Taxing Inflation

After Budget 2018-19, India's tax laws are more friendly to assets like gold, real estate and bonds than they are to investing in equity, whether directly or through mutual funds. In fact, what is truly strange is that even unlisted equity, which often consists of sweetheart deals lacking all transparency, is treated better than listed stocks and equity mutual funds. It's hard to see the logic in this, probably because there is none.

I'm actually not talking of the restoration of Long-Term Capital Gains Tax itself. Even the RBI Governor has pointed out that the returns from capital are now taxed at five stages and this will definitely affect investment decisions.

However, on top of that, the decision to not allow inflation indexing for this tax is truly strange and completely unjustifiable. Inflation indexation is allowed for every other form of long-term capital gains in India. So far, there are no exceptions to this. Inflation indexation is a cornerstone of fair taxation. It arises from the principle that the government cannot ask you to pay a tax on values that increase because of inflation. It's hard to understand why this principle is being ignored for this particular tax now.

The Finance Minister and his officials have presented this tax primarily as a way of taxing capital gains made by FIIs and large corporate investors. Those types of entities may be the primary target, but they are not the only ones. India now has crores of middle-class and upper-class retail investors who are investing in equity and equity funds. There are more than Rs 5000 crore flowing in through SIPs in equity mutual funds every month. Why are these people being swept up in the same tax dragnet as the big fish?

The lack of indexation makes the situation much worse. On an average, equity returns are rarely more than three to four per cent above inflation. Ten per cent of the full returns could easily be 20 to 30 per cent of the real, inflation adjusted return. That's right. This tax is likely to be 20 to 30 per cent (sometimes more) of your returns on every transaction.

In fact, even that is an underestimation. Your real, inflation-adjusted, returns could be negative and you will still have to pay this tax. Think of an investing period where your returns are, say, eight per cent and the inflation is ten per cent. For investments that have indexation, there would be no tax in this case. However, in this particular tax that Mr Jaitley has imposed, you will have to shell out money despite having made an effective loss.

In the last few years, there are plenty of examples like this. This typically happens in funds or stocks which do not do well and investors want to get out of them. A big example in recent years would be the thousands of crores of investments that were made in infrastructure funds just before the 2008 crash. Today, a typical investment like this has gained a total of 50 per cent over the years. This is well below the inflation indexing level. If such a tax had existed during this time, savers would have been taxed despite having made losses in real terms.

As I said earlier, this would have been merely unjust were it to be the case for all types of assets. However, to single out listed equity and equity mutual funds alone for this treatment is simply unconscionable.

India has always had a primarily fixed-income investing culture. Such investments hardly have any real returns and are a major reason why so many people are in financial distress despite saving all their lives. Equity-based investment are the only asset class available today to the ordinary saver to beat inflation. The data shows that people are increasingly beginning to use this option. To start taxing inflation at this stage will be counter-productive. The minimum that the Finance Minister can do is to give listed equity the same inflation indexation options as other asset classes.