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How govt’s move to remove benefits on long-term capital gains could push investors down riskier paths

The govt should have attempted to bring uniformity in taxation before withdrawing tax benefits on long-term capital gains on debt instruments, or at least debated it in Parliament.

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The government has bowled a googly by suddenly withdrawing tax benefits on long-term capital gains on debt instruments. It has included this last-minute change in a Finance Bill that has been passed by Parliament without debate.

As it happens, India’s tax rates for capital gains have been far too lenient and favoured the top income-earners who comprise the bulk of the asset-holders. A review was therefore overdue, but not in the form of the government’s piecemeal approach.

The first issue is one of principle: That “unearned” income should not be taxed at lower rates than “earned” income. Not everyone accepts the principle, and one could quibble about what is earned and what is not. You certainly have to work at investing your capital wisely, but it is your money that is working for you, more than the other way round. Either way, there is no case for preferential treatment. Such logic is ignored in practice, for most countries offer preferential rates of tax for capital gains.

This is heavily influenced by the fact that capital crosses national boundaries more easily than workers, and a country that has stiff taxes on capital gains will get less foreign portfolio investment, if not suffer a capital outflow. Practicality rules.

Nevertheless, in a world of growing inequality of income and wealth, preferential tax treatment of capital becomes steadily more difficult to defend. The question though is what should be taxed: The wealth itself or income from that wealth? Or both?

Most countries have some form of tax on wealth, usually with convenient loopholes. India is an outlier as it has abolished both estate duty and wealth tax, and it has no gift tax for close relatives, including linear descendants. Surely, this should be the first point of attack, because the lack of any tax on wealth perpetuates inequality from one generation to the next. The practical counter is that you are unlikely to garner much revenue.

When it comes to taxing returns on invested wealth, there is no uniformity on either rates (10 per cent, 15 per cent, 20 per cent, and the slab rate) or the qualifying holding period (one, two, and three years for different kinds of assets).

Some assets are taxed only after adjustment of value via a price index (to neutralise inflation) while others do not enjoy such indexation. And the method of indexation is by using the consumer price index, which can vary quite widely from a measurement of asset price inflation for (say) real estate.

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Indexation (which the government has just removed for long-term debt holdings, but not from equity) is easily defended since wages in the formal sector are usually indexed for inflation. Minimum wage stipulations also get adjusted periodically for inflation. And in the informal labour market, there is evidence of de facto indexation even if imperfectly so. So, there is no real reason to not offer indexation for capital unless you want to reduce the real value of capital over time (the rich become less rich).

The difficulty in the debt market is that interest on bank deposits is taxed without indexation, creating a non-level playing field. The justification could be that bank deposits are at fixed rates of return and have a strong safety element, unlike mutual funds, where the returns are variable and you could even lose money. Many forms of fixed-interest savings (like the public provident fund and other small-savings avenues) also get an initial tax benefit, which the usual market-quoted instruments don’t. One could simplify matters by offering a preferential rate on all capital gains up to a certain limit, as some advanced countries do. This would separate ordinary retail investors from the wealthier ones.

With many issues and options to consider, perhaps the government should have first attempted uniformity (on the applicable tax rate and period of indexation) before getting into more substantive questions. In any case, these issues should have been debated, in Parliament and outside, especially because of the likely consequences. As it happens, the government’s step could push investors to choose riskier equity, or to fall back on bank deposits — thereby negatively impacting the debt market, which actually needs to grow.

By special arrangement with Business Standard

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