Critical Analysis of the Impact of Increased Capital Gains Tax on Indian Capital Markets: A Post-Budget 2024 Perspective

This article has been written by Jefferson Paul R, School of Law, CHRIST (Deemed to be University), Bengaluru.

INTRODUCTION

The Indian government’s Budget 2024 has sent shockwaves through the country’s capital markets with its proposal to increase the capital gains tax. This move has sparked intense debate among market participants, policymakers, and economists, with many questioning the viability of this decision on its prospective effects on the capital markets in India. In a bid to augment revenue and bridge the fiscal deficit, the government has hiked the capital gains tax, a move that is expected to have far-reaching consequences for the Indian economy. The capital gains tax, a levy on the profits earned from the sale of securities, has long been a contentious issue in India, with investors and market intermediaries often at loggerheads with the government over its rates and applicability. Against this backdrop, it is essential to critically analyse the impact of this tax hike on Indian capital markets, particularly in the post-Budget 2024 scenario. This article argues that the increase in capital gains tax in India’s Budget 2024 will have significant implications for the country’s capital markets, affecting investor sentiment, market valuations, and the overall economy.

WHAT IS CAPITAL GAINS TAX?

Capital Gains Tax (CGT) is a type of tax levied on the profit or gain made from the sale of a capital asset, such as stocks, bonds, real estate, or other investments. In India, the Income-tax Act, 1961, governs the taxation of capital gains. The tax is calculated on the difference between the sale price of the asset and its cost price, after adjusting for inflation and other expenses.

It is classified into two types: Short-Term Capital Gains (STCG) and Long-Term Capital Gains (LTCG), based on the holding period of the asset. The tax rates for these gains vary depending on the type of asset and the duration for which it is held. For equity shares, if held for more than 12 months, the gains are considered long-term. And if held for less than 12 months, the gains are considered short-term.

HISTORICAL CONTEXT OF CAPITAL GAINS TAX IN INDIA

The decision to increase the capital gains tax in Budget 2024 is not an isolated event, but rather a culmination of the government’s efforts to reform the capital gains taxation regime in India. To understand the rationale behind this move, it is essential to delve into the historical context of capital gains tax in India and the reasons that prompted the government to take this step.

Historically, the capital gains tax in India has undergone several changes, with the government oscillating between imposing and withdrawing the tax to achieve its policy objectives. Prior to 2004, long-term capital gains were exempt from tax, while short-term capital gains were taxed at the applicable income tax rate. However, in 2004, the government introduced the Securities Transaction Tax (STT), which effectively replaced the capital gains tax. The STT was levied on the sale of securities, with the revenue generated being used to compensate for the loss of capital gains tax revenue. In 2018, the government reintroduced the long-term capital gains tax at a rate of 10% on gains exceeding ₹1 lakh, with the aim of discouraging speculation and encouraging long-term investments. The move was also seen as a measure to reduce the widening fiscal deficit and augment revenue. In 2024, the Union government has hiked the Short term capital gains (STCG) tax to 20% from 15 % and Long term capital gains (LTCG) tax to 12.5% from 10%. Though the exception from the capital gains tax was increased to ₹1.25 lakh for equity.

RATIONALE BEHIND THE GOVERNMENT’S DECISION

The recent increase in capital gains tax in Budget 2024 is largely driven by the government’s desire to achieve two primary objectives. Firstly, the government aims to reduce speculation in the capital markets, which is perceived to be a major contributor to market volatility. By increasing the capital gains tax, the government hopes to discourage short-term trading and encourage investors to adopt a long-term investment approach. Secondly, the government seeks to promote long-term investments, particularly in the infrastructure sector, which is critical for India’s economic growth. The government’s decision to increase the capital gains tax is also influenced by the need to bridge the fiscal deficit, which has been widening in recent years. The increased tax revenue generated from the capital gains tax hike is expected to help the government meet its fiscal targets and fund its various social welfare and infrastructure development programs. While the government’s objectives may be laudable, it remains to be seen whether the increase in capital gains tax will achieve the desired outcomes. The impact of this move on investor sentiment, market valuations, and the overall economy will be critical in determining the success of this policy initiative.

IMPACT ON DIFFERENT TYPES OF INVESTORS

The increase in capital gains tax in Budget 2024 is expected to have a significant impact on different types of investors, including individual investors, institutional investors, and foreign investors. Each of these investor categories will be affected in distinct ways, and their responses to the tax hike will shape the overall trajectory of the Indian capital markets.

Individual Investors

For individual investors, the tax hike will likely lead to a re-evaluation of their investment decisions and strategies. With the increased tax burden, individual investors may become more cautious in their investment approach, opting for more conservative investments that offer lower returns but also lower tax liabilities. This could lead to a shift away from equity investments, which are typically more volatile and subject to higher capital gains tax rates.

The tax hike will also impact the returns of individual investors, particularly those who have invested in equity-linked savings schemes (ELSS) or other tax-saving instruments. With the increased tax rate, the effective returns on these investments will decline, making them less attractive to individual investors.

Institutional Investors

Institutional investors, such as mutual funds, pension funds, and insurance companies, will also be impacted by the tax hike. These investors will need to reassess their investment strategies and portfolio allocations in light of the increased tax burden. Institutional investors may respond to the tax hike by:

Rebalancing their portfolios: Institutional investors may rebalance their portfolios to minimize the impact of the tax hike. This could involve shifting from equity investments to debt investments or other asset classes that are subject to lower tax rates.

Adjusting their investment horizons: Institutional investors may adjust their investment horizons to minimize the impact of the tax hike. This could involve investing for longer periods to qualify for lower long-term capital gains tax rates.

Exploring alternative investment avenues: Institutional investors may explore alternative investment avenues, such as private equity or real estate, which are subject to different tax regimes.

Foreign Investors

Foreign investors, including foreign institutional investors (FIIs) and foreign portfolio investors (FPIs), will also be impacted by the tax hike. The increased tax burden will reduce the attractiveness of India as an investment destination, particularly for foreign investors who are subject to withholding tax on their investments.

The tax hike may lead to a decline in foreign investment inflows, particularly in the short term. Foreign investors may respond to the tax hike by:

• Reducing their exposure to Indian equities: Foreign investors may reduce their exposure to Indian equities, particularly if they perceive the tax hike as a negative development for the Indian market.
• Exploring alternative investment destinations: Foreign investors may explore alternative investment destinations, such as other emerging markets or developed markets, which offer more favourable tax regimes.
• Seeking tax-efficient investment structures: Foreign investors may seek tax-efficient investment structures, such as offshore funds or alternative investment vehicles, to minimize the impact of the tax hike.
• Overall, the impact of the tax hike on different types of investors will be significant, and their responses will shape the trajectory of the Indian capital markets in the coming months and years.

MARKET IMPLICATIONS

The tax hike is likely to increase market volatility in the short term, as investors adjust to the new tax regime. The increased tax burden will lead to a reduction in trading volumes, as investors become more cautious and risk-averse. This reduction in trading volumes will, in turn, lead to a decrease in market liquidity, making it more difficult for investors to buy and sell securities quickly and at fair prices.

The increased volatility and reduced liquidity will make it challenging for market participants to price securities accurately, leading to potential mispricing and market inefficiencies. This could result in an increase in bid-ask spreads, making it more expensive for investors to trade in the market.

Effects on Market Valuations and Price-to-Earnings Ratios

The tax hike will also impact market valuations and price-to-earnings (P/E) ratios. The increased tax burden will reduce the after-tax returns on investments, making equities less attractive to investors. This could lead to a decline in P/E ratios, as investors become more cautious and demand higher returns to compensate for the increased tax risk.

The impact on P/E ratios will be more pronounced for companies with high price-to-earnings multiples, such as those in the technology and pharmaceutical sectors. These companies may experience a greater decline in their stock prices, as investors become more risk-averse and demand higher returns.

Analysis of the Potential for Market Corrections or Crashes

The tax hike increases the potential for market corrections or crashes, particularly if investors become overly pessimistic about the impact of the tax hike on the market. A market correction or crash could be triggered by a variety of factors, including:

• Overvaluation: The Indian market has experienced a significant rally in recent years, leading to concerns about overvaluation. The tax hike could be the catalyst for a correction, as investors become more cautious and demand higher returns.
• Liquidity crisis: The reduction in trading volumes and market liquidity could lead to a liquidity crisis, making it difficult for investors to exit their positions quickly and at fair prices.
• Global economic uncertainty: The global economy is facing significant uncertainty, with concerns about trade wars and slowing economic growth. The tax hike could exacerbate these concerns, leading to a decline in investor sentiment and a potential market correction or crash.

Thus, the tax hike will impact market volatility and liquidity, influence market valuations and P/E ratios, and potentially lead to market corrections or crashes. Market participants must be cautious and adapt to the new tax regime to navigate the challenges and opportunities that lie ahead.

COMPARISON WITH OTHER MAJOR ECONOMIES

The increase in capital gains tax in Budget 2024 has also sparked a debate about India’s competitiveness as an investment destination. To put this debate into perspective, it is essential to compare India’s capital gains tax regime with that of other major economies. India’s capital gains tax regime is now more onerous than that of many other major economies. The increase in the capital gains tax rate to 20% for short-term capital gains and 12.5% for long-term capital gains makes India’s tax regime less competitive than that of many other countries. n particular, India’s capital gains tax regime is now more onerous than that of the US, UK, and China. This could make India a less attractive investment destination, particularly for foreign investors who are sensitive to tax rates.

POLICY RECOMMENDATIONS

To mitigate the negative impacts of the tax hike, policymakers and regulators should consider the following recommendations:

1. Reconsider the Tax Hike: The government should reconsider the tax hike and explore alternative measures to achieve its fiscal goals. A more progressive tax system or a wealth tax could be more effective in reducing income inequality and generating revenue.
2. Introduce a More Progressive Tax System: A more progressive tax system, where higher-income individuals are taxed at a higher rate, could be a more effective way to reduce income inequality and generate revenue.

CONCLUSION

The increase in capital gains tax in Budget 2024 will have significant implications for India’s economy and capital markets. The tax hike will reduce the attractiveness of India as an investment destination, lead to a decline in foreign investment inflows, and reduce the incentives for domestic investors to invest in the stock market. The tax hike will also lead to a shift towards more tax-efficient investment options, such as real estate and gold, and potentially lead to a decline in India’s economic growth and development. Ultimately, the success of the tax hike will depend on the government’s ability to balance its fiscal goals with the need to promote economic growth and development. By carefully considering the implications of the tax hike and implementing measures to mitigate its negative impacts, the government can create a more equitable and sustainable tax system that promotes investment, growth, and development in India.