Govt keeping PPF interest rate lower than what formula says due to tax benefit

According to the RBI, the government’s formula dictates that the rate of interest for the PPF should be around 40 basis points higher than what it currently is.

The government has "consciously" not increased the rate of interest on the Public Provident Fund (PPF) in line with changes in market interest rates due to the tax benefit the scheme offers, a senior government official has said.

The PPF, which currently offers an annual rate of interest of 7.1 percent, is one of the most popular small savings instruments of the government as the interest earned is not taxed, with savers able to deduct their annual contributions up to Rs 1.5 lakh under Section 80C of the Income Tax Act. However, the current rate of interest – which has not seen any changes for more than three-and-a-half years, is lower than that prescribed by the government's own formula.

Also Read: Govt raises interest rate on one small savings scheme by 20 bps for Q3 FY24

Small savings interest rates, while set by the government, are linked to market yields on government securities at a spread of 0-100 basis points over the yield of these securities of comparable maturities. As such, when market yields on government securities rise or fall during the reference period, interest rates on small savings schemes should move in the same direction as per the government's formula.

One basis point is one-hundredth of a percentage point.

According to the Reserve Bank of India's (RBI) latest Monetary Policy Report, released on October 6, the formula-based rate of interest for the PPF should be 7.51 percent.

A committee headed by Shyamala Gopinath, then an RBI deputy governor, had said in its report in June 2011 that interest rates on small savings should be linked to prevailing market rates on government securities of comparable maturity. Starting 2016-17, the government started to notify these rates on a quarterly basis instead of annual.

"What the Shyamala Gopinath committee possibly missed out was the tax benefit implications of certain schemes like PPF. If you add the tax benefit, I think it (return) exceeds 10 percent," a senior government official said.

After keeping interest rates on small savings schemes unchanged for nine consecutive quarters during the COVID pandemic – when government bond yields fell sharply on account of the RBI’s record liquidity injection – the government has raised them for five quarters in a row starting October-December 2022. The quantum of rate increases over the last five quarters has been 40-150 basis points.

Source: Reserve Bank of India

"With these revisions, the actual interest rates on most SSIs (small savings instruments) are now better aligned with the formula-based rates," the RBI said in its October 6 Monetary Policy Report.

Apart from PPF, the only other small savings scheme which currently offers a lower-than-expected rate of interest – when compared to what the formula prescribes – is the five-year recurring deposit. However, on September 29, the finance ministry raised the rate of interest on this scheme by 20 basis points to 6.7 percent for October-December.

"The cost is not only the interest the government pays against receipts from the PPF but also the revenue loss from the tax benefits. So, the government has consciously taken the decision that it will kind of manage itself within the present rates, which are by far one of the highest that we have seen," the aforementioned official added, requesting anonymity.

Despite being linked to market rates, small savings interest rates have seemingly continued to be administered due to their sensitive nature. Most famously, the finance ministry had notified a huge cut in small savings interest rates for April-June 2021, with the PPF rate brought down by 70 basis points to 6.4 percent. However, the decision was withdrawn the next day, with Finance Minister Nirmala Sitharaman saying the order had been issued "by oversight".