As I'd written last week, the long-term capital-gains tax (LTCG) on equity investments, which was reimposed after two decades in 2018, is beginning to have a serious effect only now.
However, this is a uniquely unfair tax which alone, among capital gains taxes of all kinds in India, does not compensate for inflation. The structure of taxes should be fair and logical and while the tax-givers and the tax-takers will always be at odds over what is fair, this tax defies the very logic that capital-gains taxes on all other types of assets follow. This inconsistency seems to have no reason behind it and for the last two years, I am yet to find any explanation for it.
The problem is simple - capital gains are effectively inflation-adjusted, through the mechanism of the cost-inflation index that the income-tax authorities announce every year. When you sell a capital asset, you have to pay tax on the gains, which is obviously the difference between the sale price and the cost price. However, the cost price is adjusted upwards using the cost-inflation index. This is fair because the general devaluation of money in the economy means that some of the nominal gains that you have made are not real - the value of money has eroded by that much. Therefore, in all fairness, tax is not charged on the proportion of your returns that are deemed to be just an artifact produced by inflation. Of course, this is optional. You are free to either adjust for inflation and pay 20 per cent or not adjust and pay 10 per cent.
Sometimes, the inflation-adjusted option is better but the point is that the adjustment is available. Except that strangely, for equity investments, it's not. Let's take an example. Let's say that you invest in some equity asset on February 1, 2018. Let's assume that this asset's value tracks the Sensex. When the market falls in 2020, you get worried but as it starts recovering and as you get some gains in September or so, you sell. This is not all that hypothetical because a lot of investors did exactly this. From the beginning of February 2018 to the end of September 2020, you would have gained about 6 per cent as the Sensex would move from about 35,000 to 37,000.
However, if we take the cost-inflation index of the tax department into account, you have not made any gains. This index was 280 for the financial year 2018-19 and 301 for 2020-21. Effectively, after adjustment for this transaction, the Sensex level in February 2018 would be 37,500 and you would have made a loss!
Here's the important thing: the gains are an illusion; you ACTUALLY have made a loss. The value of your money really has eroded by 10 per cent. On top of that you are paying a tax out of your pocket on this loss. And this is true only for equity and equity mutual funds. If this were an investment in a fixed-income fund or anything else, you would be able to adjust.
As I said last week, this tax is uniquely discouraging for equity investments. In terms of savings, India is still overwhelmingly a fixed-income country, something that is made worse by falling interest rates, pushing more and more retirees towards old-age poverty. There's no solution to this besides making equity investments simple and attractive. This kind of an inconsistent tax structure does the opposite.
With the Union Budget just a few days away, one hopes that this anomaly is removed from the tax system.