capital gains tax changes

In the new budget, the government made impactful changes to the way capital gains on equity are taxed in India. 

The past

Until now all short term capital gains (held for less than a year) were taxed at a flat rate of 15%. All long term capital gains (held over a year) were fully exempted from tax; Security transactions tax was being paid on each transaction. All dividend income up to Rs.1 m was exempt at the hands of the investors. Dividend distributions tax was being paid by the corporates announcing dividend payouts. 

What's new

Long term capital gains are going to be taxed at a flat rate of 10% on all investments made with effect from 1 February 2018; all gains up to Rs.100,000 are exempt. All gains made up to 31 January 2018 continue to be tax exempt. This means to calculate gains in future, the cost basis is considered as the higher of the actual price paid and the highest market price as of 31 January 2018. These nuances apart, what it means to the new investors is that they will have to pay long term capital gains at 10%. 

What doesn't make sense

There are a few things I find don't make sense especially when you want to look at direct taxes as progressive which they should be. I see at least five problems with the new rules:

Short term capital gains: are being taxed at a 15% flat rate. For those who are in the marginal tax rates of less than 15%, this does not make sense. Someone with marginal rate of say, 10%, will have to pay 5% more just because of equity transactions. Yet, someone with marginal tax rate of say, 25%, is going to have fun playing short term with equities. This is absurd when you want to take care of the small, retail investors. The ideal rule should be to add the short term capital gains on equity to the ordinary income, and tax at the marginal rates. 

Long term capital gains: up to Rs.100,000 are made tax exempt. And the logic is that the government will have to take care of the retail investors. This defies logic though, for Rs.100,000 in today's times is not a meaningful amount for those coming to the equity markets. To make any impact on small, retail investors, the exemption limit should be say, Rs.500,000 to Rs.600,000. Gains made in excess of this value are usually by the bigger investors, and tax there should be fine. 

Another problem with the flat rate of 10% on long term gains is that there is no regard for the inflation component. Equities are considered to be hedges against long term inflation. That's the primary reason for equity investments. By not allowing for some sort of indexation benefits, long term investors are left out. There isn't any reward for the truly long term investors.

Security transactions tax was introduced in lieu of the long term capital gains tax. Now both taxes are being retained at the cost of investors. 

Finally, investors do not find any major advantages of long term taxes (10%) over short term taxes (15%). As I noted there isn't any reward for the truly long term investors. If you do the math, it is still better to play the long term game, rather than the short term, but the distinct advantages which were there earlier are gone. For all I can see, the new rules encourage short term trading as opposed to long term savings and investments. 

A better way forward

Of course, the joyride on the long term capital gains should be over. After all, all income earned should be appropriately taxed. Here are my suggestions though:

1. Add short term capital gains to the ordinary income, and tax at the marginal rates.
2. Increase exemption limit to Rs.500,000 on all long term equity capital gains.
3. Remove security transactions tax. 
4. Bring in indexation benefits to deal with inflation on long term gains.

An investor-friendly market is in the best interest of both the investors and the government.