One of the fresh tax reliefs that has come as an outcome of the budget 2010 is the deduction allowed for investing upto Rs 20000 in the infrastructure bonds. Many articles and the FM 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. 1.6-5 lakhs

Tax group 2: Taxable income Rs. 5-8 Lakhs

Tax group 3: Taxable income above Rs. 8 lakhs

Parameters

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

Actual tax saving (lets 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?).

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 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 lock-in and 5 year lock-in

Lets assume the rate of return on infrastructure bonds = 5.5% per annum.

Lets consider overall rate of inflation to be 8%. (Food inflation itself is currently at 18 %).

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%.

Savings

Parameter 1: Actual tax saving: 10% of Rs 20,000 = Rs 2000 (if you invest Rs 20000 in the instrument you get to reduce your taxable income by 20,000 thus giving a 10% 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 20000 would fetch an income of Rs. 3484. When added to the tax saved we get an effective return of Rs 25485 (Rs 20000+3484+2000) 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 on a long period.) the investment would fetch an effective return of Rs 27, 376 (Rs 20000-2000=Rs 18000 invested @15% per annum for 3 years).

Countering inflation

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 slab of 1.6-5 lakh the benefit out 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.

Click here to see the benefits for each segment as well as for a scenario where the lock in period is 5 years.

As seen from the table, it makes sense for people in the >Rs 8 lakh taxable income slab to use the infrastructure bonds as a tax saving instrument. For the people in the 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 1.6-5 lakh bracket it would be an absolute no-no to invest in Infrastructure bonds for tax saving purpose.