Towards sensible capital gains taxation

The Government’s proposed Direct Tax Code has been widely welcomed. It seeks, rightly, to bring corporate tax rates closer to the Chinese and ASEAN level, and combine lower rates with fewer exemptions. The proposed income tax changes will give substantial relief to the middle class, but may cause excessive revenue losses.

Experts have already analysed most proposed changes threadbare. But virtually none have focused on one area where the proposed Code goes seriously wrong—capital gains tax. Indeed, the underlying issues are fundamentally misunderstood globally.

Any financial expert will tell you that it prudent to diversify your savings, putting them in different asset classes (shares, bonds, real estate). It is also prudent to diversify within each asset class like shares—you should distribute your holdings of shares between different sectors such as finance, auto, healthcare, and IT. The sums you allocate to different assets should change with time—textiles constitute a sunset sector and IT a sunrise sector, and you should reshuffle your portfolio accordingly.

A fund manager who never reshuffles his portfolio will be sacked on the ground of incompetence. He will be guilty of having harmed the savings of the clients whose interest he is supposed to serve. Yet the proposed capital gains tax will exempt people who never sell any assets, and penalize those who do. Assets rise in value whether they are sold or not. Reshuffling a portfolio of assets means selling some assets and buying others. The proposed tax will be levied only on gains from sales, not on gains in the value of unsold assets.

So although reshuffling is economically efficient and financially prudent, the proposed Code will tax this good practice and exempt the bad alternative. That is terrible policy.

It makes better sense to levy capital gains tax only on assets that are liquidated—converted to money. Tax reshuffling should be encouraged, and so the new tax code should exempt reshuffling.

Three considerations should govern any tax proposal: efficiency, equity and simplicity. That is, a tax should promote economic efficiency and provide incentives for desirable behaviour; it should aim for vertical equity (rich folk should pay more) and horizontal equity (some sorts of gains should not get preferential treatment over others); and it should be simple to administer, reducing litigation and evasion. The proposed change in capital gains tax fails on all three counts—efficiency, equity and simplicity.

International studies show that revenue from capital gains tax is typically under 1% of total revenue. It is nevertheless widely used to check the conversion of income into capital gains to avoid tax (zero coupon bonds are one example of such conversion). For the same reason, many countries levy gift tax: this too yields little revenue but checks evasion.

This, then, is a sound reason for levying capital gains tax in India. It also improves vertical equity to the extent it gathers revenues from rich folk who are taxed relatively lightly today.

However, economic practice can vary dramatically from theory in India. Despite some improvement in tax administration in the last decade, taxes are widely evaded and many transactions (and associated capital gains) are not officially reported. Agricultural land (save that within 8 km of a town) is exempt from capital gains tax, a huge legal loophole exploited by evaders. So taxing capital gains, which looks theoretically good in terms of vertical equity, can in practice be bad for equity—it taxes honest folk while leaving out very rich evaders.

Besides, with the opening up of foreign portfolio investment in India through Mauritius and other tax havens, foreigners—as well as crooked Indians laundering their black money —are investing in stock markets via tax havens, escaping capital gains tax. In theory foreign investors have to pay capital gains tax, but they escape if they route investments through zero-tax countries with whom India has an avoidance-of-double-taxation treaty. Horizontal equity is offended when foreign investors get preferred tax treatment over Indians, and when Indian black money laundered through tax havens gets preferential treatment over white money.

How does the proposed capital gains tax score on efficiency? It will be inefficient to the extent it strengthens laundering through the Mauritius loophole. And it will reward inefficiency and imprudence in portfolio management.

What about simplicity of administration? Because of widespread tax evasion, former Finance Minister Chidambaram abolished long–term capital gains tax on shares transacted on stock exchanges, and instead levied a securities transactions tax (STT). This was clearly non-optimal in economic theory. Any tax on transactions discourages them, and so imposes deadweight losses on the economy. The STT impacts day traders more than others, and to that extent is horizontally inequitable. Unlike capital gains tax, STT does not check those seeking to convert income into capital gains.

However, STT has a huge advantage over capital gains tax in simplicity of administration. STT is collected automatically from all stock markets, and is a rare tax that is not evaded at all. Stock market turnover has risen sharply after the imposition of STT, suggesting that its adverse effects on transaction volume have been limited. STT is a case where what looks second best in economic theory can be the most effective in practice.

So, viewed from the three criteria of efficiency, equity and simplicity, the proposed tax code needs a different approach to capital gains tax. The STT should continue. To check income tax evasion, it could be combined with a low, flat tax on capital gains—say at 12.5%, half the corporate tax rate. Most important of all, portfolio reshuffling should be fully exempt from capital gains tax.

The ensuing tax system will be efficient: it will promote portfolio churning. It will be equitable (by raising revenue from richer folk) and will provide horizontal equity between foreign and Indian shareholders. It will be relatively simple—STT is collected automatically, and a flat capital gains tax will also be simple to administer. That is the way to go.

What do you think?