Recently, newspapers reported that the Indian government has used up 96% of the fiscal deficit by end of October. There are five more months to go for the financial year.

Of course, if economic growth were faster and the denominator expanded faster, there might be some room to increase the numerator too. Based on evidence of economic growth in the first two quarters of the financial year, the growth rate will fall short of assumptions made in the budget. Under such circumstances, the government will have to find ways to increase revenue as well. But what is surprising is that it has left the equivalent of a jackpot unclaimed. Both the major political parties swear by their commitment to economic development and do not wish to be seen as parties of, for and by the rich. Yet, over the last 12 years neither of them has bothered to revisit one of the most bizarre and regressive tax exemptions given to the rich.

India exempts capital gains made in listed stocks, on which a short-term transaction tax has been paid, from tax if the stocks had been held for 12 months. This tax exemption is so wrong on so many counts that one does not know where to begin and, having begun, where to stop.

No respectable country that is not a financial tax haven provides this exemption for capital gains arising out of stock market investments. Capital gains are taxed everywhere. Even in India, long-term capital gains arising out of real estate transactions are taxed. A democratically elected government in a predominantly poor country has no reason to exempt returns to capital from tax. Very few Indians are invested in the stock market. A vast majority of them who do are rich by Indian standards. Some of them are very rich. So, large capital gains earned by a small proportion of Indians who are the richest go untaxed. It cannot get more bizarre than this.

Recently, there was much chest-thumping about an improving share of financial savings among Indian households. One has to wait for posterity to know if this is a good thing or not for them. But, if the fear is that they would be discouraged from deploying their savings in capital markets, there can be a monetary limit on the tax exemption afforded capital gains. That would be seen as an encouragement to middle-class investors. Strictly speaking, that is not necessary either.

The purpose of investing in capital markets is to earn returns that are higher than those available in other safer financial instruments. On that count, Indian stock markets have delivered. Since May 1994, the Morgan Stanley Capital International Index of Indian stocks has delivered an annualized return of 7.3% in dollar terms. An index of emerging market stocks has delivered 5.2% and China stocks, 2.7%.

If held for the long term, Indian stocks have rewarded investors. But long-term is not one year. Even if the intent was to encourage long-term investing so that capital could be invested in the stocks of those companies that are using it optimally, benefiting investors in the process, one year is too short a time horizon to be called long term. It actually rewards myopia. Long-term is, at the minimum, five years. Seven years would be better.

One of the best decisions that this government took was to put an end to the tax benefits that were conferred on foreign investors into India who set up establishments in jurisdictions that had signed a double-taxation avoidance treaty with India. That removes one of the specious justifications for the capital gains tax exemption given to stock market investors. Allegedly, it was done to level the playing field for domestic stock market investors. Now that foreign investors will have to pay all the taxes domestic investors have to, this cannot be used as justification for the exemption given to domestic investors. One can level the playing field again by restoring the long-term capital gains tax for both classes of investors. It is best to keep a lower tax rate for long-term capital gains with long term defined as a duration of three years in the first stage and five years in stage two. The short-term transaction tax (STT) paid on the transactions can be set off against the long-term capital gains tax payable.

The fear that this would all lead to a meltdown in the stock market can be easily handled. Meltdown happens when stock prices get way ahead of value. In such situations, tax concessions will not matter. In the long term, the real issue is one of economic returns. If India reinstates tax on long-term capital gains in the stock markets and if stock prices drop consequently, it will only make it more attractive for genuine long-term investors, considering the prospects and India’s superior track record mentioned earlier.

India should remember that investors have lapped up the 100-year bonds issued by Argentina, a country that has defaulted five times in the last 100 years. The Indian government can stare down petulant investors. Given what is on offer in India, they will blink first.

Academic studies have shown that taxing capital gains in the stock market could yield around 0.3% of gross domestic product in terms of tax revenue. That is Rs45,000 crore (about $7 billion). It can only increase further. About time for the government to claim the jackpot.

Source: LINK 


Please enter your comment!
Please enter your name here