Savings, tax, and economic growth

The economic growth of a nation is largely attributed to the level of savings. Prof Raghuram G. Rajan, Professor of Finance at the University of Chicago, USA delivering the Guest speech on ‘Foreign Capital for Economic Growth in Developing Countries’ at the 57th Anniversary of the Central Bank of Sri Lanka reiterated the importance of domestic savings. Unfortunately this is hampered by burdening a tax on interest earnings as savings result in investment and investment results in economic growth. However, the government has imposed a withholding tax on the interest earned on savings accounts and fixed deposits.

In developed nations savings are encouraged by making deposits in savings accounts tax deductible when arriving at the assessable income. That is, whatever deposits made in savings accounts are deducted in arriving at the taxable income of an individual. The result being the increase in savings due to two motives; earning interest and less tax paid. Many countries which have implemented such a system however collect tax upon liquidation/withdrawal of such tax exempted savings.

These two motives should encourage people to save more and the funds should be directed to investments. The investments would create more jobs and result in economic growth. This would also be an answer for the current lack of funds and over dependence on foreign direct investments.

However, the increase in savings does not always correspond to an increase in investment. If savings are stashed in a mattress or otherwise not deposited in a financial intermediary like a bank there is no chance for these savings to be recycled as investments by businesses. This means that savings may increase without an increase in investments.

However, the positive effects of such a reform cannot be expected in the short term. People should be educated on the benefits of such a system. From a Sri Lankan context there are three main pitfalls in implementing such a system; i.e. lack of government backing due to loss of tax revenue in the short run, less tax payers (only private sector employees are paying tax) and saving not materializing in investment. Though government would lose tax revenue in the short term, once savings result in investments the tax revenue would grow.

To increase the number of taxpayers and to make sure monies in savings deposits go into investments current policies should be reformed, for instance (extreme, yet called for) government employees income should be increased and then taxed to make the net/real income the same.