Although there is a need to ensure asset-price stability, the 2022-23 Budget has left the capital gains tax on equity investment unchanged. In this post, Gurbachan Singh examines the idea of a tax as a wedge in maintaining asset-price stability, how the capital gains tax creates constraints in this context, and how a revenue-neutral change can be made in the tax laws.
The 2022-23 Budget has left the capital gains tax on equity investment unchanged1 except for, what is, in a sense, a minor change2 (Government of India, 2022). On the other hand, the NSE (National Stock Exchange) NIFTY50 has been at a high level for some time. The price earnings ratio is 23.12 and the price to book ratio is 4.43, as on 1 February 2022. The need for asset-price stability can be hardly over-emphasised. Could the Budget have done something in this context?
While the idea of a tax as a wedge is common in economics literature, it is generally used in the context of efficiency in the allocation of scarce resources across different uses. What is much less familiar is the idea of a tax as a wedge in maintaining asset-price stability (Atkinson and Stiglitz 2015, Gruber 2019, Slemrod and Bakija 2017) and this will my focus in this post. More specifically, we will see how the capital gains tax can come in the way of asset-price stability, and how a change can be made in tax laws in a revenue-neutral way. Though the concern is with both the long- and short-term capital gains tax, I will discuss the former. For simplicity, I will henceforth refer to this as capital gains tax.
The prevailing capital gains tax
The prevailing capital gains tax applies to realised gains only and not to the gains that have only accrued. Hence, the tax is not equitable. On the other hand, the tax applies not only to cases where an asset is sold to finance consumption (or gift/donation) but also where the sale proceeds are used to purchase another asset. Note that in the latter case, we have a mere change in the portfolio of assets. And yet we have a capital gains tax, though there are some exceptions. An important case is as follows. If the investment is through a financial intermediary, like a mutual fund, and a change in the portfolio of assets is carried out by such an intermediary on behalf of the ultimate investors who stay invested in a given scheme, then the capital gains tax does not apply. In what follows, the main issue is outside of these exceptions.
What are the issues with the prevailing capital gains tax? Consider two asset classes A and B; think of debt and equity, or investing in stocks in emerging market economies other than India versus investing in stocks in India. Suppose that it is felt that asset A has become under-priced or asset B has become over-priced. This may appear to be a clear arbitrage opportunity – it makes sense to sell asset B and buy asset A. However, in practice, there are difficulties – even if we abstract from transactions costs, which are anyway small these days. When it comes to making a decision, there could be an issue of not being certain of the true value of assets, in which case investors may choose to do nothing. Besides, there are practical limits to arbitrage. There are two reasons.
First, financial markets are not unambiguously efficient (Barberis and Thaler 2003). Given the irrationality in the market, asset A can become further under-priced and/or asset B can become further over-priced before the correction happens. The rational trader faces the risk that mispricing may worsen in the meanwhile. If they have limited capital and a short investment horizon, they would take a limited position in what may appear as a clear arbitrage opportunity. And, given that traders take limited positions, the mispricing could persist for a while (Shleifer 2000).
Second, there can be a capital gains tax on the sale of an existing asset. So, it is a meaningful arbitrage opportunity only to the extent that the gain due to the price gap involved in the apparent arbitrage opportunity is more than the tax payment involved in shifting from asset B to asset A.
How does all this matter? As we know, prices of stocks change considerably, relative to other assets. In fact, they can go up to very high levels at times. A notable question arises here: Why do investors not sell, or not sell adequately, when stock prices are high? The first reason discussed above applies primarily to traders, speculators, and short-term investors, and the second to long-term investors. The first has become common in the behavioural finance literature (Shleifer 2000). The second one is much less common. Here, I will focus on the second one.
A capital gains tax is an important consideration even in a country like the US, for big and reputed long-term investors like Warren Buffet who may choose to stay invested despite high prices; it is primarily the other money which is from dividend (and other cash inflows) that are held as cash till the stock market provides new opportunities for such investors. This implies that long-term investors do not sell adequately when prices are high. Hence, fluctuation or deviation of prices from their true values can be somewhat persistent. What is the way out? Before we proceed further, it is important to present the relevant terminology.
The term capital gains tax is a bit misleading because such a tax actually applies to not only a rise in capital but also to an increase in wealth in general, by way of appreciation in price of gold, land, works of art, etc. Hence, it is more appropriate to refer to it as the ‘wealth gains tax’ instead of the capital gains tax. The wealth gains tax is different from wealth tax. Wealth tax applies to the stock of wealth while the wealth gains tax applies to the flow of gains in wealth.
At present, we have, as mentioned earlier, the distinction between accrued and realised capital gains. We may call these accrued wealth gains and realised wealth gains. Furthermore, we can have two additional concepts, which are encashed and not-reinvested wealth gains, and encashed and reinvested wealth gains. These are two kinds of realised capital (wealth) gains.
The motivation for the use of word ‘encashed’ is that is not clear if it is appropriate to use the label of realised gains in case an asset has been sold at a gain, but the proceeds have not been used for consumption. It is true that the gains have been encashed in which case these may be called encashed gains3. We can now consider the tax laws proposed here.
Proposed tax laws
There can be some practical considerations in the tax laws. There are reasons to believe that these are not significant in the context of the wealth gains tax from a long-term point of view. So, in what follows, I will abstract from practical considerations in tax laws.
I propose that the wealth gains tax be applied to only those wealth gains that are not reinvested. The rationale is simple. In all other cases – where the wealth gains are reinvested – they are just cases of a change in the portfolio of assets. If a wealth gains tax is zero in case of a change in portfolio of assets, then it is easier to shift from one asset to another. This helps in arbitrage (broadly defined) and consequently, in maintaining asset-price stability (Singh, forthcoming).
It is true that the above proposed plan so far implies a reduction in the tax revenue collected from the wealth gains tax. In this context, I propose that the wealth tax be brought back in India. The wealth tax collected can make up for the loss of revenues from the wealth gains tax, such that the proposed plan is revenue neutral.
It may be argued that though the proposed plan can make investing and trading easier, it may be worse for asset-price stability because investing and trading can be irrational. In fact, lower taxes may spur such irrational activity. However, it is important to remember the distinction between mispricing and volatility that can persist due to irrationality or due to tax laws. The former can be dealt with through a change in the legal, regulatory, and institutional framework under which the financial markets function (Singh, forthcoming). So, we need to worry here about mispricing and volatility that tends to stay on due to tax laws. In this context, the policy suggestions discussed above may be summarised as follows:
- All wealth gains, including the accrued gains, are taxed, and not just those that are encashed.
- All wealth gains are taxable whether these are made directly or indirectly through a financial intermediary like a mutual fund.
- All wealth gains are taxed only once.
- If the wealth gains are not reinvested, they get taxed under the wealth gains tax.
- If the wealth gains are reinvested, then the gains are encompassed within wealth in which case the wealth tax applies.
At present, the long-term wealth gains tax rate on sale of stocks is 10% in India. Under the proposed tax laws, the tax rate can be less, now that all wealth gains are sought to be taxed. This is unlike the case of the prevailing policy regime wherein only some wealth gains are taxed; the wealth gains that accrue to an investor but are not encashed do not get taxed at all. Furthermore, and importantly, under the prevailing tax laws the taxation of wealth gains can come in the way of arbitrage, and asset-price stability. This is not the case under the proposed policy regime wherein wealth tax gains get taxed in one way or another so that the decision to retain an asset portfolio or change an asset portfolio can be carried out without worrying about the tax issues.
A tax as a wedge in allocative efficiency is quite a familiar concept. A tax as a wedge in asset-price stability is much less familiar. It is important that the government (and the commentators) consider not just the immediate concerns but also long-term issues in fiscal policy while discussing the annual budget. Real progress can only come from such an approach.
In this post, I suggest that the wealth tax be brought back. This is in the context of the so-called capital gains tax, and asset-price stability. However, the wealth tax may be reconsidered in its own right in India (the wealth tax is used even in capitalist countries). But that is a different story. While I consider a simple wealth tax, the arguments can be extended to incorporate a progressive wealth tax, and at the least, there can be a threshold of wealth beyond which the wealth tax applies.
Finally, in a country like India, the issue of tax laws coming in the way of a change in the portfolio of assets goes beyond asset-price stability. It matters for development economics as well. The market for real assets is huge in India and it has often been felt that there is a need to expedite the shift towards financial assets. But this change continues to be slow. One reason is the tax laws (and the related black money issues in real assets). The tax laws need to change in this context as well. This can happen on the basis of the general principle laid down in this post.
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- The government charges a 10% long-term capital gains tax on profits made on equity investments of Rs. 1 lakh and above, if these are held for more than a year. Short-term capital gains are taxable at 15%. This post abstracts from the distinction between short- and long-term capital gains.
- The government will, in the future, cap surcharge on long-term capital gains tax on all equity investments at 15%, which is expected to benefit unlisted companies in India.
- Finally, in so far as the wealth tax is concerned, I am not suggesting any change in terminology.
- Atkinson, AB and JE Stiglitz (2015), Lectures on Public Economics (Revised Edition), Princeton University Press.
- Barberis, N and R Thaler (2003), ‘A survey of behavioural finance, in Financial Markets and Asset Pricing’, in GM Constantinides, M Harris and RM Stulz (eds.), Handbook of the Economics of Finance.
- Government of India (2022), ‘Budget at a Glance 2022-23’, Ministry of Finance.
- Gruber, J (2019), Public Finance and Public Policy (6th edition), Macmillan International.
- Shleifer, A (2000), Inefficient Markets - An Introduction to Behavioural Finance, Oxford University Press.
- Singh, G, Thinking Afresh on Macroeconomic and Asset Price Stability, forthcoming.
- Slemrod, J and J Bakija (2017), Taxing Ourselves: A Citizen's Guide to the Debate over Taxes, The MIT Press.
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