The Hindu Business Line : Implications of capital gains giveaway

The extravagant fiscal concession of abolishing long-term capital gains from securities transactions tax appears to have triggered the speculative surge in the stock market, but at the expense of revenue foregone by the state

Just before the Foreign Institutional Investments surge began, and influenced perhaps by the sharp fall in net FII inflows in 2002-03, the then Finance Minister declared in the Budget for 2003-04: "In order to give a further fillip to the capital markets, it is now proposed to exempt all listed equities that are acquired on or after March 1, 2003, and sold after the lapse of a year, or more, from the incidence of capital gains tax. Long-term capital gains tax will, therefore, not hereafter apply to such transactions. This proposal should facilitate investment in equities." (Ministry of Finance, Government of India 2002: Paragraph 46.)

In the very next year, the Finance Minister of the UPA Government endorsed this move. In his 2004 Budget speech he announced his decision to "abolish the tax on long-term capital gains from securities transactions altogether." (Ministry of Finance, Government of India 2004: Paragraph 111.)

It is no doubt true that he attempted to introduce a securities transactions tax of 0.15 per cent to partially neutralise any loss in revenues. But a post-Budget downturn in the market forced him to reduce the extent of this tax and curtail its coverage, resulting in a substantial loss in revenue.

Thus, an extravagant fiscal concession appears to have triggered the speculative surge in the stock market that still persists.

THE EXTRAVAGANCE

The implications of this extravagance can be assessed with a simple calculation which, even while unsatisfactory, is illustrative.

Let us consider 28 of the 30 Sensex companies for which uniform data on daily share prices and trading volumes are available for the years 2004 and 2005 from the Prowess Database of the Centre for Monitoring the Indian Economy. (In one case — Larsen & Toubro — the data on trading volumes were not available in Prowess for 25 out of 254 trading days in 2004. For those days, we use the annual average trading volume as a proxy.)

Long-term capital gains were defined for taxation purposes as gains made on those assets held by the purchaser for at least 365 days. These gains were earlier being taxed at the rate of 10 per cent. Assume now that all shares of these 28 Sensex companies bought on each trading day in 2004 were sold after 366 days or the immediately following trading day in 2005. Multiplying the increase in prices of the shares concerned over these 366 days by the assumed number of shares sold for each day in 2005, we estimate the total capital gains that could have been garnered in 2005 at Rs 78,569 crore.

BOON FOR SHARE BUYERS

If these gains had been taxed at the rate of 10 per cent prevalent earlier, the revenue yielded would have amounted to Rs 7,857 crore. That reflects the revenue foregone by the state and the benefit accruing to the buyers of these shares. It is true that not all shares of these companies bought in 2004 would have been sold a year-and-one-day later.

But some shares which were purchased prior to 2004 would have been sold during 2005, presumably with a bigger margin of gain. And this estimate relates to just 28 companies.

In practice, therefore, the estimate provided is likely to be an underestimate of total capital gains from transaction that would have been subject to the capital gains tax.

While it needs to be noted that the surge in the market may not have occurred if India had not been made a capital gains tax haven, the figure does reflect the kind of gains accruing to financial investors in the wake of the surge.

Once the FII increase, resulting from these factors triggered a boom in stock prices, expectations of further price increases took over, and the incentive to benefit from untaxed capital gains was only strengthened.

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