Capital gains tax: First principles first
Will the Union Budget impose a tax on longterm capital gains on shares? There is a lot of speculation on this now. The Prime Minister has been hinting at it for over two years. On January 29, 2016, speaking at a business summit, he said, “Dividends and long-term capital gains on shares traded in stock exchanges are totally exempt from income tax even though it is not the poor who earn them.” On December 24, 2016, the PM said in another speech “those who profit from financial markets must make a fair contribution to nation-building through taxes ... the contribution of tax from those who make money on the markets has been low… may be because of the structure of our tax laws. Low or zero tax rate is given to certain types of financial income.” Since only longterm capital gains and dividend income are tax-free, it was clear what the PM was hinting at. On both occasions the markets fell after the PM’s speech and the finance minister stepped in to control the damage.
The PM sees zero tax on longterm capital gains and dividend income as unfair since the beneficiaries are not poor, only the well-off dabble in shares. It is unclear whether it strikes the PM as unfair (since he has not articulated it) that rich farmers don’t pay taxes, since farm income is tax-free, a loophole exploited by many netas and babus. As we head towards the Budget day, once again there is media speculation that tax on long-term capital gains tax from listed shares, which was made zero in 2005, is about to come back.
Unfortunately, the debate has not been wellinformed. For instance, the points that the PM has made are political and perhaps aimed to appeal to the vast majority who don’t invest in shares. Second, many discussions in the popular press argue that no country in the world exempts shares from capital gains, except a rare one like Singapore. This is not true. There is either no tax, or a minimal tax on longterm capital gains in many countries such as New Zealand, Sri Lanka, Korea, Turkey, Switzerland, and the Netherlands.
There is a good reason why long-term capital gains from shares were made tax-free. To understand it, you need to give up your simplistic notions of what seems fair and unfair and look for the principle behind it. The idea was first mooted in the Vijay Kelkar committee report, submitted in December 2002, when a BJP-led alliance was in power. The committee argued for “the elimination of all tax preferences thereby increasing the effective tax burden on corporate profits to the statutory rate of 30 per cent … The divergence between the effective corporate tax rate and the statutory tax rate would be eliminated. Consequent to these recommendations, the retained earnings of a company would bear the full impact of the corporate tax. A substantial portion, if not all, of the long-term capital gains on equity represent the value of retained earnings. Since the profits of the company would bear the full burden of the tax, the retained earnings would have also suffered full taxation. Any tax on such long-term capital gains on equity would tantamount to double taxation of the retained earnings.” Urjit Patel, currently governor of the Reserve Bank of India, and TV Mohandas Pai, then finance head of Infosys, were members of the Kelkar committee.
This logic that shareholders are owners of companies and company profits are already taxed (and to that extent, the shareholders who have capital gains have already paid their tax) does not apply to other cases like gold, property, and bonds. The committee clarified that “that the proposal to exempt long term capital gains on equity is founded on the argument of double taxation and not as an incentive to boost capital market. We do not find double taxation in any other asset market.” This principle has held for the past 13 years.
All this talk of taxing long-term gains from shares unfortunately sidetracks the fact that India has one of the most complicated capital gains tax regimes in the world and a serious reform is needed there. Real estate and gold are taxed separately from bonds. Bonds are taxed differently from debt mutual funds. And equity funds and stocks are taxed differently from the others. We have different tax rates for each of these categories and different periods to define what is long-term and short-term. And then we have separate definitions for a capital asset and stock-in-trade, plus different treatments for residents and foreign portfolio investors! This maddening mess and attendant litigation will continue if we do not dump patchwork solutions, our impressionistic notions of “fairness” or arbitrary ideas of short- and long-term. What we need to do is establish an overarching set of first principles of capital gains taxation, from which will clearly flow what, why, and how much we tax. Such principles will also prevent future tinkering by policymakers based on expediency and gut-feel.