Bankers are grumbling that growth in bank deposits has been affected by the upsurge in the stock market. Funds are being diverted into not just the secondary market, but also mutual funds that have the icing of tax breaks.

Returns from these investments vary between 15-25 per cent, while bank deposits give just 5.5 per cent to 6 per cent. Banks are quite clearly at a disadvantage.

Further, government savings in the form of small savings, public provident funds and post office deposits receive higher rates with the same amount of security, that is, risk and also carry tax benefits (at least the PPF does, while others offer a better rate such as post office certificates and deposits).

Therefore, there is even a stronger case for providing tax breaks on bank deposits to maintain a level playing field.

The starting point is that both the government and banks collect money from the public. Money collected by the government is used directly and, hence, it can reward the savers with a better rate with the added sop of tax breaks as the intermediation costs are low.

Banks, on the other hand, cannot offer higher rates on deposits because if they do so, then they have to increase their lending rates, which in turn, will cause industry as well as the Reserve Bank of India [Get Quote] (RBI) to do some adverse commenting.

And as they are answerable to shareholders (private banks) and the critics (public sector banks), they are expected to make a profit that is a challenge given these constraints. Now, if funds are going to be diverted to other avenues, banks could face a severe resource crunch, which is why they have a genuine case for arguing for tax breaks on deposits to keep the funds flowing in.

The two questions to be posed are: what could be done, and is there any economic rationale to support this view?

The tax breaks could be in two ways. The first is where the amount locked into a deposit should be a part of the corpus that forms the Rs 100,000 limit set by the finance minister last year for tax exemption. If, say, a five-year deposit is reckoned for this purpose, then surely it is on par with the PPF that blocks your principal effectively for six years.

The other way is to exempt the interest earned on long-term deposits from the tax net. Earlier, bank interest income came under section 80L, and was, hence, tax free within limits. But now the interest earned is also taxable.

If exempted, one would save, say, on the 30 per cent tax rate and the effective interest rate would increase from 5.5-6 per cent to 7.5-8 per cent, which brings it on par with unadjusted returns on PPFs.

But the return would still be lower than those on mutual funds that are often ploughed in the secondary market with no links to fresh capital formation, but nevertheless exempted from the tax net.

Hence, in the current scenario, the principal amount is not included in the exempted Rs 100,000 of savings/investments. To top it all, the interest earned is also taxable and, hence, is a poor substitute in the savings portfolio of the household. In fact, this also means that deposit holders are being quite na�ve to channel their savings into bank deposits.

While these arguments are compelling enough, there is a more deep-rooted thought that supports the tax breaks idea. Bank deposits are garnered for two purposes - for lending and to support the government borrowing programme.

The lending programme is further bound by the concept of priority sector lending wherein banks have to keep aside 40 per cent of their credit to specific sectors.

This is a kind of social responsibility that is being taken on, which is being indirectly financed by the public. If the public's money is being used for this purpose, then there is a case for providing some kind of a break here.

It is also curious that infrastructure bonds issued by banks have had preferential tax treatment in the past, which is not available today on deposits that are collected partly for this purpose. This discrepancy comes in the wake of the disappearance of the DFIs that traditionally collected such funds and is now perforce being performed by commercial banks.

The other pre-emption is through what is called the statutory liquidity ratio, which is currently 25 per cent of bank funds. This amount is invested by banks in GSecs that are floated to support the government's borrowing programme.

If the government borrows from the public in the form of PPF, you get paid a higher interest rate and also escape tax. If you invest in NSCs, the amount is part of the Rs 1 lakh kitty, and you get a better rate than on deposits.

But the same amount when channelled in this form through a bank is taxable and gets no tax break. There is evidently an anomaly. While competition between institutions and instruments is essential, the ground rules must be the same.