Now You Know Which Way The Wind Blows

The picture and opinion piece by Madan Sabnavis-Chief Economist at CARE Ratings, below, were published in the ET in the course of the past week.


Financial inclusion and equity markets are two sacred shibboleths that are hard to dislodge, and questioning them is blasphemy .The first is an indicator that someone cares while the other is held sacrosanct as it represents everything that success all about. It is against this background that one can review the issue of tax arbitrage which has been in the spotlight in the Budget.Investors preferred to save in FMPs as the capital gains tax was applied at a lower rate of 10% or 20% compared with bank deposits, which were taxed at the income tax slab rate. This was a tax anomaly, which put bank deposits at a disadvantage and was corrected by putting debt funds gains on par with interest on deposits. The exception now is that debt-based growth schemes would qualify for capital gains tax at 20% if kept for more than three years. Using this logic one can question the sense in still exempting equity gains from any tax if held for more than one year.

First, what is the justification for giving special treatment to equity? Fresh equity helps in capital formation and hence there is a priori justification for giving exemption. But does this hold for secondary market transactions? Here there is only transfer of money from one buyer to seller and the company does not get money. But high secondary market activity provides a boost to companies to raise more equity and hence indirectly helps investment. Besides, such exemptions are a reward for risk-taking unlike debt, where returns are known before investment.

But there is a counter argument here.While primary purchase of equity and subsequent sale after an acceptable period of time can be tax-exempt, a secondary market deal is speculative. There is no value created for anyone except shareholders who could reap high rewards. When the company value goes up, existing shareholders enjoy the benefit even though the company is not going in for additional investment. Therefore, such gains have to be taxed.In fact, using Piketty’s logic, it could be said that the principle of not taxing such gains is a clear case of capitalist advocacy influencing policy making. It is a measure of growing affluence, which needs to be taxed to lower policy-induced inequality.

The argument of risk-taking cannot be justified here as the decision is based on personal choice and does not lead to the Keynesian animal spirits leading to investment. There is little anecdotal evidence to say that when stock markets boom, capital formation increases. In fact it has been coming down in the past few years even as the market has done well. Investment decisions are based on demand, interest rates and overall economic conditions.

Curiously , money invested by debt funds and bank deposits qualify better for tax benefits.Bank deposits are diverted directly to lending according to government dictats through priority sector lending, or into government securities through SLR stipulation, and hence meet national goals.Investments made by debt funds go into corporate bonds, CDs and CPs -all used for productive purposes.Therefore, there is justification to argue that there is direct link with productive activity .

How can the issue be resolved? We need to see if there is a link between secondary market activity and primary equity issuances as also the tendency of companies to prefer equity to debt. Equity issuances in the past 10 years have crossed Rs40,000 crore only once and have been less than Rs10,000 crore in the past three years. Corporate debt raised has averaged Rs3.3 lakh crore in this period — corporates prefer debt to equity as source of finance. The stock market has increased by almost two-thirds during this otherwise dismal period while it has soared by a multiple of four times over a decade. Quite clearly, equity issuances have not increased even as the secondary market has boomed.

The boom in the secondary market has often been linked with foreign institutional investor funds and the accompanying sentiment and has been divorced from economic fundamentals. This being the case there is reason for revisiting the tax benefits provided to gains on equity to bring about financial parity. In fact the existence of this tax arbitrage will channel more money into this higher risk alternative.

The way out is really to put all savings on a similar plane. Small savings too would be under the scanner. But there are limits on investment that can be made here and they are locked in for a longer period of time.This lock-in concept should now be extended to other instruments as well. Hence, if a three year lock-in is required for debt growth schemes to qualify for capital gains, the same should apply for bank deposits as well as equity. Risk cannot be accorded any tax benefit except for the entrepreneur, which is available through tax holidays.

According special status to equity gains hence may not seem convincing. While this may sound heretic in today’s world where stock market indices have become the barometer of sentiment and confidence, such a step would be a very bold one, considering no one would like to disrupt this equilibrium, which may have a proclivity to the rich.But, if we are talking of correcting tax arbitrage, extension to equity may be argued as being a corollary .


Having got dismal returns from equity since 2008,many retail investors in India now eschew stocks altogether and prefer to chase fixed income instruments which carry notionally high returns in response to the persistently high inflation in the economy. DIIs who have shown insipid equity returns now find it easier to sell debt products to local customers. Small wonder that struggling domestic companies choose to play the Piketty card to cut down their international rivals. In the midst of this tussle and a cash strapped government to boot, what’s a retail investor to do? Why, just follow Buffett’s example and acquire stocks where your favourite holding period will be for ever. Should any asinine laws get passed, be certain, the companies who really value their investors will find good ways to reinvest dividends  and in the process avoid taxable incidents. And since you won’t be trading, you won’t see taxes eating into your returns. But don’t ditch stocks altogether. Nothing but returns from good stocks will outstrip the stubbornly high inflation in the country.


About Keerthika Singaravel

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