A person earns Rs. 2000 per month over and above his salary as additional charge allowance. However, 30% of this additional income will be deducted as additional income-tax at source. If the person would deposit Rs. 1000 per month on a long-term saving fetching 12% interest his tax liability on the additional allowance would reduce to 10%. What is the effective interest for this person for money invested in the long-term savings scheme ?

Initial TDS on the additional allowance at 30% is 0.30×2000 = Rs.600; after the investment the tax on the allowance becomes 10% i.e. 0.10×2000 = Rs.200, so immediate tax saving = Rs.400 per month [2]. The person deposits Rs.1000 but effectively parts with only 1000−400 = Rs.600 net outflow. The investment yields 12% on the full Rs.1000, i.e. Rs.120 per year. The effective return on the actual money parted with = 120/600 = 0.20 = 20% per annum. This uses the standard notion of effective interest as benefit divided by net cash outflow [3].

Sources

1. [1] Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 4: Government Budgeting > Following are certain basic features of the above taxes: - > p. 168
2. [2] Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 16: Terminology > 16 Terminology > p. 463
3. [3] Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > 2.4 Securities > p. 43