on equity funds under section 112A and recent volatility in the equity market, the investments in ELSS still remains more attractive provided one remains invested in the ELSS, an equity product, for a longer period and which is very risky for short duration. The risk which is inherent in equity investing gets reduced if one remains invested for fairly long period. ELSS, surely gives you better post tax returns in the long run.

Let us understand this with an example where one conservative investor invests in PPF rs. 1,50,000/-  and other one who has risk taking abilities also invests in ELSS 1,50,000 every year. Both avail the tax benefits under Section 80C. Presuming that the presently offered  interest rate @ 8% remained fixed for next 15 years on PPF. For ELSS I have assumed 12% annualised for the next 15 years which are closer to historical returns given by ELSS as a category.  With contribution of 15,00,000/- the conservative investor will accumulate Rs.  43,98,642/-   in PPF account and the other investor would have accumulated Rs. 62,62,992/- in ELSS after completion of 15 years. In the 15 years principal investment for both the investors will be Rs.  22,50,000/-. Even after deducting tax liability of Rs. 4,01,300/-  @ 10% from the profits of  Rs. 40,12,992/-  net maturity value of ELSS will be Rs. 58,61,693/-. Which is 33 % higher than the one accumulated by the investor who had put his money in PPF account. The overall tax liability can be reduced by intelligent tax planning by claiming tax benefits upto Rs. 1 lakhs each year.

 So for those who are at the beginning of the career and thus capable of taking the higher risk associated with equity investing and also do not have no liquidity requirements, can just by investing in ELSS instead of PPF can generate 33% higher returns.  However for retired persons who does not have much risk taking ability, PPF is preferable than ELSS. The tax payers in the middle age can make rational allocation between these two instruments based various factors like proximity to the goal/s for which the saving is to be made. No readymade solution exists in the investment world and has to be tailor-made for each individual.

Balwant Jain  is a tax and investment expert and can be reached on [email protected] and @jainbalwant on twitter

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September 2021