Prime Minister Narendra Modi signalling the introduction of capital gains tax on equities has caused a tremble in the stock market. He puts forward the argument that profits from the capital market should make a fair contribution to nation building through taxes. Even though the Finance Minister has come up with a clarification on this, there is speculation on the possible changes in tax structure in the capital market.

The idea of imposition of higher on capital gains has received mixed responses from different quarters. The supporters for the imposition of higher tax argue that gains from the equity market should be taxed in the same way like any other gains. But the idea of capital gains tax was not well received by the investors, evident from the resultant tumble in the stock market.

Capital gain is the difference between price received from selling an asset and price paid for it. Capital asset can be any kind of property held by a person or securities held in accordance with the regulation made under SEBI Act, 1992. Capital gains arising from the assets are classified into short term and long term gains, based on the holding period of the assets. Assets like shares (equity and preference) come under the category of short term assets, if they are held for a period of 12 months. If the shares are sold in less than a year, there will be 15 per cent tax on gains. On the other hand, if shares are held for more than a year, they are long term capital assets and are exempted from capital gains tax.

It is speculated that in the upcoming budget, short term capital tax will be hiked from 15 per cent to 20 per cent with the holding period for tax exemption to be extended to three years.

Many economists including Alan Greenspan argue for zero per cent tax on capital gains, as they believe lower taxes can bring economic prosperity to the country.

Start-ups and Venture Capitalists

Increasing the rate of capital gains tax can severely dent the investor sentiments in the country. In India, everyone is talking about promoting start-up culture and wants the country to be the next Silicon Valley. The Central Government has unveiled a plan in similar lines by introducing the Startup India programme in 2016 for boosting entrepreneurship in the country. The Government has to provide a favourable environment for emerging entrepreneurs to function, which includes better access to funds.

The major source of funding for start-ups comes from venture capitalists or angel investors. They are taking risks by investing in unproven start-up companies with the hope that they will be able to gain from their investments in the future. The imposition of higher taxes on capital gains can dissuade them from taking such risks. As per the Venture Intelligence Data, venture capital investment in the country was down by 29 per cent in 2016. Hiking the capital gains tax will only help intensify the crisis.

There are several examples from around the world, which clearly show that hiking capital taxes can have a depressing effect on the business sentiments in the country. For example, in the US, when capital tax rates were increased from 27 per cent to 49 per cent during 1969–1977, there was a dip in the number of Initial Public Stock Offerings (IPOs), dollars raised from those IPOs and the dollars committed to venture capital firms. The number of IPOs declined from 780 in 1969 to 40 in 1977, dollars raised from IPOs declined from $2605 million to $151 million and commitments to venture capitalists declined from $506 million to $68 million during the same period. But a reverse trend was visible when the capital tax rates in the US were slashed, helping start-ups to have more access to funds. Thus, high tax rates on capital gains will only act as a roadblock in innovation and growth of entrepreneurship in the country.

Lock-in Effect

An increase in the holding period can lead to lock-in effect, whereby the investors delay the selling of shares to avail tax exemption. Longer holding period of assets can have a negative impact on the overall growth of the economy, as it prevents the transfer of resources from low valued uses to high valued uses.

A Source of Revenue for the Government

An important argument put forward for the imposition of high tax rates on capital gains is that it will help the Government to mobilise resources from the capital market. But it should be noted that the Government is garnering around Rs 7400 crore from the capital market in the form of Security Transaction Tax (STT). STT, whereby an investor has to pay tax on the total amount paid or received in a share transaction, was implemented in October 2004.

At present, when a share transaction is made, the investor is liable to pay STT, Service Tax at 14 per cent of brokerage, Exchange Transaction charges, Stamp Duty charges, Swachh Bharat Cess Tax, Krishi Kalyan Cess Tax and Service Tax at 14 per cent other than brokerage. Hence, it is a misconception that the capital market is not making any significant contribution to the tax receipts of the Government. Increasing the capital gains tax will bring more tax pressure on the investors, which can have an opposite effect on the Government’s tax revenue. On the contrary, a lower capital gains tax will bring down the cost of capital, encourage risk taking and push the economy to a higher growth trajectory. In the long run, this can lead to a higher growth in Government receipts.

The investment climate in the country can be improved to a great extent by simplifying the tax structure. The higher rates on capital gains will not only complicate the tax structure but will be an impediment to the overall growth of the economy.

*The author is Research Associate at CPPR-Centre for Comparative Studies. Views expressed by the author is personal and does not reflect that of CPPR.

This article was first published in The Dialogue


Deepthi Mary Mathew
Deepthi Mary Mathew
Deepthi Mary Mathew is Senior Research Associate at the CPPR Centre for Comparative Studies. She has an MA in Economics from the University of Kerala and is also a PhD scholar at the Gokhale Institute of Economics. She can be contacted by email at [email protected] or on Twitter @DeepthiMMathew

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