MF-FD symmetry, a Leg-up for tax parity

The Finance Bill 2023 passed in Parliament last week brought the tax treatment of debt schemes of mutual funds (MFs) on a par with that for bank fixed deposits (FDs) to plug arbitrage in fixed-income investments. This serves the interest of tax parity among similar investment pathways, but could affect the development of India’s corporate bond market that is dwarfed by the bank term deposits. The tax advantage of indexation on long-term capital gains from debt MFs – held for at least three years – acted as a sweetener, and its withdrawal is expected to push bank deposits amid a spurt in lending. This broadens the credit funnel to cater to a wider swathe of borrowers such as small enterprises that are typically excluded from the corporate bond market. Besides, policymakers have better control over channelling bank credit as a development finance tool.

From a risk management perspective, however, an overemphasis on bank lending to companies increases concentration in the system that can be reversed by accelerated growth of a corporate bond market. Government borrowings have a pre-emptive claim on bank lending by statute and a mature marketplace for corporate debt does bring down intermediation costs. India, however, trails other emerging economies in terms of the size of its corporate bond market relative to GDP, due in part to interest-rate differentials that make external commercial borrowings compelling for top-rated Indian companies. Reasons for the pace of growth need to be sought beyond tax-assisted retail investment flows into debt schemes of MFs.

Tax-advantaged equity investments could be the other beneficiary of the change in treatment of debt funds, and this tends to reinforce concentration in favour of riskier equity. But inflows into equity and debt schemes of MFs are anyway tilted hugely in favour of the former. By itself, the changed tax treatment of debt schemes of MFs is not expected to cause big shifts in investment behaviour. So, the overriding logic of equitable taxation should hold.