Moneycontrol Pro Panorama | A capital idea whose time is coming

Debt comes with an explicit promise to return the money with interest, unless something goes horribly wrong such as bankruptcy.

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When the government quietly inserted an amendment to the Budget, taxing all income from debt MFs as short term, Pro Panorama had asked if equity was next in line to suffer a similar fate. Not surprisingly, a trial balloon appears to have been floated, with Bloomberg reporting last week that if the BJP government returns to power in 2024, it may consider a higher tax on equity capital gains, particularly on high-income earners. The government promptly debunked any such move and the matter has been forgotten for now. But the idea has been sown in the public’s conscience, so to speak.

There was unequal tax treatment in debt. In debt, if you invested in a bank fixed deposit (FD), then whether you held it for a year, or for three years, whether interest was paid out annually or accumulated, it was added under ‘income from other sources’ in the ITR and taxed. In MF debt schemes, long-term gains were taxed at lower rates and could also benefit from indexation. The post-tax capital gains became even more lucrative when yields fell and bond prices went up. The counter argument was that debt too carried risk, and these gains were a just reward. That’s history now, as debt MF gains are to be added to income and taxed. Can the same logic apply to equity capital gains? After all, both equity and debt are sources of capital. Why should two sources attract different rates of capital gains? And, if short-term capital gains on listed equity are taxed at 15 percent, should long term also be taxed at the same rate? Will a 5 percentage point increase make such a big difference to equity investors?

One answer to how changes to tax rates influence investment decisions should be available in FY24, based on how bank FDs and debt mutual funds fare. If there is no appreciable change in flows, then it will mean that tax did not play as big a role as perceived.

Apart from parity between short and long term, between debt and equity, another reason could be tax policy. Remember that the government slashed corporate tax rates sharply in 2019, to boost corporate investments. That alone means a higher EPS (earnings per share) for companies and higher returns for investors, which is a continuing benefit. The direction of tax policy may be to shift the benefit to the companies, but to ask investors to part with a share of their gains.

But there is a big difference between debt and equity. Debt comes with an explicit promise to return the money with interest, unless something goes horribly wrong such as bankruptcy. Equity comes with no such promise and even a solvent company can deliver negative returns to investors. Still, equity investors turn up at the gates, putting their money behind what they believe are promising bets, some entrusting it to fund managers of active MF schemes while some believe in the wisdom of crowds and invest in passively-managed schemes. All of this money is risk capital, which gives entrepreneurs the ability to invest in growth plans and contribute to economic growth.

Also, unlike debt, in equity a differential regime exists only between listed and unlisted equity, and not like in debt where the tax rate could change based on whether you invested in a fixed deposit or a mutual fund debt scheme.

Most importantly, just as a globally competitive corporate tax regime can encourage entrepreneurs to invest, although it’s not the only criteria, a competitive capital gains tax regime is also crucial to attract and retain equity investors. The really wealthy ones can easily change their tax residency, and they already do so, but still invest in the domestic market through alternative means, reap the gains but not pay taxes. It will be retail investors left burdened with high tax rates.

In debt, the government struck one swift blow to equalise the tax treatment. But, in equities, it would do well to take an incremental approach so that it can correct course based on experience. A slightly higher rate of tax on long-term capital gains, which could be universal or applicable above a certain threshold of income could be the first step in the process.

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Ravi AnanthanarayananMoneycontrol Pro