How the tax on LTCG doesn’t add up…

Disclaimer: I am not an economist. I am a salaried Chartered Accountant in my early 30’s (India’s largest chunk of population) and a risk taking investor in equities market.

With the disclaimer above I am letting out my reaction to the Long Term Capital Gains tax introduced in the budget at the rate of 10% for gains above Rs. 1,00,000. Also, the distribution of

First some numbers:

Mutual Fund Investors in India : 6.65 crore folios at the end of 2017 vs 5.28 crores in 2016

New additions through 2017 : 1.37 crore new folios (ie. 26% new folios) vs 70 lakh in 2016.

Overall, mutual funds have seen an infusion of Rs 2 lakh crore, while equity and ELSS alone attracted an impressive inflow of over Rs 1.5 lakh crore. Over the last few years, they have proven to be a low-cost, compliant and transparent way to channelise savings towards financial investments. Source: BloombergQuint

Now the reason this happened:

1. The markets were very bullish. (Obviously)
2. No tax after 1 year of gains made. (Obviously, again. Huh!)
3. The new investors trusted the Mutual Funds rather than investing directly in equities
4. Any other

Now, any mutual fund investor is supposed to pay a tax of 10% after a holding period of 1 year for the investment.

Does this change anything?

Logically, No.

But us Humans are emotional and Indians are bargain hunters.

So what changes?

Let’s say Ramesh and Suresh are both in Middle Income Group (MIG) and earns less than 12 lacs a year and have a corpus of Rs 5 lacs each mostly invest their savings in Mutual Funds.

Suddenly whenever they receive a dividend or redeem the mutual funds units they receive 10% less than what they thought they will receive. Well, that’s tax which is as certain as death. Yes?

But, Ramesh thinks that this will not favor him and approaches his stock broker to redeem the mutual fund units and invest directly in the equities because he thinks that the capital gains will be less than 1 lac anyways and he will be able to save the tax and maybe he will be able to make some more money.

The fallacies of the new behavior is that he doesn’t have the sufficient knowledge and has to depend on his broker and friends and family for finding the stocks to invest. And since he is investing directly he becomes anxious and spends some time everyday to monitor his nest egg. There are chances that sometimes he feels that he can time the market and gets into risky trades. He might as well make some short term capital gains (STCG) what’s the difference in tax anyways (just the 5%, you see!).

While Suresh being a risk averse investor keeps his Mutual Funds portfolio but have to allocate more funds every month to reach his goals due to the tax impact. This will reduce his monthly spending capacity.

They will also start feeling the stress for realising their financial goals may be putting some more stress in their personal and professional lives.

What this might mean, well to my mind at worst it is a lot. If people become disinterested in mutual funds and expose themselves to direct investing there is a higher chance of loosing the money. If they have to put in more money in the Mutual Funds every month they will become conservative in spending. And finally there are no other options of investments left. Fixed Deposit rates are at an all time low, gold is actively discouraged as an investment opportunity and real estate is far too expensive to invest small amounts.

Now my two cents, would the tax on LTCG would trigger behavioral changes for marginal investors? If yes, it would be a reversal of the hard work gone into changing the habits of investing in Mutual Funds in the first place. Second, if this happens would this leave the investors worse off or better. Could they loose money or opportunity just by charging the tax?

In sum total it would expose the risk taking investors to vagaries of market and for risk averse investors, compress their spending capacity or longer period to achieve their goals.

Next is, what if?

What if the benefit of LTCG tax exemption was extended from 1 year to let’s say 2 years. The income estimated from the LTCG tax for the Govt. is estimated at Rs. 20,000 crores. There must be more people who will derive the STCG gains if the period for LTCG gains is extended to 2 years and would fulfill the tax requirements also.

If the tax is to deter conversion of black money through the markets, well extension of the time period would have had the same impact.

So, how does the math add up?

Originally published at https://www.linkedin.com on February 2, 2018.