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With a mere stroke of a pen, a government can make investors wealthier or poorer. Making long term capital gains tax-free, then bringing it back, the imposition and hiking of the securities transaction tax, are events that have had far-reaching implications for Indian traders and investors. Of course, policy actions in other areas such as the more recent slashing of corporate tax rates or the liberalisation wave of the nineties have been market-moving events too, but here we are talking about measures directly concerning investors.
Every budget, there is that inevitable speculation on whether the capital gains tax on stocks will see any change. Budget 2023 ticked that box by making capital in fixed income mutual fund schemes taxable as short-term capital gains. That meant no indexation and no 20 percent rate either. Gains would get added to income and taxed at the marginal tax rate just like your fixed deposit interest, irrespective of tenure.
But last Friday’s (May 3) events were intriguing. It followed speculation that once voted back, the government would commence work on a list of priority areas relating to tax, one of which was a relook at the capital gains tax.
Since the finance minister denied any such thinking, it’s better to not get into what was being speculated. But what was really puzzling was the market’s reaction, as indices slumped from their opening highs and closed with a loss of 1 percent. Since the FM had clarified on Friday itself that there was no such move, surely on Monday the markets should have recovered fully. But as of 12.30 pm, they were up by only 0.3 percent.
What does that mean? Are markets still discounting some adverse tax measures or are other factors making them wary on Monday?
If mere speculation during the time of elections can lead to this reaction, before the results have been declared, before the Final Budget work has officially started, what does this say about the fragility of the market? But another question is also whether the Street perceives such a move as being credible enough, to give an upper hand to the bears.
One reason could be to raise revenue, which is a priority of any government. In today’s edition, my colleague Manas Chakravarty writes about whether Warren Buffett was right when he warned about the US fiscal deficit, and whether taxes may be raised to close the gap.
The Indian government too is targeting a lowering of the fiscal deficit, as it seeks to return to the path of responsible fiscal management. One way is to cut expenditure. It has been exhorting the private sector to take over the task of investment spending, but the response has been tentative. If the government has to keep at it, then it needs to find the revenue for it.
If the owners (shareholders that is, and in India’s family-controlled enterprises they are the managers too) of private capital don’t invest, but their wealth keeps growing due to rising asset values, do they become fair game then in the quest to raise revenue? For instance, many new companies have indeed listed but in many, a fair share of the capital is being used to buy out existing shareholders. No new assets are being created with this portion of funds being raised. If wealth creation is the name of the game, should it get a higher share of the pie?
While answers to all of these should become clear once the Final Budget is revealed, what is most needed for Indian investors and even companies is certainty. It would be better if the government spells out a tax roadmap with proposals and a timeline. Some of these may be unwelcome, but once there is a roadmap, they will get discounted in valuations and knee-jerk movements as seen on Friday due to tax-linked speculation will become rare.
Piecemeal changes also lead to avoidable consequences. For instance, the fixed income tax change has led to the MF industry structuring fixed income-like schemes specifically to beat the higher tax.
Will the equity cult get eroded under a less favourable capital gains tax regime? How much of the ability to raise equity capital by companies depends on the long-term taxation on these instruments? These are all questions that can be debated in an academic setting but in the real world, why rock the boat is what investors will still ask.
Oh and yes, a word of caution for a government from Ruchir Sharma, in his FT column (free to read for Pro subscribers) on how some countries hailed as 'model' economies strayed from the path with just 'One basic mistake or miss, and any country can find itself stuck — until it finds the leadership and vision to chart a way out'. While this is not about taxation changes, it's a timely word of caution.
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Ravi Ananthanarayanan
Moneycontrol Pro
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