Long-term capital gains tax (LTCG) is flawed in design and it’s not likely to enhance tax revenues considerably.
Also, it will manifestly increase the discretionary power of taxman, which has its own set of governance problems.
Why is the logic behind LTCG flawed?
There are well-known promoter-operator networks which manipulate the prices of penny stocks, and drive the price upward.
The operator-promoters then cash out at a higher price (a year or so later), and pay no tax, which is indeed a legitimate evasion concern.
While an element of double corruption is indeed involved in this, there is very little data available on the exact magnitude of such designs.
While tax authorities should get innovative to sabotage such networks, slapping a LTCG tax isn’t prudent as it can damage the entire eco-system.
Rather, the best tax policy is one that maximises revenue, and not that maximises morality, or discretionary powers of the ‘taxmen’.
Why is the government’s estimated revenue form LTCG Tax false?
Based on IT returns filed, the government has claimed that the total exempted capital gains from listed shares is around Rs 3,67,000 crores for the FY-17.
This seems to suggest that if these revenue is taxed at 10% as proposed, a whooping Rs 36.7 thousand crores can be netted.
But some assessments have questioned the veracity of the government’s claim as such high estimates are unlikely to correspond for an average year.
Firstly - Stock market gained an average amount of only 3.9% in FY17, the year which has been stated in the government’s above estimate.
Significantly, even when the stock markets grew faster between 2011-15 at an average of 8.8% year on, the cumulative LTCG income (accruing from stocks, property, gold etc) for four years was merely Rs 279 thousand crores.
Secondly - The accumulated Short-Term Capital Gains income (at 15% tax), for these four years, was just Rs 125 thousand crores.
A reasonable liberal estimate is that long-term capital gains income for stocks alone is 1.5 times STCG income, which accounts to Rs. 188 crores for 4 years.
This accounts to an average of Rs 47 thousand crores a year (even when the sensex grew at 8.8%), which is merely 13% of government’s claim for FY-17.
Thirdly - It is likely that in years of high stock market increases, more long-term sellers enter the market, in order to avail of a zero tax benefit on sale.
But even for a high market growth year like FY-14/15, the reported STCG income for this year was no more than Rs 73 thousand crores.
Even this is less than a fifth of that assumed by the MoF.
The Conclusion - All estimations reiterate that, Long-term capital gains income in 2016/17 is unlikely to have exceeded Rs 50 thousand crores.
Hence, the imposition of a 10 per cent LTCG tax rate is unlikely to yield more than Rs 5000 crore in tax revenue (against the estimated 36,000 crores).
What then explains the IT filings regarding LTCG for FY-17?
If Rs. 367 thousand crores were actually declared in income-tax returns in 2016-17, it is clearly an outlier that needs probing into.
As this has happened when the stock market was not showing significant returns for the average investor, this seems peculiar.
There is a possibility that demonetisation could’ve caused this trend, i.e. stock markets could’ve been used to launder money outside the tax net.
Even if this is the case (like the promoter-operator nexus) it requires a very different policy response than the imposition of a LTCG.
What is the way ahead?
A loss set-off is allowed against LTCG taxation, and this includes losses aginst business too, which furthers the scope for tax subversion by offenders.
Case for STT - The 2002 Kelkar report had advocated the abolishment of LTCG tax and dividend tax, but the retention of STCG tax at 10%.
Kelkar Report had also recommended the introduction of the Securities Transaction Tax (STT), to boost revenues.
Notably, over the years, regardless of market direction, it has been observed that STT generates considerably stable revenues.
Hence, it will be much simpler to increase the STT to 25%, and will enhance revenue collections by Rs 3,000 crores per year.
New Direct Tax Policy - A committee constituted by the government for evolving a new direct tax policy is already working under ‘Arbind Modi’.
Hence, it would be prudent for the government to withdraw the proposed LTCG tax and wait for the committee’s report.
Until then, Finance ministry should focus on mechanisms to identify penny stock manipulators and other nefarious designs within the capital markets.
