The Hindu Business Line : Consistency in tax laws key for financial planning

THE 2004-05 Budget has introduced measures that may have a bearing on financial planning. The changes in short-term and long-term capital gains tax apply to securities that are listed on stock exchanges.

This makes investments in equity mutual fund less attractive. A high net worth individual (HNI) who invested earlier in mutual funds will have to reconsider his decision, as portfolio management schemes will be more tax-efficient.

Such instability in the tax structure discourages financial planning, essential to maintaining the standard of living. Besides, financial planning could lead to less noise trading by retail investors.

That may, in turn, prevent asset prices from wandering too far away from their intrinsic value. The Government has to adopt a stable tax structure, especially when such measures relate to long-term and retirement investments.

Financial planning: This is essentially the process that helps investors in their asset allocation decision. This involves constructing a risk-return matrix and mapping various asset classes to investors' risk class. Such planning is essential for investors to achieve their long-term objectives. The idea is to improve the standard of living through optimal investments.

Take a risk-averse investor who needs Rs 15 lakh after 10 years for his child's higher education. Assume that the investor, in consultation with his financial adviser, decides to invest 75 per cent in a fixed maturity growth plans and 25 per cent in equity funds.

Now, suppose in the second year of investment, the Union Budget introduces a measure that imposes a 10 per cent tax on growth plans of mutual funds.

The financial planning made in the previous year has to be changed. The reason is that cash flows will be affected because of a change in tax structure. Changing the portfolio composition each year because of change in tax structure renders such long-term planning meaningless. Note that this is quite different from portfolio rebalancing that an investor has to do each year to meet his long-term investment objectives.

Of course, an argument can be that the recent Budget has not increased taxes. Rather, the Budget has sought to remove long-term capital-gains tax and instead introduce transaction tax. If anything, such a measure benefits long-term investors. But this proposal makes direct investing more attractive than investing through mutual funds.

If the Budget introduces such measures each year so as to make one investment vehicle more attractive than the other, long-term investors may be forced to think short term. After all, investors always seek to optimise their post-tax returns.

Long-term financial planning, hence, becomes pointless. Investors have to live with the random walk in asset prices. An exogenous event such as a change in the tax structure will only increase the uncertainty in post-tax returns.

Market efficiency: At present, intra-day trades constitute three-fourth of the market turnover. Such trades are executed by operators and noise traders. The latter can be defined as people who invest on momentum and not on information. The operators are those who manipulate stock prices. The operators are successful because noise traders exist. An operator may, for instance, decide to move Vimta Labs from Rs 400 to Rs 1,000. But unless other players enter the stock, it is highly unlikely that the operator may be able to achieve his objective. After all, he needs counter parties so that he can accumulate the stock at lower levels and exit at Rs 1,000.

The point is that noise traders also have to set aside capital for the long term. At present, such a process does not happen for various reasons. If the government were to promise a stable tax structure for the long term, financial planning may be encouraged. Noise traders may then consider allocating more funds to match their long-term goals.

This may lower the capital invested in intra-day trades. With lesser money for such trades, the level of noise trading in the market may come down. That, in turn, may prevent asset prices from walking too far away from their intrinsic value.

Note that intrinsic value is a perceived variable, not a fixed number based just on fundamentals. A reduction in noise trading could prevent perceptions from varying wildly and too frequently. And that could remove excess volatility in the market and encourage more long-term investments.

(Feedback can be sent to bvenky@thehindu.co.in)

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