One year has passed since the Long Term Capital Gains tax on equity was reimposed and I hope that the Finance Minister will rethink this tax in next week's budget.
I say the tax was 'reimposed' because there was a similar tax in place till 2005, when it was removed in that year's Union Budget. Even though some variant of this tax had been expected for a number of years, it's exact nature was an unpleasant surprise. From February 1st 2018 onwards, selling stocks or equity mutual funds that you have held for the long-term (greater than one year, just like earlier) has meant paying taxes on gains accrued since markets' closing on January 31st, 2018. If, in any given year, you realise more than Rs 1 lakh of such gains, then 10.04 per cent of that (a 10 percent base tax plus cess) has to be paid as tax. Unlike every other kind of capital gains tax (past or present), there is no option for indexation but more on that later.
The tax exacerbates the worse problem that threatens the Indian saver, who is wallowing in the financially damaging tradition of sticking overwhelmingly to deposits. Savers need all manner of encouragement to switch to equity-based on investments. In terms of savings, India is still overwhelmingly a fixed-income country. However, as fixed income returns have fallen, and savers still sticking to their habits, more and more retirees are sliding towards old age poverty. There is no solution to this, except to make equity-based investments simple and attractive to understand and implement. Before the current reimposition of the long-term capital gains tax, this was very much the case. However, one year of experience has shown that this tax will be a considerable impediment in achieving that.
You might think that a tax of ten percent of your returns when you sell your investments is nothing much. However, this ten percent is an illusion. In reality, over an extended period of time, the dent in your investments is much higher, perhaps two or three times as high.
How is that? Well, you must have heard of 'The Magic of Compounding'. Now meet its evil twin, 'The Horror of De-compounding'. What I mean is that no equity investor is going to hold the exact same investments for long periods like five or ten years. At some point, they would sell some of their holdings and buy something else. Given the structure of tax laws, capital gains would be taxed on each such switch, leading to less capital being available for compounding subsequently. The eventual impact would be quite large, but would differ for each investor depending on the quality of the investments they make and their resulting buying and selling pattern.
What's worse is that each time an investor needs to switch to a different investment, a mental trade-off has to be made whether the financial cost of sticking to a bad investment will be greater than the tax hit. Of course, most of the time there would be no rational basis for making such a trade-off and it would end up being a random and possibly harmful decision.
Last year, when this tax was first announced, I was shocked that it did not have the indexation option. It is a cornerstone of fair taxation that the government cannot ask you to pay a tax on values that increase because of inflation.
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 percent of the real, inflation adjusted return. Therefore, this tax is likely to be 20 to 30 per cent (sometimes more) of your returns on every transaction. In fact, I'm being quite conservative--it is entirely possible that 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. Do note that when such a tax used to be there before 2005, it had the indexation facility. So, all other long-term capital gains taxes in our country have indexation except this one. Why this exception? There is no valid reason, at all.
The bottomline is that this is a bad tax, and a so-called 'election budget' is a good time to get rid of a bad tax.
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