It has kind of become an annual ritual that every time budget is approaching and there is any decline in stock markets, it is attributed to the possibility of long term capital gains coming back in equity investment.
We at this paper believe that it will be foolhardy to bring back long term capital gains tax because it will not only have a major negative impact on macro saving structure — which shifted toward financial asset only in the last 12 months — but will also, more importantly, hit the government in terms of finance. In the end, it will be the government exchequer that will be the loser.
Taxes are imposed to increase the revenue of the government and not just because some feel that others are making money and they should be taxed. It is a fact that till recently long term capital gains tax exemption have been misused by certain people to change the colour of their money. In the past there were some listed stocks which were used to be manipulated by using this long term capital gains route. But in the last three years, market regulator had done enough clean up and has referred all those cases to income tax department for further investigation and fines have been imposed which has acted as a deterrent for such practice.
The reason why government should desist from either directly or indirectly bringing any sort of long term capital gains tax are twofold. First, government will have to abolish securities transaction tax (STT), because STT was bought in lieu of long term capital gains tax, so both taxes cannot stay.
If STT is removed, the seamless collection of revenue which is happening today, where money being collected is going to exchequer every week will shift to year end. This might appear to be a small thing but in real term this means a lot to the cash flow of the government. Also, long term capital gains to investor may or may not happen, they will not happen when the market is in bearish phase. There was hardly any long term capital gains to investor in the period between 2010 and 2013. But as far as equity transactions are concerned, they are bound to happen every day. The fact that on an average more than Rs 20,000 crore is flowing in equity market every month only through domestic institutional investors, let alone the direct flow from investors, clearly indicates that volumes in equity markets are going to increase even further. Thus, it makes sense to stick with STT rather than taking the uncertain route of long term capital gains.
Secondly, if the tax is imposed, then the savings — which after a long period of time are shifting to financial assets rather than physical assets — are going get hit. At this point, it will be foolish because if money flows into physical assets like real estate, it pushes inflation up further. So, there are enough macro reasons to leave the current taxation regime alone.
But the biggest reason is that if government brings any such tax and the equity market shed weight sharply, then valuation of the government shares is going to come down. For instance, the government, the bigger money raiser from capital market by selling its stake in FPO and IPO, is easily able to raise money by selling its stock of PSU at price earning multiple of anywhere between 17 to 19. But if the overall multiple given to market comes down to 17, then the government will have to sell its stake at a lower multiples than over all market valuation. Now this drop in valuation will hit the government collection and that difference is unlikely to be fulfilled by what it collects by way of long term capital gains tax. So, there is no logical reason why government should dent its own cash flow in order to make it appear that every gain is being taxed. India as an economy is at a stage when saving needs to be given a push. Changing any tax structure will hinder this goal and should be avoided.