Why do governments offer tax deductions?
How governments "invest" in tax deductions
With tax season just around the corner, everyone is looking for ways to save tax. And it seems pretty understandable, that people want to minimise the amount they pay to the government. Because no matter how the government uses taxpayer funds, it cannot give you the same subjective utility as spending the funds as you see fit.
The question then arises, why would the government allow for tax deductions at all?
Imagine you were the governing authority, in place to improve the lives of your citizens. Would it not make sense to have as much money as possible, so you can allocate it wherever you feel it is necessary? Maybe not.
We can try to understand this on the basis of the deductions themselves. Let’s look at this for a typical salaried employee.
Tax deductions:
There are two major categories of tax deductions, aside from a few miscellaneous deductions:
Expenses and Allowances
These deductions are based on expenses you incur or allowances you receive. They directly impact your taxable income.
These deductions are affected by expenses and by the allowances available to a citizen as part of their employment contract.
Deductions include HRA, insurance premiums, and other essential expenses.
Investments and Contributions
These deductions are based on investments you make or contributions you pay. They help you save tax while encouraging financial planning.
These deductions are affected by the investment habits of the citizen.
Deductions include donations to certain organisations, insurance premiums and other select long-term investments such as PPF, FDs, ELSS, etc.
If you look at it closely, these deductions are largely dependent on the spending and investment patterns of citizens. The deductions try to guide citizens towards certain financial habits that the government considers beneficial, both to the citizen in question, and the state as a whole.
Let’s take an example:
By offering deductions on insurance premiums, the government incentivises citizens to purchase health and life insurance, keeping them insured against major damages and helping maintain financial stability.
This is also cheaper for the government, since if they were to tax such expenses instead, it could reduce the number of people paying for their insurance out of pocket. This would increase the load on the public health system and cost the government more in the long-term.
Okay, this makes sense for expenses. But why would the government care how you invest your money?
Interestingly enough, your investing habits are even more important than your spending habits, to the government, at least.
As you may have seen, tax deductions on investments are almost exclusively for long-term investments. The question then changes to, why does the government want you to invest in long-term assets over shorter-term ones?
The Role of Credit
This question can partially be answered by understanding the role of credit in the economy. Credit serves to reallocate capital to wherever it is needed most, and this happens rather organically.
People deposit their money with banks when they have no immediate use for it; and the banks subsequently loan out these funds to people making large purchases or trying to build businesses, etc.
The credit given out in this way helps the economy grow, which directly increases income, and starts a virtuous cycle. And as we saw in the previous newsletter, more deposits allow for more credit. Parallelly, longer-term deposits allow for longer-term credit.
As we can see, on the whole, more long-term deposits lead to economic growth. So, by reducing their own income through taxes, governments can greatly increase organic growth. And subsequently, the governmental income will see a growth as a result of the economic expansion!
So, governments indirectly raise their long-term income by directly sacrificing short-term income. Sounds a lot like investing, doesn’t it?
We have recently introduced tax-saving FDs on our platform, with rates as high as 8.1% p.a. You can invest with confidence, save tax, and help our nation grow, all at the same time!
In today’s edition, we have shown you why governments offer tax deductions on certain expenses and deposits, and how investing in longer-term assets helps the nation grow. We hope you learned something new!
At Stable Money, we’re going to keep you informed and ensure that you make the best investment decisions.
Best,
Team Stable Money