Why deposits need a tax break

Deposits should not be seen as just a part of the banking business guided by market forces. Critical contributions are made to nation building by the deployment of these funds.

First, banks are mandated to maintain a statutory liquidity ratio, whereby they must invest 18% of deposits in government paper. The ability to invest in government security auctions is contingent on how these deposits grow. Almost 35% of government borrowing is funded by banks, and these funds support various schemes.

Second, bank regulation also mandates that 40% of all money lent should be to the ‘priority sector.’ Therefore, after keeping aside ₹22 of every ₹100 in deposits for SLR and CRR (cash reserve ratio), 40% of the ₹78 left must be lent to farm-sector borrowers, MSMEs, affordable housing projects, among others. This leaves banks with only ₹47 for discretionary lending. Intuitively, it is clear that if growth in deposits slows down, banks would have less money to subscribe to government paper or meet social objectives through priority-sector credit.

There are two major initiatives taken by the government to push financial inclusion and digitization that are based on or enabled by bank deposits. UPI, which allows bank payments made via mobile phones, has been a big success story in the field of digitization. All UPI payments are made from deposits and its growing use will need bank balances in savings accounts, on which the returns right now are minimal. Then there’s the Jan Dhan scheme for mass financial inclusion.

As households at the lower end move up the income ladder, taxes on interest income can act as a disincentive to save money with banks. There has been a steady increase in the earnings of people below the taxation threshold, and in around 3-5 years, many more are likely to come into the tax fold.

At a different level, around 40% of term deposits are held by people in the age group of 60 years and above. Many households rely for their daily expenses on interest payments from banks, especially homes of retired folks and the elderly.

At this age, few venture into the equity market, preferring the lower but guaranteed returns on safe investments. Their ability to consume is linked directly with their effective earnings. But the present tax structure adds interest income to total income for the calculation of taxable income. Hence, overall consumption in the economy, which the government is striving to increase, is also impacted by what this age group earns from fixed deposits.

The country’s conundrum today is that savings in general have been migrating to the capital market, which offers higher returns at higher risk, with tax arbitrage playing a role in this shift.

Under a policy regime of declining interest rates, returns on bank deposits are quite low. The transmission of the central bank’s 1-percentage-point cut in its repo rate since February has resulted in the average time-deposit rate on fresh deposits falling by a little more than 1 percentage point. Equity and other debt holdings have been more lucrative. Capital market returns, however, tend to be uneven.

For example, the BSE Sensex at the end of September 2025 was up just 0.6% over its value a year earlier. It was negative at the end of August. On an annualized basis, of the last 10 years, its returns have been negative in two years, 5% or lower in two other years, but very high in six.

For the entire period, the index’s average return was around 13%. But, the pattern shows, there could be high volatility and one may need to exit at a loss if money is needed at a time of market weakness. While retail investors have been warned to stay away from the high-risk derivatives segment, even the cash market for shares would have surprises for investors.

The treatment of these assets for the purpose of taxation is different. Equity gains and those on hybrid mutual funds get taxed at a different rate if kept for over a year. Interest on deposits, however, is treated as regular income and taxed on the basis of income slabs. The justification offered is that the equity market helps companies raise funds, which are channelled into investments, which in turn favour economic growth.

However, as mentioned earlier, bank deposits perform multiple functions; these range from priority-sector lending and funding government expenditure to providing Indian industry with credit, which serves the same economic aim. In fact, it is still not established if secondary-market trading (unlike public-offer subscription) has a direct correlation with investments that boost the economy, since it only involves the transfer of funds among equity investors.

There is thus a good case for the government to consider tax relief on the interest earned from bank deposits. A lower tax rate is the obvious choice, which could place bank savings at par with equity gains. Alternatively, the interest paid should be indexed to inflation and then taxed, so that real effective returns remain steady.

Another option would be to tax only 50% of the interest earned, since around half of all deposits are directed at government objectives. What’s clear, however, is India’s need to review its taxation of bank deposits.

These are the author’s personal views.

The author is chief economist, Bank of Baroda, and author of ‘Corporate Quirks: The Darker Side of the Sun’