The government had been proactive in improving the business environment in India through programs like ‘Make in India’ and ‘Startup India’ which have paid decently. The clear testimony of this being the jump in FDI inflows and the uptake of government’s Learning &Development (L&D) module. FDI inflows grew more than 48% in the 12 months following the launch of ‘Make in India’ program compared to the preceding 12 months. On the other hand, 191,000 firms have opted for the L&D module offered by the government under the Startup India program. Other structural reforms taken by this government have resulted in an improvement of India’s position in the Ease of Doing Business (EODB) from130 to 100.
However, with the upcoming general elections next year, the government hadto change its focus to other aspects like agriculture, rural development, health, education, employment, MSME and infrastructure sector. This initiative will not only require a lot of regulatory and administrative changes but it will also entailan increased burden on government’s budget. Additionally, the government aims to maintain the fiscal deficit within the promised bounds of 3.3% in fiscal year 2019.
To increase its revenue generation, budget 2018-19 has introduced a number of reformslike increasing customs duty on products like mobiles, clothing and footwear, imposition of long term capital gains (LTCG) tax on gains made from equities and introduction of a dividend distribution tax. Imposition of LTCG, however, hasn’t been well received. Sensex has been very volatile since the announcement andnervous investors are pulling out their money.
LTCG tax was first removed in 2004 to give a stimulus toequity markets. Additionally, due to the Double Taxation Avoidance Treaty with Mauritius, the FII inflows from Mauritius could only be taxed there. But Mauritius had zero capital gains taxation. So, non-Mauritius FIIs had a disadvantage and many a times had to flow funds through Mauritius just to avoid taxation. The LTCG tax was removed to make a level playing field for all FIIs. Now, with the treaty being changed the government had incentive to reintroduce LTCG tax. The government has justified the reintroduction stating that capital gains amounting to INR 3,67,000 crores were exempted from taxation during A.Y 2017-18. This income must be taxed considering the fact that equity markets have gained substantial buoyancy. However, the government says that it has been cautious while designing the taxation structure so as to not depress the equity market.Ithas imposed only 10% LTCG tax on gains made over and above INR 1,00,000 from listed equities.
In this budget, the government has walked the path of taxing the rich and distributing to the poor. But as the famous economist Arthur Laffer once taught the world, increasing taxation rates may not simply raise the total tax revenue. The government’s stance could not only decrease the current investments intoequity markets but also deter smaller and newer investors from entering them. This could affect the growth of Indian economy and concomitantly decrease the potential revenue that could have been made through taxation.
The government could have changed the existing taxation system by increasing the duration of short term to one and a half year or two years. That way the government could have collected 20% taxes on gains made within the revised short-termperiod, if the consumer decided to exit the market within that period. This would have discouraged speculative practices by the consumer and also helped capital to stay for long in equities.
To ensure that investors don’t change to dividend plans from growth plans in order to circumvent the LTCG tax the government has also imposed a dividend distribution tax of 10% on mutual funds. While the LTCG tax is applicable to only those making profits excess of INR 1 lakhs, dividend distribution tax will be paid by all.
The introduction of thesetaxes comes at a point when the recently released Oxfam report highlighted the extent of inequality in India. According to the report, 73% of the wealth generated in India went to the richest 1% of the population. At such levels of inequality, equitable distribution through taxation was much overdue. While arguments are made that the richest take huge risks while investing their money, it is not entirely true. The large cap equity funds give decent returns and carry little risk. Justifying a tax free status to such investments would not only stand against the logic of taxation but would also be a disservice to the poor.
However, looking at how retail investors will behave, makes this tax seem less attractive. The investors will look for other markets and investment options rather than stay in the equity markets. This will also impact investments into mutual funds. The mutual fund houses manage assets over INR 20 lakh crore which is a substantial amount in an absolute sense. But as a percentage of bank deposits it is only 20 per cent. When compared to USA, where mutual fund houses manage assets over 150 per cent of bank deposits, India has miles to go. Imposition of this tax will dampen the market further. Investors who invest in the tax saving equity linked mutual fund schemes, will see lesser returns from such schemes and may have to look for other arenas to save taxes. The money might flow into countries which have lenient tax system and tax havens where most of the black money resides.
In its efforts to curb black money and chalk out tax havens, the GOI has brought changes to many old tax treaties with countries like Cyprus and Mauritius. This has reduced the number of tax havens for residents of India. It is becoming increasingly difficultto find tax exempt investment avenues. However, it is difficult for the government to negotiate all tax treaties, andinvestment avenues and countries to save taxes will continue to exist.
For the investors who might wish to stay in the markets, there are still ways to circumvent this taxation. Since the tax will be deducted at source a person can pull out the money from the investment before it crosses the level where it provides gains of INR 1 lakh. A person can cumulatively make gains from multiple investments exceeding INR 1 lakh and still pay no LTCG tax if each investment is sold off before making a gain of INR 1 lakh from it.
Had the government increased the duration of ‘short term’ for investments in equity markets, the investor sentiment would not have dampened as much and the investments would have stayed for long in equity markets.Now, the government should at least remove the securities transaction tax that the investors need to pay for,in addition to the long-term capital gains tax. That forms an additional cost which is not justified for the investors who are already paying taxes on their investment.
There is no point in lamenting the changes introduced. The government has done what it needed to raise taxes albeit not in the best way it could have. The long-termimpact of the LTCG tax on the equity and mutual fund market remains to be seen. The government should closely watch the reaction of investors and make necessary amendments if the total tax revenue falls after the introduction of LTCG tax or the equity market loses its buoyancy.