A Union Budget is approaching, and once again, like clockwork, the issue of imposing long-term capital gains tax on equity has come up. A newspaper report earlier this week claimed that such a tax--which was abolished in 2005--was actively being considered by the finance ministry. Predictably, there was a chorus of protests--some private, some public and some social--from investors and investment managers.
Exactly a year ago, the same thing had happened, except that at the time, the story began not with a newspaper quote from anonymous ‘sources’, but with a public statement from the Prime Minister himself. On 24th December, 2016, in a speech delivered at the inauguration of the new campus of National Institute of Securities Markets, the PM said that, "those who profit from financial markets must make a fair contribution to nation-building through taxes. For various reasons, the contribution of tax from those who make money on the markets has been low." He also said that, “to some extent, the low contribution of taxes may also be because of the structure of our tax laws. Low or zero tax rate is given to certain types of financial income. I call upon you to think about the contribution of market participants to the exchequer. We should consider methods for increasing it in a fair, efficient and transparent way.”
Since there is literally no kind of financial income that has zero tax except for long-term capital gains, this sounded like a clear and unambiguous warning that such a tax was coming. However, within a day, Finance Minister Arun Jaitley explicitly denied that such a tax was being considered and claimed that the PM’s statement had been misinterpreted. Maybe that was the case, but it was pretty clear that at some level, Modi sees this zero tax regime for long term capital gains as unfair. The beneficiaries of this zero tax regime are overwhelmingly likely to be richer people, something that strikes many people as unfair.
Originally, when this tax was abolished in 2005, the genesis of the move was in the report of the Kelkar committee. The idea was that the ultimate source of long-term capital gains is ultimately corporate profits and dividends, which are already taxed. So, in a sense, capital gains was derived from tax-paid income and therefore taxing them would amount to double taxation. While there is some logic here, it’s not a view that cannot be argued against. As it happens, zero capital gains tax is pretty rare around the world. The US, Canada, Australia, and all major European countries, among others, tax all capital gains and many of them tax it quite heavily.
Jurisdictions that have zero tax tend to be those that specifically set out to use it tactically, for example, Singapore, as well as other tax havens. Back in 2005, India’s zero-rating of such tax could also be seen as a tactical move to attract FII investments. However, it is arguable that this is no longer needed.
Of course, no one likes to pay more tax and it’s likely that the equity markets will react negatively to such a tax. It should be noted that over a long period like ten or fifteen years, an investor would lose more money to taxation than the tax rate. It is entirely possible--even likely--that a tax rate of, say, 15% would lead to a reduction of 50% in your actual returns over a decade or so. The thing about such a tax is that no investor is going to be in the exact same investment for five or ten years. At some point, they would need to move from one investment to another. Given the structure of tax laws, capital gains would be taxed on such a switch, leading to less capital being available for compounding subsequently. The eventual impact would be quite large.
It’s often speculated that a likely change in the tax laws would actually be to increase the holding time limit for qualification as long-term capital gains from one to three years. This may actually deliver higher tax revenue, as well as a desirable change in investor behaviour. Of course, it is actually likeliest that there will be no change at all, but if there is, then it shouldn’t come as a surprise.