As the countdown to Union Budget 2018 changes from days to hours, speculation, as well as alarm, and perhaps panic or even anger, about the supposedly imminent re-imposition of long-term capital gains tax on equity investments has peaked.
I won't say anything on whether such a tax should be imposed or not. There are arguments for as well as against, but as I experienced earlier, any attempt to explain the trade-offs is met with a large amount of vigorous criticism, to say the least. I also do not have any speculation to offer on whether such a tax will be imposed, except to repeat that I won't be surprised if it is.
However, as far as the nature of the (possibly) coming tax goes, there are three very different things that could happen. Of course, I do hope that only one of them actually happens.
A simple extension of the qualifying period
Currently, to qualify for zero tax on long-term capital gains, one must stay invested in an investment for at least one year. Mr. Jaitley could increase the holding time limit for qualification as long-term capital gains from one year to two or three.
This could increase the tax revenue without actually violating the principle that long-term equity investment should be tax-free. What is being done here is only changing the definition of long-term. Personally, I have no problems with such a change. Any smart equity (or equity mutual fund) investor knows that one year is too short a period for equity investments. One should stay invested for at least three to five years.
Therefore, for any sensible equity investor, a change in the qualifying period from one year to three should be irrelevant, and will not lead to any increase in tax liability.
A re-imposition of the pre-2005 tax
Before March 31, 2005, long-term equity gains used to be taxed. For holding periods above one year, the purchase price was inflated using the Income Tax Department's cost-inflation index, and the gains thus calculated were taxed at 20 per cent. Since the cost-inflation index roughly matches consumer inflation, one could say that investors had to pay a 20 percent tax after allowing for inflation. Of course, the rate could be lower than 20 per cent that used to be. Such a tax would have a major impact on the returns realised by equity investors. Not only would there be a tax on the returns, the returns themselves would be lower.
As I've pointed out earlier, with such a change, 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.
This impact would be lower--much lower--for mutual fund investors since switching done inside a fund is tax-free.
A Rich Tax?
There's a third possibility as well, at least when one looks at what happened to corporate dividends last year. The government imposed an additional 10 per cent tax on those who received more than Rs 10 lakh as dividends. Could a similar principle be followed? Possibly. A variation of this could be to have different capital gains tax for people who are in the top income bracket. Obviously, this is the most politically palatable option. Last year, apart from some pro-forma quotes, no one really cared about the dividend tax on the rich.
The STT question
One question is what happens to the Securities Transaction Tax if capital gains tax is re-imposed. STT was imposed in lieu of long-term capital gains tax. Therefore, it is only fair that of capital gains tax is reimposed, then STT must be removed. This leaves open the issue of what happens if capital gains tax is not reimposed but only the period increased.
Anyhow, after some 700-odd words, I get the feeling that I may have written 700 words more than should be written about this issue before the budget actually comes out. So let's just wait with fingers crossed.
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