Fears about a long-term capital gains (LTCG) tax being imposed in the Union Budget 2018 had wreaked havoc in the markets in recent trading sessions. A day ahead of the budget speech, three-fourths of the stocks comprising the BSE 500 index had fallen by 10% or more from their 52-week highs. Over a third of these stocks fell over 20%.
In short, traders and investors had already been factoring in an additional tax burden to some extent. In this backdrop, the finance minister’s decision to bring back LTCG isn’t a negative surprise. Besides, the government has softened the blow by putting in a grandfathering clause to protect gains made until 31 January 2018. It has also said that only gains in excess of Rs1 lakh will be taxed. As such, it isn’t the body blow some had feared.
Still, the new LTCG regime is a negative for the equities market. A number of investors will now need to factor in an additional 10% tax burden on new equity investments. This alters the risk-reward equation for Indian equities meaningfully, especially at a time when bond yields both globally and in the domestic market are on the rise.
So, on the one hand, returns on debt instruments are rising—yields on the benchmark 10-year bond have risen from 6.9% three months ago to 7.6% currently. On the other hand, post-tax returns on equity investments have to factor in a 10% haircut.
The new tax will also make offshore centres such as Singapore more cost effective to trade, which is strange from a policy perspective given that Singapore Exchange is out to garner a greater share of trading in Indian stocks.
While a favourable tax regime may not have been the reason for the surge in domestic flows to the equities market, removing the tax advantage can affect sentiment and flows to this segment. Note that domestic flows were largely behind the rally in Indian stocks in 2017. As such, if flows to the market from domestic investors slow down, the markets may well stutter in 2018.
Also note that stocks derive their value from post-tax cash flows of a company. Some experts argue that equity investors are, hence, taxed multiple times. First, the companies in which they own shares pay corporation tax. Then, tax is deducted when the company pays out dividend. Large investors also pay an additional tax on dividend income in excess of Rs10 lakh. Besides, everyone pays securities transaction tax (STT) while dealing in stocks on stock exchanges. And now, you have LTCG.
The irony here is that STT was introduced when LTCG was abolished. The reintroduction of LTCG hasn’t been accompanied with any relaxation on the STT front—there is no offset even. The crib about multiple levels of taxation for an equity investor, therefore, has some merit.
But leave aside the theoretical argument on whether LTCG is warranted or not. With one of the selling points about equity investments being taken away, an uncertainty arises as far as domestic flows go, and to that extent, the markets should be worried.
The silver lining in the budget is that it seems prudent on the expenditure side, especially for what is possibly the last budget before the next general election. There are no major dole outs. While there is an increased allocation for higher minimum support prices, overall, expenses have been kept under a fairly tight rein. As such, the announced target of a 3.3% fiscal deficit is something equity investors wouldn’t fret much about.
Having said that, the budget may prove to be inflationary, which is something that is also reflected in the sell-off in the bond market. Which brings us to the point about the equity markets shrugging off macroeconomic concerns that the bond markets seemed to be quite worried about.
While the budget doesn’t factor in a huge increase in collections from the new goods and services tax (GST), the fact remains that this will play a large role in balancing budgets in the coming year. “The equity market has pinned high hopes on increased government spending on housing and rural economy, which will drive consumption demand in FY2019. However, the government’s ability to spend will depend on its fiscal position. The market’s optimism may be belied if GST revenues were to fail to pick up meaningfully from current levels," analysts at Kotak Institutional Equities wrote in a note to clients last month.
In sum, the budget may not have huge positives or negatives for the market; but how things play out with respect to GST collections and the impact of LTCG can have a meaningful impact on the course of the markets this year.