A piecemeal approach is anti-investment

By Arbind Modi,

Budget 2024-25 marks the first of the new political cycle and a good opportunity to pursue tax reforms — a necessary, but a highly unpopular, exercise.

Finance minister Nirmala Sitharaman has announced her intention to undertake a comprehensive review of the Income Tax Act, 1961, within the next six months. The government, in its earlier avatar, had also undertaken this exercise and draft tax codes written by expert committees were available in the very first year of the last political cycle too, allowing abundant time for its implementation. Unfortunately, it adopted a piecemeal approach by making frequent and large-scale amendments to the existing law, thereby adding to its complexity. Despite the announcement of a comprehensive review, it continues to propose substantial changes in this Budget, again in a piecemeal manner. One hopes it will walk the talk this time around.

Taxation of capital gains has been the subject matter of comprehensive review in the Budget. While several changes have been proposed on the subject, I will restrict myself to a few significant changes.

The proposal to eliminate the benefit of inflation indexation for the cost of acquiring a capital asset was long overdue. In principle, capital gains should be taxed on “accrual” basis, but, in practice, it is imposed on “realisation” basis to overcome the problem of valuation, liquidity, and complexity. Consequently, in a world of inflation, there is a “cost” on the taxpayer arising from the erosion in the real value of the historical cost of the asset and an unintended “benefit” arising from tax deferral to the extent there is an erosion in the real value of the accrued tax liability. Therefore, in practice, most countries do not provide for any inflation indexing of the “cost” or the “benefit” since they would cancel out each other. Under the extant capital gains tax regime in India, while the “cost” is adjusted for inflation, there is no corresponding inflation adjustment for the “benefit”, thereby conferring double benefit and under-taxation of gains. Accordingly, a correction was necessary. The proposal is a pro-reform measure consistent with the international best practices so the government should not succumb to the unwarranted cacophony.

The proposal to increase the tax rate on long-term capital gains (LTCG) from listed securities from 10% to 12.5% is fundamentally flawed. Taxing LTCG from equity is complex and must consider the cumulative tax burden on profits earned through corporations, dividends, and capital gains. Generally, the tax burden on corporate profits is inter alia guided by two principles: (i) the combined tax on corporate profits, dividends, and capital gains should not exceed the top personal income tax rate; and (ii) dividends and capital gains should be treated symmetrically to avoid tax-induced distortions in corporate behaviour.

In India, the combined tax on corporate profits is estimated at 43.2% for FY24, significantly higher than the top personal income tax rate of 30% (39% including surcharge). This high tax cost of equity investment increases the hurdle rate, making marginal projects financially unviable. The proposed increase in the LTCG rate for listed equities raises the combined rate to 44.5% for FY25. Additionally, the tax on dividends remains high relative to capital gains, disproportionately affecting senior citizens.

With corporate investment already sluggish, raising the LTCG rate will exacerbate the problem. One solution is to impute corporate income tax to the shareholders by allowing a standard deduction of 50% of gross dividends and capital gains from equity, and taxing the remainder at the applicable marginal personal income tax rate. However, the standard deduction should be limited to equities held for more than one year. Besides, eliminating the surcharge on personal income tax (PIT) could further moderate the tax burden, with progressivity addressed through alternative tax instruments like a net wealth tax and an inheritance tax (both with a sufficiently high threshold). These measures could reduce the tax cost of equity investment to around 30%.

The government must revisit this issue and conduct a comprehensive review. In the meantime, the proposal to increase the LTCG rate on listed equities should be withdrawn.

Similarly, the proposal to reduce the LTCG rate for bonds is equally flawed. Interest on debt is deductible, unlike dividends, which creates a bias against equity. Therefore, all gains to bondholders or lenders, regardless of whether they are characterised as “interest” or “capital gains”, should be fully taxed and treated symmetrically. Reducing the LTCG rate on gains from bonds will exacerbate this bias against equity and increase the risk of bankruptcy. By maintaining a consistent tax treatment for all forms of gains from bonds, the government can create a more equitable financial environment and reduce the risk of financial instability. Therefore, the proposal should be reviewed to ensure that “capital gains” on bonds are treated in the same manner as “interest” and taxed under the progressive PIT rate schedule.

The proposals for reforming the capital gains tax regime for financial instruments are anti-investment and should be part of the comprehensive review of the Income Tax Act.

The author is former CBDT member and former senior economist at IMF.

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