By Invitation: Taxing fringe benefits

Taxing full contributions by the employer for superannuation as part of the Fringe Benefits Tax (FBT) introduced in the 2005-06 Budget exemplifies bad design and perverse public policy, writes Mukul Asher

A badly designed and perverse public policy

Prof Mukul Asher

Taxing full contributions by the employer for superannuation as part of the Fringe Benefits Tax (FBT) introduced in the 2005-06 Budget exemplifies bad design and perverse public policy.

To the extent the economic burden is on the employers the FBT will raise the relative cost of labour compensation, providing incentives for substituting capital for labour. At a time when India is experiencing rising share of working age persons in total population (i.e. demographic gift), and losing wage competitiveness to China and others, such tax induced shift is perverse.

In excluding government employees, the FBT tends to perpetuate dualistic labour market between private and public sectors. It represents a mind-set which regards ad-hoc measures to raise revenue as more important then social and economic consequences of these measures, including for international competitiveness, creation of jobs, and development of capital markets.


The FBT appears to be designed to broaden the tax base by bringing under the tax net various fringe benefits provided by the employers which are usually more difficult to tax in the hands of the individuals. This objective has merit, but its realization requires appropriate design to minimize rent-seeking opportunities and administrative and compliance costs; and consistence with other reform initiatives such as pension (and health care).

FBT’s design fails to meet the above requirements. It taxes expenditures which can not be classified as fringe benefits to employees (such as sales promotion); provides for special treatment for certain sectors (such as IT, and construction sectors) which open up possibilities for unproductive rent seeking opportunities; taxes deemed benefits which can only be arbitrarily valued raising administrative, compliance, and hassle costs. In all these areas, it is inconsistent with the move towards a more simplified tax regime. FBT is misnamed as well misdirected.

Inappropriate design also means that potentially positive side effects, such as movement towards cash-to-company (CTC) compensation, and towards cleaner wage, will be hampered.

The FBT treats entire contribution to superannuation by the employer as taxable at the highest marginal tax rate of 30 percent plus applicable surcharge and education cess.

The logic of the FBT and the intentions to limit use of EPFO as tax shelter reflected in current budgets suggests that tax exemption for employer’s contributions to EPFO be limited to the statutory requirements, i.e. up to a wage ceiling of Rs. 6500. As the practice of contributions to EPFO higher than statutory requirements is not uncommon, following the logic could have significant adverse impact on retirement income security of employees.

It is unclear whether the employer contributions to the New Pension Scheme (NPS), which the government intends to be a significant new avenue for provision of pensions to the unorganized sector, will be exempted from the FBT.

If they are not, then two major inconsistencies will result. First, taxing them will violate the EET (contributions and investment returns being exempt, while withdrawals at the pay-out phase being taxable) principle advocated by the current government. This will also be the case if superannuation contributions by the employers are subjected to the FBT, and withdrawals are subjected to the EET taxation.

So instead of simplifying, the FBT complicates tax structure and raises administrative and compliance costs.

Second, the FBT increases the cost of participating in the NPS, and thereby discourages voluntary participation. This in turn is inconsistent with one of the major objectives of the NPS.

India’s current retirement financing system has a narrow coverage. Only about 10 percent of the labour force is covered by the EPFO and by civil service pensions. Design inadequacies, and lack of professionalism have meant that EPFO does not provide adequate retirement income to vast majority of its members.

For some of the workers in the organized sector, superannuation benefits are an important supplementary source of retirement income. The health care financing in India is largely out-of pocket (around 85 percent of national health expenditure), with government budgetary expenditure and health insurance playing fairly insignificant role.

But as life expectancy rises (male and female in India at age 60 have average life expectancy of 16 and 17 years respectively), and as changing morbidity patterns towards more life-style type individual diseases which are more expensive to treat, raise health care costs, taxing retirement and health care benefits under FBT is perverse public policy.

Employer-based superannuation arrangements, provided they are effectively brought under regulatory purview of the Pension Fund Regulatory and Development authority (PFRDA), have the potential to assist in the development of financial and capital markets, and lend substance to the development of Mumbai as a financial centre.

The FBT is inconsistent with achieving greater efficiency in saving-investment process, a major competitive advantage which India potentially enjoys over China.

The FBT as it is currently structured is also not consistent with international tax practices, and could impact on international competitiveness of firms. As an example, in UK there is no tax liability on company contributions to pension funds. In 1997, however, exemption for income earned by company pension funds was removed, and this had adverse impact on the sustainability of these funds, hastening decline in their relative importance.

Australia introduced FBT in 1986, but contributions to superannuation funds are specifically exempted under the law.

How can FBT be restructured as far as superannuation (and health care) benefits are concerned? In some Asian countries a certain proportion of the wage bill is permitted to be tax deductible by companies for employee superannuation benefits. As an example, in Malaysia 17 Percent of the wage is eligible for tax deduction for retirement benefits. Since mandatory contribution to Malaysia’s equivalent of EPFO is 12 percent, 5 percentage points are available for voluntary benefits. This limits reduction of income tax base, while serving public interest.

India may consider adapting such practices. Thus, ceiling for employers could be between 1.50 and 2.0 times the mandatory contributions requited for the EPFO.

A broad provision, such as coverage in the superannuation plan of certain proportion of employees, for qualifying for FBT exemption would address concerns about current narrow focus of such plans. There should be enabling provision for employee contributions.

In the Indian context, a separate ceiling for contributory health benefits s will also have high social utility. These could be pegged to between 1 and 2 percent of total payroll.

The above modifications to the FBT will remove unnecessary complexity and rent seeking opportunities, while providing transparency and furthering public interest.

Mukul Asher is professor of public policy at the National University of Singapore, and currently a visiting professor at the Tanaka Business School, Imperial College, London. The views expressed are his own.