Capital Gains Crossroads: Why India’s equity–debt tax divide is back to haunt markets

This year, the fear gripping Dalal Street is not about earnings misses or geopolitics. It is about a possible capital gains tax rethink.

• Debate grows over raising capital gains tax on equities amid market uncertainty
• India's equity-debt tax gap is among the widest globally, favoring equities
• Timing of tax changes could worsen market fragility and investor sentiment

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They say only two things in life are certain: death and taxes. Death, mercifully, is unpredictable. Taxes, on the other hand, arrive right on schedule — especially around Budget season.

This year, the fear gripping Dalal Street is not about earnings misses or geopolitics. It is about a possible capital gains tax rethink.

The government’s decision in 2024 to raise long-term capital gains tax on equities from 10 percent to 12.5 percent has left a lingering aftertaste. Many market participants saw it less as revenue mobilisation and more as a “signal move” — the first step in a longer journey toward taxing equity harder.

After all, what does a 2.5 percentage-point hike really achieve fiscally? Not much. What it does achieve is nervousness. And markets hate nothing more than uncertainty.

What is making this debate more explosive is timing. Indian equities are already in reset mode. Foreign investors are pulling money out. Domestic investors are flirting with last year’s superstar assets — gold and silver. Earnings growth is muted. Valuations are still elevated. And now, on top of this, the idea of tinkering with equity taxation is back on the table.

That is explosive material.

The Big Gap: Equity vs Debt

At the heart of the debate lies a widening tax gap.

Long-term equity capital gains are taxed at 12.5 percent. Interest income on fixed deposits and bonds is taxed at marginal slab rates. Income more than Rs 12 lakh per annum is taxed at 15%, and the rate rises all the way to nearly 38% including surcharge and cess for top earners.

This gap is now among the widest globally. In most countries, equity and debt returns are taxed at similar rates. India, in contrast, continues to heavily favour equities.

Why Policymakers Favour Equity

From the government’s perspective, this is not accidental.

India is still starved of long-term risk capital. Household savings remain heavily skewed toward fixed income. Banks, insurers and provident funds continue to dominate the savings ecosystem.

Equity capital, by contrast, is pure risk capital. Of course, Indian love real estate and gold also, but the latter is unproductive, real estate is partially productive, while equity is most productive -- funds entrepreneurship, innovation and business expansion, and what not. It deepens capital markets. It reduces dependence on debt.

That’s why for long it has been argued that India’s historically low equity participation needed incentives. Preferential tax treatment was meant to nudge households away from guaranteed-return comfort zones and toward growth assets that can power the economy.

In theory, it made sense.

When Incentives Start Distorting Behaviour

But incentives, when overused, create side effects. Post-Covid, easy digital access and spectacular stock market returns pulled millions of first-time investors into equities. The pendulum has now swung decisively. Tax efficiency, rather than risk appetite, is increasingly driving asset allocation. For many savers, fixed-income returns of 6 percent taxed at slab rates barely beat inflation. Former Sebi whole-time member Ananth Narayan has aptly called this “a wealth tax without indexation.”

The result? Retirees and conservative investors are being nudged — sometimes pushed — into volatile assets just to protect purchasing power. That is not healthy portfolio construction. That is desperation investing.

Pressure on Banks and Credit Flow

There is also a banking angle.

Bankers have long blamed SIP culture for deposit pressure. The Economic Survey released on January 29 and the RBI disagree, arguing this is largely household diversification. After all, money does not vanish — it just moves within the system. There is another argument posed by bankers that the pressure on bank deposits not only eats into their margins but also makes it difficult to advance credit to small enterprises which are incapable of raising funds through bond or equity issuances. But that argument is untenable for banks need to “earn” their profitability too – and understand the days of lazy banking by simply extracting fat margins by sitting on “low-cost” savings deposits is over.

The Reality Check for New Investors

Another uncomfortable truth: many investors who entered post-Covid have only seen bull markets.

Three years of 25–30 percent equity returns have distorted expectations. Corrections now feel depressing. Volatility feels abnormal. It is not.

The old market cliché — “equities always deliver superior returns” — is only true over very long periods and at sensible entry valuations. Buy expensive markets and disappointment becomes the default setting.

A quick look at Japan or China is enough to remind investors that decades of low returns are not theoretical risks.

They are lived experiences.

Too Much Money, Too Few New Shares

There is also the valuation distortion problem.

Equity mutual fund SIP inflows of nearly ₹30,000 crore a month are fantastic to support stock prices especially when there is an avalanche of selling by foreign investors, but awkward for fund managers when there isn’t enough market depth and good money has to chase over-priced stocks. Meanwhile, private equity funds, promoters and multinational parents found a convenient exit door — selling at premium Indian valuations to mutual funds or direct investors.

India, in effect, became an attractive global exit market.

Good exits build confidence, yes. But excessive inflows chasing limited quality supply inflate prices — not productivity.

So Should Capital Gains Tax Be Raised?

Ironically, many of the arguments now emerging do support narrowing the equity–debt tax gap.

But context matters.

Markets are fragile. Foreign investors are already cautious. Consumption sentiment is soft. Corporate earnings momentum is patchy.

Touching capital gains tax now would be like adding weight to an already bending bridge.

Bull markets are ideal for reforms. Consolidation phases are not.

If equity taxation becomes the proverbial last straw, the correction could become sharper than policymakers intend.

And markets, once spooked, rarely wait for clarification.

So yes, the capital gains debate is real. The distortions are real. The risks of inaction are real. But so are the dangers of bad timing.

Sometimes, the best policy move is not what you change — but when you choose to change it.