Why the Government shouldn’t tax Capital gains

A case against the LTCG

Vinayak Sahi, Class of 2020

The Narendra Modi government tabled its fourth budget in the parliament on the first day of February. The most radical change they proposed was reinstating the Long-term capital gain tax (LTCG). To be brute, I would call this idea nothing short of regretful economic mismanagement. But before I embark on a critical massacre of this tax, I will address what the tax entails.

The tax is essentially a certain percentage that any investor (“an individual who promises safety of principal and makes adequate return on the same”, as defined by the “father of value investing” Benjamin Graham ) will have to pay the government annually. This covers everybody who has a fixed deposit account, money in mutual funds or money in common stocks and is in it for the long run: everybody will have to pay 10% annually. For a single year the amount might look small, but when you apply the financial equivalence of an atom bomb — compounding — you see that the aforesaid tax has eaten more than 50% of your returns.

Arun Jaitley argued on the floor of the parliament that it is usually the rich who invest in equity or bonds, and thus these members must be taxed on any returns that they make. He of course omitted that a large part of the middle class holds their savings in fixed deposits and they too would be taxed if they fell in the correct income bracket. The problem is that a large part of investors invests their money in financial tools so as to keep their money from being eaten by inflation.

Inflation is nothing short of a dreaded monster for money. Inflation, simply put, is when you pay $15 for the $10 haircut you used to get for $5 when you had hair. Now the combined effect of tax and inflation would mean that returns on investment are 15% lesser every year and when compounded over a decade, it would causing you a loss of more than half of your returns. The real value of the money would have depreciated leaving the common man with almost nothing to show in terms of real value after a decade.

Joseph Stiglitz in a paper in 1976 had argued as to why capital should not be taxed. The short-term benefit arising to the concerned government will be negated by the long-term problems. Essentially what he argued was that a rational investor would be incentivised from future consumption to current consumption which would drive the savings rate down. The incentive structure would mean that saving or future consumption is costlier both in terms of nominal and real value which would then mean that the investor would find an alternate to this financial tool, which in most cases is gold. Gold outpaces inflation and interest rates when looked at historically. Of course, a similar trend of prices cannot be guaranteed, but can be expected due to the increased volatility of the markets in the past decade, making gold a good investment. A shrewder investor would invest in gold futures as this would mean that she would no longer have to pay for the storage cost and would result in a better yield.

The second argument that Stiglitz provided against capital taxation is that it is a form of double taxation. A shareholder in a company already indirectly pays the state a considerable sum through corporate tax. The implicit reasoning behind the aforesaid statement is that every shareholder of a company is a part owner of the company and thus pays a certain amount of tax to the government already through the corporate tax and the new tax on capital gains is just more taxes on the shareholder. Companies due to this double taxation might then choose to adopt raising money through bonds rather than IPOs (shares).

The newly imposed tax has an equitable function. Its function is to bring about equity in an unequal society, but there are other ways of taxing the rich and not hurting the economy. A simple idea could be proposing an inheritance tax which would essentially not allow inherited wealth to be the cornerstone of an individual’s finances. The long term capital gain tax, however, is a tax which will bring about equity and money for the government, but in doing so might drive the interest rate down and seriously hurt the middle class of India.