FM should listen but not too hard: Why there is no case for lower capital gains tax on equity

Finance Minister Nirmala Sitharaman has said that she is willing to listen to investors on what they have to say about reducing taxes on long-term and short-term capital gains (LTCG and STCG). No harm in listening to anyone, but she would do well to listen to others as well, and not just equity investors who are any way mollycoddled in all tax jurisdictions.

There are two things we need to understand. Capital infusion is vital for productivity and growth, so there is a case to be made for giving equity investment some preferential treatment on taxes. The question is how much preferential treatment.

Long-term capital gains on equity are taxed at 12.5 percent and short-term at 15 percent provided the transactions are done through stock exchanges on which securities transaction taxes are paid.

Now compare this to how debt is taxed. Debt is also capital, and it is taxed in the investor’s hands at his or her tax bracket. At the top end that means a gross tax of over 30 percent, when one includes cesses and surcharges, where applicable.

Now the argument that will be made to favour equity is that it is “risk capital” and hence must be taxed even lower than what it is now.

First, this statement is not true, unless we add nuance to it.  Debt is also risk capital, but it probably carries lower risk if it is ring-fenced against defaults. Your bank fixed deposits are probably risk-free, but let us note that the Deposit Insurance and Credit Guarantee Corporation covers only Rs 5 lakh of deposits. The rest is not without risk, though in practice no government will let any bank default on savers’ deposits. But to say that it is completely risk-free is not quite right. The real risk with bank deposits is that the money may not always be instantly accessible if your bank is in trouble.

Second, there are other kinds of debt capital – mutual funds that invest in corporate, government and other bonds, or bonds themselves. Here the risk of default is not usually high, especially if the bonds are secured against assets, but there are interest-rate risks. The value of your fund falls if interest rates rise and the underlying holdings fall in market value to mirror the new yield structure. In the case of corporate bonds, the risks of default also exist. So, debt funds are not risk-free. Why not give them tax benefits too?

Third, now let us understand what investors in equity mean by risk. It means if you are holding equity, your entire investment can vanish if your company goes belly-up. This is true, and definitely qualifies as higher risk than investment in debt or bank deposits.

But let us consider another aspect: a billionaire investing millions is certainly risking his money, but there is no real risk to his financial health even if he loses it all. His risk is actually less existential than a daily wage worker who loses wages for any reason. It is existential in nature.

Then there are average investors like you and me. We invest through mutual funds or directly in shares in order to make money. But as any personal finance advisor will tell you, you put only that much money in equity that you can bear to kiss goodbye to – if that is what is in store. I am certainly taking more risk than a wealthy millionaire, for this investment may account for a larger share of my net worth than the latter. But I still don’t deserve special tax treatment because I have been warned repeatedly about the risks and if I still lose money it is my greed that is at fault.

Whether you are a rich guy or just an average middle-class investor, one can make a case for lower capital gains taxation, but here’s the larger point: the law also allows me to set off capital losses against gains, thus reducing my tax rate in net terms.

The point I am driving at is this: risk is there is any kind of investment, but in some instruments categorised as low risk (debt, deposits), the taxman poses a higher risk to financial wealth and health.

So, if one were to asked who deserves most benevolence from the taxman, I would say it is the lower-risk investor, not the equity investor. When the skies clear over the stock markets, they will make the kind of money that debt investors can only salivate over.