Housing Friendly Budget: Is the End in Sight

Housing Friendly Budgets: Is the End in Sight?

(Reflection on Task Force Report on Direct Taxes)

by

Kiran Wadhva*

Housing sector has been the recipient of a large number of fiscal incentives in the past few budgets. The motivation for continued sops to this sector can be traced to two factors namely (i) massive housing shortages and (ii) the perception that investment in housing can kickstart the economy. The latter has been an important element in the pre-budget memoranda presented by various Chambers of Commerce, Association of Private Builders and Representative bodies of housing finance companies. The incentives seem to have had a salutory effect on the housing sector. There is apprehension that the various tax incentives may be withdrawn as a result of the recommendation of the task force on Direct Taxes (TFDT). The TFDT has recommended doing away with a large number of exemptions including those related to housing. The recommendation have aroused strong opposition from various sections of population.

This paper describes exemptions available to the housing sector at present; specific suggestion made by the TFDT regarding these exemptions, justification given for their withdrawal and the likely impact on the housing sector if these incentives are withdrawn.

Existing Tax Incentives for Housing

Tax incentives have been mooted with the objective of encouraging investment in housing. These have been made available to consumers (Sec.24,88); to financial institutions investing in housing (Sec.10 (23G); enterprises carryout housing projects (Section 80IB and 80HHBA) and to housing finance companies Sections 36 (viii), 80L and 88). The objective was to make housing a more

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*The author is Chief Economist, HUDCO. The views expressed are one’s own.

remunerative activity for the developer and financier and, by reducing the cost of housing and of housing finance make housing more affordable for the consumer. The basic assumption being that without the exemptions adequate investment will not flow into the housing sector.

Tax Incentives to FIs and Builders

Tax incentives to financial institutions are available under section (10 (23G)) for investing in enterprises carrying out housing projects which satisfy certain conditions specified in Sec (80(IB). Section 80 (IB) provides for 100% tax exemption to enterprises carrying out such projects. The conditionalities include commencement after October 1998, completion before March 31,2003, built on an area of no less than one acre with maximum built up area per dwelling unit to be 1000 sqft. in Mumbai and Delhi and 1500 sqft. elsewhere. The exemptions under both 10(23G) and 80(IB) had a built-in sunset provision and is not available to new housing projects approved after 31st March 2001. However, for projects which had been approved prior to March 31, 2001, commenced after October 1998 and completed prior to March 31, 2003, the 100% tax exemption will be available.

Through this exemption the Government’s objective was to encourage the private sector to invest in building houses for the lower and middle income groups. Profit margins in housing projects for MIG-LIG segment are too low to induce private sector to invest in this segment. Further, as had been brought out by the Working Group on Housing for the 9th Plan housing shortages are more in the EWS-LIG segment.

Sec.80HHBA provides for deduction of 50% profits from projects which are awarded on the basis of global tender and aided by the World Bank.

Relief on Mortgage Interest ( Section 24)

This exemption is directed towards consumers borrowing for financing construction or purchase of houses. The tax incentive given under Sec.24 provide deduction from rented income on account of maintenance etc and interest payment on housing loans. Upto 30% of rental income is permitted as deduction on account of maintenance and other expenses. There is no ceiling on deduction due to interest payment for housing loans. In case the net rental income after deductions is negative, this can be offset against income from other heads or carried forward and offset against rental income for next 8 years. This deduction is in line with the accepted principles of public finance wherein business expenses are tax deductible.

The provision for owner occupied (0-0) housing is different. Since 0-0 housing is not treated as an investment good, allowance is not made for deduction on account of maintenance etc. Further, rental income is taken as NIL and no income tax is levied on the same. Deduction on account of repayment of interest on housing loans are permitted upto a ceiling of Rs.30,000/. For property constructed or purchased with capital borrowed on or after 1st April 1999 and before Ist April 2003 (from 1.4.2003 onwards the condition has been changed to a house constructed/or acquired within 3 years of borrowing) the limit is Rs.1.5 lakh. The ceiling has been successively increased from Rs. 5000 in 1987-88 to Rs. 30,000 in 1998-99. The incentive was mooted in the background of high interest rates and high cost of houses. The conditional increase to Rs. 1.5 lakh for a limited period was to give an added boost to investment in housing by individuals.

Other Exemptions

One owner-occupied house is exempt from wealth tax. The exemption is also available to all residential properties let out for a period of 300 days in a year.

Section 88 provides for rebate from tax on account of repayment of principal upto a maximum amount of Rs.4000/-. This rebate is not available to individuals with an income above Rs.5 lakh. Investment in housing is encouraged by exempting of capital gains from taxation if the proceeds of a long term asset /residential property are invested in residential property (Sec.54 and Sec.54F).

Tax Incentive for HFCs

Major benefit to HFCs is provided under Section 36(viii) wherein deduction upto 40% of profits is permitted Section 36(iii) provides for deduction of interest paid on capital borrowed for the purpose of business or profession. Further, cost of raising capital is lowered by extending the benefit of Sec.80L and Sec.88 to deposits made with housing agencies or HFCs. Sec.80L exempts income from deposits made in specified agencies (including housing agencies) upto a limit of Rs.9,000/-. Section 88 permits lopping off 20-30% of investment made in specified instruments (including deposits with HFCs) from income tax.

NHB bonds qualify for investment to avail of exemption from capital gains tax.

Impact of Fiscal Incentives on Housing

There has been no rigorous empirical study to investigation the impact of fiscal incentives on housing. It is therefore difficult to say as to how for have these incentives succeeded in achieving the objectives with which they were instituted.

There is no information available as to how many projects were taken up by private builders under 80IB and financed by the FIs. It seems not many. The private sector has blamed the restrictive conditions attached to the provisions and conditions on ground for its inability to take advantage of this incentive. The section despite being on the statute book for 4 years has been ineffective. Its lapse finds no mourners. The Government will have to field other policy instruments to provide housing for the lower income groups.

There is some indirect evidence available as to the efficacy of the tax relief provided on mortgage interest under Section 24 and tax rebate permitted under Section 88. The increased uptake of housing finance, as pronounced by the industry leaders, might be due to reduced effective rates of interest made possible by increased relief on mortgage interest on loans for owner occupied housing. It might however be noted that uncapped relief on interest has always been available for rental housing.* The increased relief for owner occupied housing thus would have provided an incentive for owner occupation. In this case also, tax incentive would only be one factor leading to increased demand for housing finance. The downward trend in real estate prices and in interest rates in the last few years would have also contributed to the increased uptake. The potency of this tax incentive to encourage investment in housing therefore cannot be effectively established without proper empirical analysis.

As for Section 80L and Section 88 wherein tax breaks are provided to investors in deposits of HFCs, it is difficult to figure out as to how much incremental saving got channelised into housing due to these. These two sections provide exemptions to numerous instruments and agencies. By extending the exemption to HFIs they only succeeded in providing a level playing field to HFIs vis.a.vis other privileged investment avenues.

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*It is quite possible that despite the tax incentive, not much investment would flow in rented housing due to the rent control act. The incentive extended to owner occupied housing would be much more potent.

Task Force on Direct Taxes

Tax policy has been increasingly used as a policy instrument resulting in increasing number of exemptions given to various sectors. In some cases at the net effect of the totality of incentives might be very low (if not NIL with incentives provided to all and sundry). These however made the tax system very complicated. The Government of India Constituted a Task Force with the objective to `rationalize and simplify the direct tax laws with a view to minimize exemptions, removing anomalies and improving equity’. Exemptions available to housing were also considered by the TFDT.

The recommendations of the TFDT were made in the background of the policy, stance taken by it, namely:

“optimal tax policy should be pursued in the general interest of the economy rather than for catering to sectional interests. Every exemption has a constituency and democratic systems tend to respond to constituencies – a tax break to one constituency inevitably spawns similar demand by others. Hitherto, tax policy, including exemptions , has been used in instances where other instruments at the disposal of the government are prima facie more suited to achieve stated objectives. Confusion in allocating instruments to objectives result in an inefficient allocation of resources and often defeat stated aims. Clearly demarcated distinctions among objectives to be achieved and increasing transparency in the use of expenditure and tax instrument for these objectives can be expected to yield better results”. (TFDT Report page-23).

TFDT Report and Tax Incentives for Housing

In the above stated background, the TFDT recommended reduced relief on mortgage interest for owner-occupied housing and doing away with Sections 80L and 88 altogether. HFIs will also be affected by the recommendation of abolishing Sec.36 (iii) wherein interest on capital borrowed for profession/ business was tax deductible.

The case for and against any fiscal incentive cannot be based on mere observation, weak argument, generally `accepted’ principles of public finance (namely exemptions are bad) or evidence from studies carried out in other countries with different institutional structures, policy framework and different cultural and behaviour patterns. The fiscal incentives for housing have to be examined thoroughly before a decision on retaining or jettisoning them can be taken. It is doubtful if any background research was done by TDFT in case of exemption related to housing before deciding to do away with some of these.

The arguments against tax incentives could be based on following grounds:

i)They lead to `massive’ loss of tax revenue to the Government;

ii)In case of implicit and open ended subsidies, it is not even possible to estimate the revenue loss to the Government;

iii)Tax incentives distort the investment behaviour by channelising investment in less productive sectors;

iv)In most cases tax incentives are regressive and therefore vertically inequitable not only because the exemptions make the exempted sectors more remunerative but also because people are averse to payment of taxes. Thus investment might be made in sector which even after exemption pay lower returns;

v)The impact in terms of increased investment in desired sectors is not certain;

vi)The exemptions are iniquitous.

We examine these arguments in case of exemptions related to housing.

There is no estimate available of the total tax expenditure on housing and as to by how much will tax revenue increase by withdrawal of these exemptions. In case the tax incentives have a strong positive impact on investment in housing and so far as Investment in housing has strong multiplier impact on income*, it is quite likely that the withdrawal of incentives may lead to decline in tax revenue rather than an increase. The increased investment in housing will not only generate higher revenue in terms of stamp duty, property taxes but also through multiplier impact lead to increased income through backward and forward linkages. Part of the increased income would accrue to the Government as revenue through direct and indirect taxes. Needless to add there is need to find out the net revenue loss to the Government on account of each of these incentives taking into account not only the primary but also secondary and tertiary impacts.

All income tax incentives would be regressive unless designed to be otherwise. The same holds true for exemptions related to housing. The benefit is confined to tax payers and even within that segment the benefit is more for higher income groups as compared to that for lower income groups. Similarly all tax incentives distort the market. They are designed to___ in order to achieve the desired objectives. The pertinent question is whether the distortion is in the right direction. It is quite possible that the mortgage interest relief of Rs. 1.5 lakh for borrowing to owner occupants encourages investment in ` costlier housing, distorts investment pattern by diverting investment from productive assets to

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* A recent study carried out at Indian Institute of Management Ahmedabad , concluded that an increase in investment in construction/housing will generate almost 5 times income in the economy.

housing ( which is then used unproductively by keeping it vacant for fear of rent control act), leads to increased prices of housing by capitalizing the tax incentives into the price of housing and fails to fulfill the intended objectives of increasing production of housing and ameliorating housing shortages. There is however no evidence that the tax incentives has had that kind of impact.

There is no certainity about the impact Section 80IB have had on production of housing. This however does not mean that such a fiscal incentives would be ineffective. There is need to understand the causes of its non or low success. On the other hand the relief on mortgage interest seems to have had a positive impact on the housing Sector. The `spurt’ in uptake of housing finance was at least partly a result of increased ceiling on interest relief made available to owner occupants. The unrealistically low level of existing (Rs.30,000) ceiling could barely cover the interest on a loan of approximately Rs.3 lakh and was hardly an incentive to a prospective owner occupant to invest in housing. The ceiling was thus increased to Rs.75,000 in 1999-2000 and thereon to Rs.1.5 lakh in 2001-02. The increased benefit however was available only for a limited period. It was not to be permanent. Nor was it related to inflation as claimed by TFDT.

The spunt in housing finance uptake was at least partly a result of fiscal incentives. The stable prices and lower interest rates would be significant determinants but tax incentives have a strong psychological impact. Tax incentives not only reduce the effective rate of interest but also work upon the psychology of the consumer who is seeking avenues for avoiding (not evading) payment of taxes.

Based on the perception that this fiscal incentive has not only given a strong push to the housing sector but have also helped upping the rate of growth of

GDP in a recessionary environment*, the Government extended the conditional exemption limit of Rs.1.5 lakh for all loans provided the acquisition or construction of property is completed within 3 years of borrowing. This was to become effective from 1.4.2003 onwards .

The TFDT thus seems to have targeted one of the most effective tax incentives available to housing sector. For this reason, this has become one of the most controversial of its suggestions. Specifically, the TFDT has proposed `phasing out of deduction from mortgage interest in respect of loans for acquiring an owner-occupied dwelling by reducing the deduction to Rs.1 lakh in Assessment Year 2004-05, to Rs. 50,000 in AY 2005-06 and NIL in AY 2006-07’. The rationale for doing away with this exemption is that this is a subsidy ( since owner-occupant pays no income tax on `imputed rental income) and further that this subsidy is iniquitous and inefficient. If fact removal of this subsidy will be inequitous to owner-occupants vis.a.vis owners of rented dwellings. Further in many cases uncapped exemption to owners of rented dwellings may as much be a subsidy and inequitous as is the case for owner occupants.

While the TFDT has recommended reduction in ceiling on relief on mortgage interest for owner-occupied housing, there is no cap on deduction of interest in loans taken for rented dwellings __ the rationale being that tax is paid on rental income from such housing. The tax relief therefore is not a subsidy but a permissible expense on an investment good. However, the argument of vertical inequity holds as much for this exemption. Further, due to 30% deduction on account of maintenance expenditure and the provision of setting off `negative rental income’ against other income or carry forward the loss, the tax paid on