Why Indian savers deserve tax relief

Securities and Exchange Board of India (Sebi) has sent the finance ministry budget recommendations that would please every investor, according to a Reuters report citing unnamed sources. First, the regulator has suggested removing the 12.5% long-term capital gains (LTCG) tax that foreign portfolio investors (FPIs) pay on Indian stocks. Second, it wants switches between mutual fund schemes held for more than a year to be tax-neutral. Third, it has flagged that our transaction costs, including the Securities Transaction Tax (STT), are among the highest anywhere.

The FPI tax exemption has got the most attention, since foreign investors have pulled out about $31 billion from India this year alone, but the other proposals matter more to domestic Indian investors.

I strongly support all three ideas. The tax-neutral switch proposal fixes a serious problem for long-term mutual fund investors. An investor who shifts money from a poorly run fund to a better one, as every sensible investor should, is treated as having sold the fund and pays tax on the gains. As a result, many investors are discouraged from moving out of bad funds. Such a switch was always treated as a sale, but it didn’t really matter when LTCG tax on equity funds was zero.

As for the other changes, lower transaction costs help everyone, including mutual fund investors, because STT on the fund manager’s trades drags down returns. And if a tax exemption brings foreign capital back, everyone benefits.

But it’s hard not to notice who gets what and who doesn’t. The foreign fund manager could pay zero tax on LTCG, while the Indian saver who has been running SIPs for years, and whose steady support propped up the market when foreigners ran away still pays 12.5% LTCG tax.

Worse, much worse, is that part of those gains is an illusion created by inflation, because our tax system now makes no allowance for the falling real value of money. I’m talking about cost indexation, which was once available on many types of investments but has now been abandoned.

I’ve written about this before. In January 2021, before the budget, I argued that equity was the one asset whose long-term profits were taxed without indexation. I used the example of someone who bought a Sensex-type investment in February 2018 and sold it in September 2020. That would have yielded a nominal gain of about 6% over a period when the tax department’s own cost inflation index rose by more than 10%. This clearly means the person made a real loss but would still pay tax. Far from extending indexation to equity, the July 2024 Budget removed it from almost everything, except for a partial rollback for property that had already been bought.

The argument was that the lower rate of 12.5%, compared with 20% with indexation, makes up for it. Well, sometimes it does, but a lower rate applied to an inflated number still makes you pay tax on illusory gains. And the damage is worst where it should be least.

Think of someone whose investment grows at 10% a year for a decade while inflation is 6%. In real terms, LTCG tax takes 25% of the person’s real gains. If that investment grew at 8%, the real tax rate rises to 40%. And if returns fall below about 6.5%, as they have for the Nifty 50 over the past three to five years, the real tax rate exceeds 100%. The tax then exceeds the entire real gain.

This is what makes the proposal for tax-neutral switches so interesting. That proposal implicitly accepts that people should not be punished for sensible long-term investing. Yet a tax that is effectively above 100% when returns are at their worst hits the patient, long-term investor the most.

The budget is just three months away, and the fact that ideas such as Sebi’s are being floated suggests the government may be rethinking its approach.

If the government is prepared to give up revenue to bring foreign money into India, it must surely also rethink how it taxes the Indian saver who stays invested and supports the market. Bringing back indexation and extending it to equity this time would do far more for that saver and for Indian markets than any red-carpet treatment for FPIs.
Dhirendra Kumar is founder and chief executive officer of Value Research, an independent investment advisory firm