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Thursday, February 22, 2018

LONG-TERM CAPITAL GAINS TAX - LTCG - A 10% Nudge to Invest in India..!

LONG-TERM CAPITAL GAINS TAX - LTCG - A 10% Nudge to Invest in India..!

by Ms. Indira Iyer, Ministry of Finance

The bearish run on the stock market soon after the Budget announcement of a 10% long-term capital gains (LTCG) tax has been along expected lines. This is partly due to early selfcorrection in the overvalued market.

Globally, too, the S&P 500, which till January 2018 was in one of its longest bull runs since 1929, fell by over 3.85% in the first week of February, erasing over $1trillion of its market value. However, a part of the fall in stock market prices in India can also be attributed to a change in expectations after losing the benefit of differential tax treatment of equity income.

The optimal balance of taxes depends significantly on the objectives of the government taking into account the socioeconomic situation at the time. 

So, the optimal mix of taxes changing according to societal changes and economic fundamentals is expected. A well-designed tax system will seek to both boost economic growth and generate more jobs while keeping the tax burden to the minimal.

While all taxes are distortionary, the converse is also true. Policies that influence the preferences of investors by not taxing one class of assets also ipso facto create distortions towards greater investment in the lower taxed asset. 

Contrary to popular perception, a zero capital gains tax on investment in the financial markets reduces incentives to invest in the real (goodsand services-producing) sectors. 
A useful tool to examine the distortions, or the wedge created by taxes, is to analyse the marginal effective tax rate (METR) of investments.

METR is a composite statistic that captures factors that influence business investment decisions. It is considered a better measure of tax competitiveness than the conventional corporate tax rate, as it considers both tax factors (accelerated depreciation, corporate tax rate, personal income-tax rate, dividend distribution tax, deductions for interest payments and return on long-term equity investment) as well as non-tax factors (inflation, interest rates and market rate of return) that impact investment decisions.

METR can be thought of as a tax wedge between the investment rate of return on capital assets (‘hurdle rate’) and the post-tax market rate of return (opportunity cost of funds). 
With zero capital gains tax, an investor having surplus funds could prefer to invest in the market, as his assets yield a greater post-tax rate of return with a shorter gestation period than investing in the capital assets in a firm.

The Budget has proposed a LTCG tax of 10%. Detailed analysis at the firm level indicates that a 10% gains tax significantly reduces the average METR for all firms by over 16%, while METR for the manufacturing and services sector economy decreases by over 18%. 

This implies that the tax wedge between the hurdle rate for investment in the real sector and the post-tax market rate of return is reduced. Hence, the capital gains tax, by reducing the distortions in asset preferences, would increase aggregate investment and employment, particularly in the medium term.

Seeing the implicit distortions created by taxing assets differentially, many countries have imposed a capital-gains tax. 

The average capital gain rate in OECD countries is 18.4%, with the top marginal capital gains tax rate in Denmark being the highest at 42%, Finland at 33%, Britain at 28% and the US at 20%.

The average capital gains tax in east Asian countries is generally lower, with China taxing capital gains at 25% for businesses and 20% for individuals, and Malaysia having a zero tax rate. Vietnam doesn’t separately tax capital gains as they are treated as part of taxable income, and taxed at the current corporate tax rate of 20%.

In general, countries that have a zero tax rate for capital gains are those that either use this instrument to lure foreign institutional investors, or are tax havens. While in 2005, it may have made economic sense to have zero rate to attract FIIs, this would not be the primary aim today.

In India, most of the ₹3.67 lakh crore LTCG earned are made by large corporates and trusts who prefer to now directly invest in markets, rather than in the real (manufacturing and services) sector, due to greater returns. Such an investment bias does not generate adequate second-round multiplier effects for the economy.

A10% capital gains tax, while not significantly decreasing the attractiveness of investment in the financial sector, will reduce distortions in investment decisions to generate more investment, growth and employment.

About the author..

The writer is chief director, Tax Policy Research Unit, Ministry of Finance, GoI

SRC : ET 
LONG-TERM CAPITAL GAINS TAX - LTCG - A 10% Nudge to Invest in India..! Reviewed by S. Chitra on February 22, 2018 Rating: 5 LONG-TERM CAPITAL GAINS TAX - LTCG - A 10% Nudge to Invest in India..! by Ms. Indira Iyer, Ministry of Finance The bearish run on the st...

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