Tax on equities: A calculated gamble

The stock markets reacted badly to a combination of factors post-Budget. Friday’s drastic correction wiping out Rs 4.6 lakh crore of market cap is, however, mostly attributable to the imposition of long-term capital gains (LTCG) tax on equity and introduction of tax on income distributed by equity-oriented mutual funds, besides a less stringent fiscal target. The fall in the indices may continue for a while more, but should settle down over a longer term as Indian equities as an asset class may still prove attractive, although with slightly lesser expectations over the rate of return. The fall is no knee-jerk reaction as there are serious issues here of the sudden return of LTCG. This goes against the grain of policies having assiduously promoted the stock market over a couple of decades as an avenue for the middle class as an alternative to the bank fixed deposits, which may have been the only saving option for previous generations.

The principle that those making profits must pay tax cannot be contested and the figure quoted of Rs 3.67 lakh crore invested seems big enough to invite attention to a free ride having been given since 2004-05. However, the retention of the Security Transaction Tax (STT) and no indexation benefit to go with LTCG means there is risk of an outflow of funds, particularly with foreign investors although the grandfathering clause would ensure that all past returns are protected. It is clear that a political decision reflecting a calculated gamble has been arrived at that big investors and the middle class are unlikely to be thrown off by these moves on the market in what was clearly an election-oriented Budget. It is difficult to hazard a guess whether the decision makers are right as poll scenarios are the hardest to predict.

The finance minister may be on firmer ground when he concludes that the Indian stock market has matured as seen in the many recent shocks it withstood before zooming to record high levels on a sheer adrenaline run before the Budget. There is fine tuning to be done and clarifications to be issued with regard to the changes if the market is to run a steadier, even if less frenetic, course. It is vital the middle class stays invested in mutual funds and the domestic institutional investors stay in to preserve a market that has been built up over years in a growing economy. Since the driving philosophy behind the Budget was developmental populism, there were taxation hits as well as denial of benefits to classes of people other than farmers. We could do with a lot more clarity among the targeted class too. For instance, an attractive premium in the MSP may be fine but the success of the scheme would depend on how input costs will be calculated and whether the cost of leasing or renting farms would be added. The implications of Budget spends are huge and at the end of the day they have to serve the intended purpose. That is the challenge ahead even as the stock market is expected to tide over the LTCG shock.