Equity and taxes

The stock markets are in a tizzy just ahead of the Budget, speculating about government plans to re-impose long-term capital gains (LTCG) tax on equity investments. This year, the expectation has reached fever pitch after soaring stock prices have helped Indian investors pocket handsome tax-free gains, magnifying the ‘opportunity loss’ to the exchequer. Reports suggest that the Government is mulling a couple of alternatives — either removing the distinction between long-term and short-term gains or stretching the definition of ‘long-term’ for equity investments from one to three years. While the time appears right for the Centre to prospectively impose a moderate LTCG tax on equities after a three-year holding period, the decision should be driven by larger policy considerations, and not an opportunistic attempt to prop up revenues.

From a policy perspective, it is certainly anomalous that returns on equity investments, usually owned by the creamy layer of investors, should enjoy concessional tax rates, while those on post office instruments or bank deposits are taxed at the income-tax slab rates. It is also unfair that equities enjoy a lower rate of short-term capital gains tax (15 per cent, versus slab rates on other assets) with just a one-year holding treated as ‘long-term’ (it is three years for other assets). Lately, investigations by the taxman have also revealed that sharp operators have used LTCG on penny stocks and shell companies to launder their unaccounted wealth. When the LTCG exemption was first introduced in 2004 and replaced by a Securities Transaction Tax (STT) on equity trades, the argument was that this would encourage the equity cult and bolster the tax kitty, as STT would be far easier to administer. But in practice, STT has significantly upped transaction costs in the Indian market, raised costs for pass-through vehicles such as mutual funds and pension funds, and not yielded very impressive tax collections (₹7,000–8,000 crore annually, less than 1 per cent of the total mop-up). LTCG for equities could yield better revenues in a bull market, but with the caveat that the annual mop-up would be far more volatile as it would depend on market conditions.

Unlike the STT regime, where the investor shells out tax irrespective of whether he makes a profit or a loss, an LTCG regime taxes him only if his trades prove profitable. LTCG tax can also help long-term investors set off their losses in one year against gains in another, a facility not available with STT. Foreign investors also make their investment calls based on many factors other than taxation. Therefore, any change in LTCG taxation, while it may trigger some short-term market upheaval, is unlikely to drive away domestic or foreign investors from Indian equities.

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