Choice and incentive are powerful, inter-connected drivers for economic decisions, big or small. The choice could be about something minor, like reading a book, having a drink, or net surfing for entertainment. It could be a major career decision. Or it could be something in-between, like planning a holiday destination. We always consciously or unconsciously weigh choices and consider both positive incentives and negative disincentives before making decisions.
When it comes to investment, most of the factors influencing choices can be quantified concretely. An investor can choose between many assets carrying different risks, rewards and time-value. But intangibles like personal risk-appetite, consumption factors, etc, come into consideration. For example, somebody considering emigration will rate real estate differently from someone who is intending to permanently reside in the same place.
Taxes are a great tool for influencing investment decisions. The current Indian tax code offers strong incentive to invest for the long term in equity. There is no long-term capital gains tax for assets held beyond 12 months and dividend income is also tax free for recipients. In contrast, relatively safer debt returns are taxed much more heavily.
Since this tax policy has been in place for many years, a lot of long-term financial planning is built around it. Financial planners assumed that the policy would remain consistent and advised that asset allocation be done accordingly. Foreign institutional investors (FIIs) also did their planning under assumptions of a consistent tax code.
Now, it appears that the draft Direct Taxes Code (DTC) will re-introduce capital gains tax for the long term and it could change the perspective for FIIs as well. I’m not going into the long-term, macro-economic pros and cons of DTC and further changes in the code are very possible. But the perspective in terms of incentives may well be altered. Note that India has lived with similar and higher long-term capital gains tax rates through much of its history. It has had big bull markets under earlier and much harsher tax regimes.
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But in the short run – which means while the transition occurs through the current and next fiscal years – there will probably be serious selling in stocks. There could also be a situation of heavy selling in this fiscal, followed by drops in stock market transaction volumes in the next. That could have a depressive influence on stock prices. Is this an opportunity or a threat? The answer is, it’s a bit of both. Over the long run, equity remains the best bet for high, sustained returns and, obviously, if the DTC makes it easier to transact business, it will be good for profits in general. But it would make sense for somebody who is already heavily invested to churn portfolios by selling before the new tax regime goes into force.
The author is a technical and equity analyst