In my previous article, (‘Revolutions and regression’, IE, February 10) I had argued that the imposition of a long-term capital gains tax (LTCG) was not a good idea because the tax revenue obtained from its imposition was not likely to be large. In this article, I document, according to various methods, that the LTCG formulation is not only flawed in design, but also likely to yield very little tax revenue. At the same time, it manifestly increases the discretionary power of the taxman and this has its own set of governance problems.
In the run-up to the budget, I had pointed out (as had others) that the government had set up a committee headed by Arbind Modi to provide a new Direct Tax policy; hence, few expected that Finance Minister Arun Jaitley would tinker with the direct tax schedule. This was not to be, because tinker he did. That it was manifestly not worth the tinkering is documented below.
But first, the legitimate problem of stock price manipulation and the evasion of taxes. There is a well-known promoter-operator network which manipulates the prices of penny stocks, drives the price upward, and the operator-promoters then cash out at a higher price (a year or so later), and pay no tax. There is thus an element of double corruption involved. There is very little data available on the exact magnitude of this manipulation/tax avoidance but it is something that should be handled by the tax authorities in a better manner than “punishing” 99.9 per cent of investors because of the corruption of very few.
As I have repeatedly emphasised, the best tax policy for the taxman is one that maximises tax revenue, and not one that maximises his morality, or his employment, or his discretionary powers. With that in mind, let us explore what the imposition of the LTCG tax will do for tax revenue.
In his budget speech, Jaitley made the following statement “The total amount of exempted capital gains from listed shares and units is around Rs 3,67,000 crore as per returns filed for A.Y.17/18”. Subsequently, this was repeated by Finance Secretary Hasmukh Adhia. This is an eye-popping tax revenue gazing figure; at a tax rate of 10 per cent, this is an additional Rs 36.7 thcr (thousand crore) of tax-revenue. But is this estimate of tax-revenue likely to be correct for an average year in the future? Very unlikely in our view, and we attempt to document this conclusion below according to several different assumptions.
First: The stock market gained an average amount of only 3.9 per cent in FY17 (or assessment year 17-18), the year for which the taxman claims to have lots of exempted capital gain income. The Ministry of Finance (MoF) has provided detailed income data for all taxpayers for the four years 2011/12 through 2014/15. Between 2010/11 and 2014/15, the average value of the Sensex increased from 18,607 to 26,531, a gain of 43 per cent, or a compounded annual gain of 8.8 per cent a year — more than twice the gain recorded in 2016/17.
According to the MoF website, cumulative and all LTCG income (that accruing from stocks, property, gold etc) for four years was Rs 279 thcr. In 2016/17, with just a 2.8 per cent increase in the stock market, it is very unlikely that an income gain of Rs 367 thcr was possible (see Table 1).
Second: The accumulated STCG (short-term capital gains) income, for these four years, was just Rs 125 thcr, yielding an annual tax revenue of 4,700 crore (at a 15 per cent tax rate). But what percentage of stock market gains are short-term (and hence what proportion is long-term?). A difficult question to answer, but one extreme case is that short-term trades are only 25 per cent of total trades. This implies that LTCG income is three times the STCG income, that is, for the four years, around Rs 375 thcr. But all long-term capital gains (stocks, property, etc) were just Rs 279 thcr or (279/125), 2.2 times STCG income — so three times is a huge over-estimate.
A reasonable liberal estimate (based on the recent 2011/12-2014/15 experience) is that long-term capital gains income for stocks alone is 1.5 times STCG income. Hence, for the four years for which we have tax data, the cumulative four-year long-term gains from the stock market is 1.5*125 or Rs 188 thcr, or a maximum of Rs 47 thcr a year. And remember, this is with the Sensex gaining an average 8.8 per cent a year, and not the paltry 2.8 per cent increase experienced in 2016/17. This number is just 13 per cent of the Rs 367 thcr claimed by finance ministry officials.
Now, let us take the high market growth year of 2014/15 — reported STCG income for this year was Rs 73 thcr. 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 i.e. they sell, so they can pay no tax on “high” income gains. This would mean that exempted long-term stock market gains in a good stock market year would be no more than Rs 73 thcr — less than a fifth of that assumed by the MoF.
There is an alternative long-term calculation. The Kelkar Direct Taxes task force of 2002 (with Arbind Modi as a senior member and myself as a pro-bono researcher) estimated that the long-term tax revenue being foregone in 2002/3 via the elimination of a 20 per cent tax rate on LTCG was Rs 1,000 crore. This implies that the estimated LTCG income in 2002/3 would have been Rs 5000 crore. The stock market increased by 8.5 times between 2002/3 (Sensex equal to 3,203) and 2016/17 (Sensex equal to 2,73,40). Hence, long-term capital gains income (assuming buying and selling behaviour has stayed the same on average over the last 15 years) in 2016/17 would be estimated to be approximately 8.5*5,000 or approximately Rs 43 thcr.
No matter what the method, or the assumption, long-term capital gains income in 2016/17 is unlikely to have exceeded Rs 50 thcr, and most likely a lower number. This is less than one-sixth of the MoF estimate. Hence, the imposition of a 10 per cent LTCG tax rate is unlikely to yield more than Rs 5000 crore in tax revenue.
One final note about the tax revenues gained from both long-term and short-term capital gains. The MoF website also contains an estimate of a loss set-off for each of the four years. This set-off includes losses in business because such losses are allowed to be set-off against long-term capital gains. If the new LTCG tax is implemented, there will be an additional category under set-off — long-term capital losses. In any case, it is revealing that after accounting for set-offs, the MoF has gained, on average, just Rs 3000 crore a year.
The 2002 Kelkar report had advocated the abolishment of LTCG tax, the abolishment of dividend tax, the retention of short-term tax to 10 per cent and the introduction of the Securities Transaction Tax — STT. Average annual STT revenue has been around Rs 7,000 crore, and is forecast to be Rs 11,000 crore in 2018/19. Regardless of market direction, STT makes revenue for the taxman. Isn’t it much simpler to increase STT by 25 per cent? This will yield Rs 3,000 crore more per year,
What is clear is that there is no historical data which suggests that exempted long-term capital gains amount to anything close to the Rs 367 thcr figure claimed by the MoF for 2016/17. It would seem prudent for the ministry to withdraw this tax proposal and state that they will act once the Arbind Modi report becomes available. Until then, the MoF should find a method to identify the penny stock manipulators. That will be a win-win for all.
PS: There is one consistent explanation for the possibility that Rs. 367 thcr were actually declared in income-tax returns despite 2016-17 not showing much returns for the average investor. Could this be the effect of demonetization i.e. the stock market being used to launder black cash? Even if this is the case (like the promoter-operator nexus) it requires a very different policy response than the imposition of a tax on future long-term capital gains.
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