New Delhi, March 8

Indian Prime Minister Narendra Modi's government today dropped a controversial proposal to tax pension withdrawals, caving in after an outcry by salaried workers threatened to undermine his party's prospects in upcoming state elections.

Indian Finance Minister Arun Jaitley had proposed in his February 29 budget taxing lump-sum withdrawals exceeding 40 per cent of an individual's retirement pot in the Employees' Provident Fund (EPF), unless the sum is reinvested in an annuity.

At present, withdrawals from the EPF are tax-free.

The tax proposal sparked a backlash from small but vocal professional class, with some calling it a raid on retirement savings of honest taxpayers. Only around 36 million of the 1.3 billion people contribute to the EPF.

It also drew flak from opposition parties, forcing government to change tack ahead of elections in five states in April and May in which Modi's BJP eyes gains.

"The policy objective is not to get more revenue but to encourage the people to join the pension scheme," Jaitley said.

The climbdown underscores the challenges for vital but politically-sensitive economic reforms in Asia’s third-largest economy.