Raising capital gains tax is detrimental to investor confidence and market stability

The only shadow hanging over markets appear to be persistent rumours that capital gains tax rates would be hiked in the upcoming budget.

As expected, markets surged after exit polls predicted an emphatic victory for the Bharatiya Janata Party-led National Democratic Alliance, with some projecting the coalition will secure more than 400 seats.

While the exit polls ended the election-related uncertainty hanging over the stock markets, they are not the only positive indicators. Exit poll results are among the trifecta of recent good news, the others being the GDP data for the March quarter and S&P's upgrade of India's rating outlook to positive.

GDP growth surpassed 8 percent in fiscal 23-24, with growth in the fourth quarter coming in at 7.6 percent, beating most estimates. Polls of economists by several media organisations, including Moneycontrol, placed growth below 7 percent in the fourth quarter.

The only shadow hanging over markets appear to be persistent rumours that capital gains tax rates would be hiked in the upcoming budget. Long-term capital gains (LTCG) tax in India is 10 percent and the short-term rate  (STCG) 15 percent. In recent remarks to CNBC-TV18, Helios Capital Founder Samir Aroa said a possible rise in capital gains tax was a bigger worry in the long run than the election outcome.

The government should move quickly to douse such speculation.

While as a theoretical proposition, this may be sound economics—the theory in question being that income from the sale of shares and mutual funds should be treated the same as salaries—the government should hold its hand at this stage of development of Indian markets and the economy.

There are two reasons not to impose capital gains tax on equity instruments. One is that China, India's direct rival for investments, has a 20% tax on capital gains, though for certain types of share transfers, the tax is not levied at all, according to information in the public domain.

Further taxing capital gains in India at the highest marginal rate could mean taxation at a 42.7 percent rate, one of the highest in the world. This rate applies to those earning over Rs 5 crore under the old tax regime. According to PwC, Hong Kong, whose market capitalisation briefly fell behind India last year, does not tax capital gains from equity sales. It is true that many countries tax capital gains at the income tax rate applicable to that taxpayer, but India's tax rates—35 percent for incomes above Rs 1 crore and over 40 percent for Rs 5 crore—are on the higher side.

International competitiveness apart, there can be little doubt that the rise in markets and the consequent wealth effect has significantly bolstered sentiment in favour of the incumbent government.

Further, the wealth effect boosts consumption as a rise in the value of equity and mutual fund holdings encourages purchases. This may reinforce the premiumisation of consumer spending widely referred to by FMCG companies, but until there is a structural solution to the problems of rural underemployment, we may have to live with a faster growth in consumption of relatively pricier goods.

Further, the surge in SIP inflows since FY22 has created a large category of people, many of them new investors, who have benefited from stock market investments. Inflows rose to Rs 20,371 crore in April 2024 from Rs 8,183 crore in May 2019.

Remarkably, the amount collected in April this year is almost half the amount during the whole of fiscal 2016-17. The number of SIP accounts soared to 8.7 crore, more than four times the June 2019 number, according to AMFI data. A sudden rise in capital gains tax would undermine investor confidence, particularly affecting domestic investors who lack the protections foreign investors enjoy under tax treaties.

A drastic alteration of the capital gains tax regime should be off the table for the foreseeable future.