EPFO basics: Capping allowances at 50% of salary will raise EPFO/ESIC burden

The government’s plan, as reported by Business Standard, of capping various allowances/reimbursements at 50% of basic pay appears good on the face of things since it will mean more retirement savings, but it is riddled with all manner of problems. Indeed, it can lead to greater informalisation of the economy as well. Right now, the government’s argument is that, with employers structuring salaries to keep the basic salary as low as possible, the contribution to EPFO and ESIC are kept artificially low. Take the example of a person earning Rs 100 and various social security contributions at 30.5% of the basic salary—24% for EPFO and 6.5% for ESIC. If the entire salary is the basic, the take-home salary (assuming no tax) is `69.5; if the basic is 75% of the actual salary (or cost-to-company), the contributions fall to `22.875 and to 7.625 if the basic is just 25% of the total salary. Putting a cap on the allowances will raise social security contributions, so chances are that a section of employees will prefer to get their salaries in cash—this will also lower income tax collections, apart from social security contributions. A more informal economy also means lower productivity and lower competitiveness.

So, if the government is going to try and cap various forms of allowances/reimbursements, it has to be more realistic about the cap. Equally important, it needs to rethink the levels of EPFO and ESIC contributions. A lower deduction from the current 24% could, for instance, encourage employers to fix the share of basic salary at higher levels than what it is today. Also, EPFO has very high administrative charges—and, till recently, it essentially invested in just government and PSU bonds that have zero risk—so the more sensible thing is to allow employees to invest in the New Pension Scheme (NPS) that offers higher returns and has lower costs; indeed, if the NPS offers higher returns, this also lowers the amount that needs to be invested to provide the same post-retirement savings. ESIC is even worse since, while it is essentially medical insurance, its claims ratio is much lower than for any medical/group insurance that people can buy—a look at ESIC’s rising surpluses makes this clear. So, if the government feels that employees need to have mandatory medical insurance, why not just mandate that a certain size of medical cover—relative to the annual salary—has to be bought, either as group or individual medical insurance? This will provide the same cover, but at a fraction of the costs. Instead of trying to get employers to rework their salary structures, the government would do well to work on fixing the pain-points in its current social security schemes