The lure of equity despite stretched valuation Bias in favour of investments in MFs, insurance

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TAX FRAMEWORK continues to make stocks more attractive.
TAX FRAMEWORK continues to make stocks more attractive.

Suresh Krishnamurthy

Last year, the Finance Minister had talked about a road map for moving towards an EET system - meaning investments would earn tax rebates at the time of investment, income from such investments would be exempt while proceeds received on redemption would be taxed. Such a system would reduce the tax benefit from investments, indirectly increasing the tax payable by investors.

Investors, especially the salaried class, since then have been dreading its introduction. To the pleasant surprise of investors, the Finance Minister did not make even a cursory reference to an EET system. Buoyancy of revenues and rapidly growing economy appear to have let the investors off the hook for now.

There were also not many major proposals impinging on investments. Long-term fixed deposits will now fetch tax rebates and taxpayers can now invest up to Rs 1 lakh in pension plans. Tax incidence on balanced funds may increase if such funds do not increase equity exposure to more than 65 per cent.

Legislative framework has been rationalised for the introduction of meaningful mutual fund schemes that will invest in overseas securities. Securities transaction tax has been hiked. These measures though did not change the prevailing bias in the tax framework towards equities.

In fact, the reduction in yield on post office monthly schemes prior to the Budget only reinforced the message sent by finance ministers over the past five years - invest more in equities.

There is no tax on long-term capital gains from equities. Short-term capital gains get taxed at 10 per cent while dividends get taxed at nearly 12.5 per cent. So even if equities fetch returns of only between 8 and 10 per cent prior to tax, they will offer far superior returns compared to debt investments. Hence, it still makes sense for investors to invest more in equities even if valuations are stretched.

From an investor's perspective, the only issue of concern is on the interest rate front with its implications for floating-rate housing loans. Liquidity in the banking system is now stretched to its limits.

Another year of booming credit growth and the interest rate on housing loans could go up even further. Borrowers should not get locked in to fixed rate loans if they do want their incomes to be interest-rate proof.

The system is also now firmly in favour of investments through mutual funds and insurance plans.

Such investments in both equity and debt markets are as tax efficient or more tax efficient than direct investments managed by the investor himself.

Particularly in the case of debt investments, mutual funds make more sense than direct investments in small savings schemes or fixed deposits. There is only one element that is now against institutions - tax structure for fund of funds.

Fund of funds suffer taxes even if they invest predominantly in equity-oriented funds. If this anomaly is rectified, then investors' reliance on professional fund managers will increase even more.

(This article was published in the Business Line print edition dated March 1, 2006)
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