Infrastructure bonds: To invest or not to invest?

One of the fresh tax reliefs that have come as an outcome of the budget 2010 is the deduction allowed for investing up to Rs 20,000 in infrastructure bonds. While the FM is stressing on the advantage of the same, the benefits are not neutral for all individuals. Here is a take on the pros and cons of investing in infrastructure bonds for tax saving purposes.

Tax groups post budget 2010.

Tax group 1: Taxable income Rs. 1.6-5 lakhs
Tax group 2: Taxable income Rs. 5-8 Lakhs
Tax group 3: Taxable income above Rs. 8 lakhs.

To understand the pros and cons of tax saving investments we need to look at 4 major parameters:

Parameter 1 : Actual tax saving (let’s take the highest saving possible)

Parameter 2 : Returns from the investment (during the lock in period)

Parameter 3: Opportunity cost (what if you had invested the same money elsewhere?)

Parameter 4: Effect of inflation on the returns on investment (what would the worth of your investment when you redeem/encash it?)
 

Assumptions

For the sake of parameter two we will have to take an assumption on the lock-in period (as nothing has so far been announced by the Finance Minister). As is generally the case with most tax saving instruments we can assume two scenarios—3 year and 5 year lock-in

Let’s assume the rate of return on infrastructure bonds is 5.5 per cent per annum and overall rate of inflation is 8 per cent.

For people in the 1.6- 5 lakh taxable income group:

As per the new norms the income will be taxed at a rate of 10 per cent for this group.

Parameter 1:

Actual tax saving: 10 per cent of Rs 20,000 = Rs 2000 

(If you invest Rs 20,000 in the instrument you get to reduce your taxable income by 20,000 thus giving a 10 per cent benefit)

Parameter 2:

What will be the returns at the end of the lock in period? For a lock in period of 3 years an investment of 20,000 would fetch an income of Rs. 3484. When added to the tax saved you'll get an effective return of Rs 25485 (Rs 20000+3484+2000) on your investment

Parameter 3:

If this same amount were to be invested in a market instrument that fetched a return of 15 per cent, you would get an effective return of Rs 27, 376 (Rs 20000-2000=Rs 18000 invested @15 per cent per annum for 3 years)

Parameter 4:

What would be the minimum amount required to counter inflation at 8 per cent? The amount would be Rs 25, 194.

Thus for a person in the slab of 1.6-5 lakh the benefits of investing in an infrastructure bond as a tax saving instrument will be only Rs 291 (Rs 25485-25194) whereas the benefit out of paying the tax and investing the balance in any decent instrument would be Rs 2182. 

Similarly we can calculate the benefits for each segment as well as for a scenario where the lock in period is 5 years as given in the table below. 

Rate of tax	Investments made	in infrastructure bonds	Tax paid in lieu of investing in infrastructure bonds
Slab	Tax savings	Effective Returns	Investment returns from market after tax
		3 yrs     | 5 yrs	3 yrs    | 5 yrs
30%	6,000	29,485| 32,139	21,292 |28,159
20%	4,000	27,485| 30,139	24,334 |32,182
10%	2,000	25,485 | 28,139	27,376|36,204
Required returns to counter inflation effect		25,194  | 29,387

Bottom-line

If you fall under the Rs 8 lakh taxable income slab, it makes sense to opt for the infrastructure bonds as a tax saving instrument.

If you are under the 5-8 lakh bracket it is advisable to invest in infrastructure bonds only if the period of investment is 3 years, not five years.

If you come under the 1.6-5 lakh bracket it is an absolute no-no to invest in infrastructure bonds for tax saving purpose.


Thanks,
Dewang K. Mehta
DENIP Consultants - www.denip.in