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All eyes on Budget 2017 proposals on capital gains tax

Posted by: Uma Shashikant on Jan 17, 2017, 07.52 AM IST

By Uma Shashikant, Chairperson, Centre for Investment Education and Learning

In the weeks leading up to the Union Budget, every conjecture and speculation makes headlines. Fortunately, the Budget proposals are guarded with utmost secrecy, with no leak of details to anyone, however privileged they may be. So while we must dismiss opinions about what the Finance Minister is “sure” to do, we can think about issues that matter to us ordinary taxpayers, investors and savers. My attention this week is on taxation of capital.

Capital gains are taxed differently from income. In most countries, the rate of tax applicable on capital gains is lower than the marginal rate of tax on income. This has invited arguments about the unequal treatment of two factors of production—labour and capital. A hardworking super-specialist scientist pays over 30% of her income as taxes, while the lazy inheritor of equity can earn tax-free dividends and capital gains. Or maybe things aren’t as simple.

Why is capital given preferential treatment? Let me point out that when capital is lent, the interest income earned is taxed at the same rate as wages and salaries. It is equity capital that enjoys the privileged treatment, apart from other capital assets such as property and gold. There are at least three arguments for why this is so.

Also Read: All you need to know about upcoming Union Budget

First, interest is an expense that a business deducts from its revenues, before paying taxes. A business that utilises capital, creates assets and generates revenue is able to charge depreciation, expenses and interest to its income, before arriving at profits. On that profit, it pays corporate income tax. So interest is paid to lenders pre-tax. But dividend is post-tax. It is the residual profit after tax that is distributed as dividend to equity shareholders, or retained with a corresponding increase in networth. In India, businesses are also subjected to dividend distribution taxes. Therefore to tax dividends, or increases in the value of equity shares over time, is to double tax the same income.

Second, when taxes are paid on wage or salary income, you pay as you earn. The income is in today’s rupees, and the dreaded TDS on salary also made on today’s rupee. But when you invest in a capital asset, say residential property or equity shares, you invest today, but pay taxes years later when you sell. Or, you pay taxes on the nominal value of the asset, which includes any appreciation due to inflation. Therefore, capital gains are subject to indexation benefits, which allows the investor to rework the cost based on the cost of inflation index published by the CBDT. This lowers the tax liability. Capital assets mostly represent accumulated wealth, not current income.

Third, when you receive your income you have two choices: spend it today and consume all that you wish; or save it for consumption later. Policy makers believe that this ability of income earners should be encouraged. If one sacrifices current consumption and instead makes that capital available for asset building activities that will foster the economic growth of the country, incentive to encourage such acts of saving and investing should be provided.

Capital finds its way into risky ventures, unknown businesses, untried products and such enterprises incentivised by lower tax when equity shares are sold to realise the capital gains. The idea of exempting at purchase or investment and taxing at sale or redemption, or taxing capital gain at all, comes from this idea of incentivising as long as the saving remains invested, but taxing it when it is drawn for consumption. This is also the basis for the EET regime for long- term savings, where taxes apply on redemption.

Why the outrage about capital gains? First, the richest in the world, and in India, have a large portion of their wealth in capital assets on which they pay no taxes. There is too little to redistribute or invest in public good. The burden of government expenses falls disproportionately on lower income groups. In a widely discussed book, Capital in the Twenty First Century (2014), Thomas Piketty argued that the obnoxiously high income of the top 10% is primarily income from capital, creating severe inequality.

Second, the differential tax rates for income and capital gain within and across countries, has spawned an obnoxious industry of tax arbitrage. Businesses modify where they will locate, operate and book their revenue; rich individuals create complex global trust structures; corrupt operators round trip money across domiciles; assets are bought and sold not for their economic value but for the capital gain taxes that they save, and the capital losses they will set off. The differential treatment of capital gains and the lower or nil taxes on it, has led to active and harmful transmission and conversion of income and capital gains.

How are we doing, given this context? First, long term investment needs incentives in a capital-starved country. But by no stretch of imagination is 12 months “longterm.” We need a sound and uniform treatment across assets. Second, the securities transaction tax (STT) is an administrative convenience to collect some taxes; it is not a substantial tax that will bring government the revenues it badly needs. That it helps round-tripping of black money through tax havens is a shame. Third, given the high rates of income tax and even higher evasion, there is no tax morale with the investing public. They see capital gains taxes on sale of property and gold as unreasonable. Those assets will continue to sell in the black markets if capital gains are taxable at a high rate.

The FM has two choices. First, succumb to the administrative convenience argument and introduce a banking transaction tax much like the STT, and equalise the taxes on income and capital gain by making both zero. The government will have to bet that the surge in economic activity will generate better wages and will take the burden off the government to make capital expenditures. Markets and the public would love it, but it fails to address income inequality.

Second, reduce the rates of taxation on income to encourage better compliance. Normalise and keep capital gains taxes on all assets lower but closer to that rate. This still leaves the government with revenues and an active role in wealth distribution, while irking the markets and the “foreign capital.” But it also places the onus of tax compliance on the government, a task it has very poorly discharged for too many years. This article appeared in Economic Times dated Updated: Jan 17, 2017, 07.52 AM IST

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