Taxing Capital Gains

Is it a good idea for the Indian economy?

In his speech at Mumbai, the prime minister hinted at taxing capital market profits. While the exact contours of the plan are not available, there are a variety of possibilities. More importantly, what are the arguments for and against taxing the capital markets? And will it really work in practice?

How could taxes be tweaked? 

Currently, short term capital gains (STCG) are taxed at 15% in case of equities while long term capital gains (LTCG) are entirely tax-free. Also, the definition of long term is more favorable at 1 year in case of equities compared to 3 years for other asset classes. While we see LTCG staying outside the tax ambit, there are other changes that are conceivable. Firstly, it is possible that the government may choose to shift the definition of capital gains on equities to 3 years instead of 1 year. This will make it actually long-term. Secondly, the tax rate on STCG may be reverted to the individual’s peak tax rate. Currently, a person who earns interest on bonds and FDs pays 30% tax but the trader who earns STCG pays only 15% tax. This obviously creates a slightly weird situation where conservative investors are getting penalized. Lastly, there is the possibility of the STT being raised. This is highly unlikely as the FM has, in the past, focused on progressive taxation. STT, being an across the board tax, is not exactly progressive. Doing away with STT does not likely too!

What are the pros and cons? 

On the positive side, it will put equities at par with other instruments, in that at least STCG gets taxed at the normal rate, which was the case earlier. However, this could dissuade liquidity in the equity markets. Equities in India are already subject to double taxation. For example dividends paid are subject to withholding tax. Those who earn more than Rs.1 million as dividends per year already pay an additional 10% tax. This is a clear case of double taxation since dividends are a post-tax appropriation. Equity penetration in India is already quite low and this should not be allowed to reduce further from these levels. 

Is it really practical?

The big challenge in taxing capital gains will be tracking the loss write-offs. This used to be the area where traders used to artificially underplay their profits in the old days. Of course, with better regulation and financial intelligence that will stand reduced. There seems to be a trend emerging. Firstly, the government is moving towards progressive taxation and it was evident from the reduction in STT and higher tax on dividend income. Secondly, the government really wants to push people more towards the safety of equity mutual funds rather than direct equities. Taxing equities and exempting equity funds could be one way of doing this. For the details we will have to await the Union Budget! ©

You can ask us your stock related questions with #AskReligareOnMarkets via our Twitter channel @religareonline

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