CIRCUIT BREAKER. Why not tax stock market gains?

Was the Prime Minister floating a trial balloon on taxing equity gains, when he asked market participants to make a ‘fair contribution to nation-building’ in a recent speech? If he was, the Finance Minister was quick to pop it.

But though the very idea tends to send the stock market into convulsions, it is a legitimate question to ask— is it time to do away with the special tax treatment for capital gains from stock markets?

There does seem to be a good case for it.

In recent years most financial instruments have been swept willy-nilly into the taxman’s net. So the interest received on bank and corporate deposits which used to enjoy section 80L benefits, are now taxed at the slab rate. Returns on post office schemes, save two, are subject to similar taxation. Capital gains on bonds and debt mutual funds are taxed at the slab rate if held for less than three years, and at 10 per cent if held longer.

But equity investments alone continue to enjoy the blue-eyed boy status. For equity and equity mutual funds, long-term capital gains are entirely free of tax. There’s a concessional 15 per cent tax on short term capital gains and dividends are subject to a distribution tax of 15 per cent. As a bonus, even the definition of ‘long term’ has been shortened from 36 months to 12 months for the equity investor!

In lieu of these tax breaks, equity investors are required to pay a Securities Transaction Tax (STT) at 0.10 per cent of the trade value. Derivative equity trades see sellers of futures contracts taxed at 0.01 per cent and options at 0.05 per cent (on premium).

But what is the explanation for this special dispensation? One line of reasoning is that these tax incentives are needed to encourage financial savings.

True, given Indian households’ penchant for squirelling away money in physical assets such as gold and real estate, it is necessary to encourage financial savings.

But then, bank deposits, bonds, small savings schemes and corporate fixed deposits are financial instruments too. And they do just as good a job of channelling household savings into productive uses, as equity investments. In fact, it can be argued that, secondary market transactions in stocks do not really help the economy as they don’t create new assets.

Stock market players argue that because Indian households are generally risk averse, they need special allurements to invest in equity. But the decision to assume more or less risk with one’s portfolio is a personal choice best left to the investor himself.

Going by the tenets of financial planning, it is perfectly logical for Indian households to stick to safe avenues at lower levels of income, and dip their toes into the equities when they have more savings to spare.

Equity investments, in India, are also favoured by a relatively small and well-off sliver of the population. Household savings data from RBI tells us that of the 11 per cent of income invested in financial assets, just 0.7 per cent goes into equities.

To induce first-time investors into financial savings, therefore, it would be a better idea to extend tax concessions to bank deposits or small savings ahead of equities.

Of course, it was for very practical reasons that the UPA government, in 2004, decided to slash capital gains tax on equity to replace it with STT. STT, collected by the exchanges, was seen to deliver more revenues to the exchequer than capital gains tax.

But in practise, the tax hasn’t really lived up to this promise. STT has collected just ₹6,500 crore to ₹7,500 crore in recent years, chipping in with just 2 per cent of personal income tax collections.

As we know, FIIs - the most active market players — have traditionally gotten get away with nil capital gains tax, by routing their exposure through low-tax regimes and taking shelter under Double Taxation Avoidance Agreements (DTAAs). Domestic institutions such as mutual funds enjoy pass-through status on taxes. Many retail investors avoid declaring equity capital gains, as compilation is cumbersome.

However, all this is changing. In the past year, the Modi government has made a laudable effort to renegotiate DTAAs, to force FIIs to pay their fair share of capital gains tax in India. With depositories and online portfolio utilities facilitating data capture, getting a snapshot of one’s equity transactions for the entire year is no longer a struggle for the retail investor. Centralised demat accounts also make it quite easy for the taxman to track down high-value equity transactions.

Therefore, the time appears right for policymakers to overhaul the tax regime for equities. Doing away with STT and extending the holding period for equity investors to claim the ‘long term’ capital gains benefit to 36 months, can be good first steps.

A ballpark estimate suggests that the additional tax revenues from such a rule change can be significant. Today, the NSE and BSE jointly register ₹48 lakh crore in annual trading turnover. Even assuming trades by domestic institutions (about 40 per cent) remain exempt, and only a third of the remaining transactions yield capital gains, transactions valued at about ₹9.5 lakh crore would turn taxable. If capital gains amount to a tenth of the trade value, that’s ₹95,000 crore in taxable income. A 15 per cent levy can yield ₹14,250 crore.

But then, cash trades are just the tip of the iceberg. Futures and options trades on the exchanges register a whopping ₹840 lakh crore in annual turnover. These trades are subject to low STT and there is considerable ambiguity about whether they should be treated as business or speculative income, leading to under- reporting of gains. Removing STT and imposing a simple, flat rate of tax on derivative profits, can yield a rich harvest for the exchequer. Moving from STT to a capital gains tax regime may be not be all that bad for the equity investor either. Today, you shell out STT on all your share trades irrespective of whether they finally earn you a profit or a loss.

This makes the powers-that-be rather indifferent to the gyrations of the stock market.

But once its own tax revenues are linked to market fortunes, the Centre would have a vested interest in ensuring that equity investors do pocket some capital gains. This may also prompt the Government to weigh the stock market reaction before unleashing any policy bombshells.