Markets Pause Amid Capital Gains Tax Concerns Ahead of Budget Announcement

The Indian stock markets appear to be in a holding pattern after reaching record highs last Thursday, July 18, with the Nifty ending at 24,801. On Monday, the Nifty closed down by 21.60 points at 24,509.30, despite positive market breadth.

Investors are seemingly waiting for Tuesday’s budget, amidst persistent rumors of a potential hike in capital gains tax rates. Currently, the long-term capital gains (LTCG) tax in India stands at 10%, while the short-term capital gains (STCG) tax is 15%.

Many market participants have expressed that a higher capital gains tax is a more significant concern in the long run compared to any political instability that might arise if the BJP’s tally in Parliament falls below the 270 mark.

Interestingly, the Economic Survey released on Monday references a June 2024 IMF staff paper that recommends "well-designed excess corporate profit taxes and high personal income taxes on capital" through better enforcement of automatic information exchange between countries and enhanced taxation of capital gains. This IMF paper aims to address inequality potentially caused by the large-scale adoption of AI, although there is no direct correlation between its conclusions and the possible increase in capital gains tax in the upcoming budget.

Despite these concerns, the upcoming budget is expected to leave capital gains tax rates unchanged. While theoretically sound economics might suggest that income from the sale of shares and mutual funds should be taxed similarly to salaries, the government should consider the current stage of development in the Indian stock markets and economy before implementing higher rates.

There are compelling reasons against imposing higher capital gains taxes on equity instruments. Firstly, China, with which India competes directly for investment, imposes a 20% tax on all kinds of capital gains, with certain exceptions. Secondly, taxing capital gains in India at the highest marginal income tax rate could mean a taxation rate of up to 39%, one of the highest in the world. For those earning more than Rs 5 crore, the income tax rate is 39% under the old tax regime and around 42% for those opting for it.

Furthermore, according to PwC, Hong Kong, whose market capitalization briefly fell behind India's last year, does not tax capital gains from equity sales. While many countries tax capital gains at the applicable income tax rate, India's rates are on the higher side, at 35% for incomes over Rs 1 crore and around 40% for Rs 5 crore and above.

Beyond international competitiveness, the rise in markets and the resultant wealth effect has significantly boosted sentiment, benefiting the incumbent government. This wealth effect also boosts consumption, as an increase in the value of equity and mutual fund holdings encourages spending. This trend may support the premiumization of consumer spending, as noted by FMCG companies. However, until there is a structural solution to rural underemployment, faster growth in consumption of pricier goods may persist.

Additionally, the surge in SIP inflows since 2021-22 has created a large group of new investors who have benefited from stock market investments. SIP inflows were Rs 21,260 crore in June 2024, compared to Rs 8,183 crore in May 2019. Remarkably, the amount collected in June 2024 is about half of the total collected during the entire fiscal year 2016-17. The number of SIP accounts reached 8.99 crore (89 million), more than four times the June 2019 figure, according to AMFI data. A sudden rise in capital gains tax would likely hurt the confidence of these investors.

While foreign portfolio investors might be protected under various tax treaties, domestic investors would not have such protections. Therefore, a drastic alteration of the capital gains tax regime should be avoided, at least for now.

Source: https://www.moneycontrol.com/news/opinion/no-need-to-raise-capital-gains-tax-for-now-12775085.html