It's the weeks before the Union Budget and it's time to think about issues regarding personal finance and taxation that the government should fix. Since last year, the top most item on this list has been long-term capital gains tax on gains made on listed stocks and equity mutual funds. In Budget 2018, the reimposition of this tax - which was removed in 2005 - was the biggest change made to savings-related taxation in a long time. If this tax had never been removed, investors would have always been used to it, but obviously, the reimposition rankles them quite a bit.
First, let's recap the basics of this tax. Since February 1st, 2018 onwards, selling stocks or equity mutual funds that you have held for the long-term (greater than one year, a period that is unchanged) has meant paying taxes on gains accrued since January 31st that year. In each financial year, Rs 1 lakh of such gains are tax-free. On the amount of gains that you make exceeding Rs 1 lakh, you have to pay 10 per cent (plus surcharge) as tax. Let's say that during a certain tax year, you sell a number of equity investments on which the total gains are Rs 6 lakh. Out of this, the gains made after January 31, 2018 are Rs 4.8 lakh. Then the taxable amount is Rs 3.8 lakh and the actual tax payable will be Rs 38,000 plus surcharge.
While paying taxes is always painful, this does not, at first sight, look like an unreasonable tax. However, depending on how you invest, the real incidence of this tax could actually be higher - much higher. Over a long period like ten or fifteen years, investors would lose a lot more money, perhaps as much as 20 or 30 per cent. The reason is that no equity investor will ever hold the exact same investments for a long period. At some point, they would have to sell off 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 of course differ for each investor depending on their buying and selling pattern.
The participation of the Indian saver in equity-based investing is quite small. However, in recent years it has been rising, primarily due to SIPs in equity mutual funds. The imposition of a tax on this type of investing just when things have started moving introduces a friction just when it can do most harm. Of course, there are ways of mitigating this impact, but the fact remains that the logic of capital gains tax is weak. It is arguable that capital gains tax is effectively a tax on income that has already been taxed, as it is essentially a downstream impact of the corporate profits that have already been taxed. This was recognised in the report of the Kelkar Task Force on taxation in 2002 which was the original recommendation of the removal of this tax in 2005.
In practice, this tax does tremendous damage to the long-term gains that savers can make from their equity investments because of the 'anti-compounding' effect that I have described above. And it's not just the impact on the maths of investing that matters, but also the psychology. Earlier, if an investment was doing badly, there was no impediment in choosing a better one. There was a short-term capital gains tax till one year, which was useful in preventing a hair-trigger approach, but after that there was no cost to choosing a better investment. Now, one has to balance out the potential damage done by staying in a suboptimal investment with the damage done by the tax. There's no way of making the right choice - it has to be a guess. This is not the kind of investment behaviour that the tax laws should trigger.
Actually, the only real solution to this problem is an investment account. In this system, gains are only taxed when they are taken out and used for other purposes. As long as they are redeployed to equity, they are sheltered. This is probably the best balance of tax revenues and benefit to savers and investors. In fact, this was actually proposed in the original Direct Tax Code but then abandoned as being too complex to implement. However, in the decade since then, we have come a long way in a fully networked financial environment and surely it's time for something like this.