Tax: Should you invest in Infrastructure Bonds?

One of the fresh tax reliefs in the Budget 2010 is the deduction allowed for investing up to Rs 20,000 in infrastructure bonds.

Many media articles and the finance minister have said that this is a very positive thing. But how can the same thing be positive for every individual? If not negative, it should at least be neutral for many. Else life would be so boring.

This article will try to look the pros and cons of investing in infrastructure bonds for the sake of tax-saving. The analysis will be from the perspective of the different 'tax groups' post Budget 2010.

• Tax group 1: Taxable income Rs 1.6 lakh to Rs 5 lakh.
• Tax group 2: Taxable income Rs 5 lakh to Rs 8 lakh.
• Tax group 3: Taxable income above Rs 8 lakh.

To understand the pros and cons of any tax-saving investment, we need to look at four major parameters:

• Actual tax-saving (let's take the highest saving possible);
• Returns from the investment (during the lock-in period at the least);
• Opportunity cost (what if the same money had been invested in some other investment?); and
• Effect of Inflation on the returns on investment (what would the worth of your investment be when it comes to redeem/encash it?).

Assumptions

For the sake of parameter 2, we will have to make 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 -- a 3-year lock-in and a 5-year lock-in.

Let's assume the rate of return on infrastructure bonds = 5.5% per annum.

Let's consider the overall rate of inflation at 8%.

For people in the Rs 1.6-5 lakh taxable income group, income will be taxed at the rate of 10%.

Parameter 1: Actual tax-saving: 10% of Rs 20,000 = Rs 2,000 (if you invest Rs 20,000 in the instrument you get to reduce your taxable income by Rs 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 Rs 20,000 would fetch an income of Rs 3,484. When added to the tax saved we get an effective return of Rs 25,485 (Rs 20,000 + Rs 3,484 + Rs 2,000) on our investment.

Parameter 3: If this same amount were to be invested in a market instrument that fetched a return of 15% (which is very reasonable considering that the benchmark Sensex and many mutual funds have given comparatively higher returns over a long period), the investment would fetch an effective return of Rs 27,376 (Rs 20,000 - Rs 2000 = Rs 18,000 invested @15% per annum for 3 years).

Parameter 4: What would be the minimum amount required to counter inflation at 8%? The amount would be Rs 25,194.

Thus we see that for a person in the Rs 1.6-5 lakh slab, the benefit from investing in an infrastructure bond as a tax-saving instrument will be only Rs 291 (Rs 25,485 - Rs 25,194) whereas the benefit from paying tax and investing the balance in any decent instrument would be Rs 2,182.

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.

The bottomline

As seen from the table above, it makes sense for people in the over Rs 8 lakh taxable income slab to use the infrastructure bonds as a tax-saving instrument.

For the people in the Rs 5-8 lakh bracket, it would be advisable to invest in infrastructure bonds if the period of investment is 3 years, but not for five years and for those in the Rs 1.6-5 lakh bracket, it would be an absolute no-no to invest in Infrastructure Bonds for tax-saving purpose.