Budget should clean up capital gains, DDT mess

The problem of the Indian budget exercise has been to somehow get the reluctant individual to pay income tax. Step back and see that a government needs tax revenue to run the government itself, pay for government institutions (health, education and defence, to name just a few), spend on infrastructure, pay interest on borrowings and so on. A prudent government’s capacity to spend depends on its capacity to raise revenue through taxes—both direct and indirect. A profligate government will simply borrow recklessly and kick the problem down the road for future governments to handle.

A key problem that faces the Indian budget is that too few people pay income tax, with just 32.3 million people filing ITR-1 (the return for salaried individuals) on a population base of 1.37 billion. Successive governments have attempted to get the reluctant Indian to pay income tax and failed. Therefore, they have used a tax on incomes and profits on investment to try and get those who should pay, to pay. But successive governments have then gone on increasing the burden and the complexity of this taxation so that today two taxes are in a total mess: the dividend distribution tax (DDT) and the capital gains tax.

DDT is a tax on dividends distributed by profit-making firms. Given the difficulty of collecting it from individuals, the government asks firms to deduct the tax and pay it on behalf of the investors. Remember finance 101, when a firm makes profits, these profits can be distributed as dividends to the shareholders or get reinvested into the business. The dividends are distributed out of profits that have already been taxed. Therefore, DDT has been seen as an unfair second layer of tax—the government is taxing what is already taxed. Because of the way DDT is levied and coupled with the surcharge and cess, the effective tax rate on the shareholder today is 20.56%. But to catch the rich dividend earner, the government then put an additional 10% on dividend income over ₹10 lakh in Budget 2016. That’s a three-time tax on one income source.

The story gets worse when we move to equity mutual funds that potentially pay four layers of taxes on dividend income. In addition to the 20.56% paid already, the equity fund has to pay another effective 12.94% of dividend tax and then the 10% tax if dividend income is above ₹10 lakh. Of course, smart equity mutual fund investors use the systematic withdrawal plan rather than this cascading tax matrix to draw income from their holdings. The government needs to stop this tax excess and simplify the system. Maybe a low flat tax on dividend income in the hand of the individual, whether he goes directly to the stock market or through a mutual fund, could work better. Or remove it totally and give equities a boost as a destination for household savings.

The second problem is in the capital gains taxes. You make a capital gain when the price at which you sell an asset is higher than the price at which you buy. The tax rates are lower for holding an asset over a longer period, therefore short-term capital gains (STCG) tax is higher than LTCG tax. But we have a mess in the definition of what is long- and short-term. Equity long-term is a one-year holding period. Real estate goes long term at two years and debt goes long term after a three-year holding period. There is an urgent need to align the holding period with the asset class attributes. Debt is an asset class that does well for short-term goals, equity and real estate are long-term assets and both should have at least a five-year holding period to go long term. Different assets have different rules on reinvestment of profits as well. Real estate long-term profits, if reinvested in another property within two years of the sale, escape capital gains tax, but equity does not enjoy the same rebalancing-the-portfolio carve-out. Either take away the reinvestment benefit to real estate or allow all asset classes a similar carve-out. Ideally, an investor in an equity mutual fund should not need to pay tax if he is simply punishing a poor fund manager and moving to a better fund. Given the technology available, it should not be a difficult task to tax only money that is redeemed out of equity for other use rather than a rebalancing activity between similar funds.

Then there is a free pass to investments in insurance policies that are mutual funds and bank deposits masquerading as insurance plans. With just 10% of the invested amount going towards the insurance cover premium and 90% going towards investment, surely the tax rules of the heavier allocation should apply. The government should make up its lost revenue from removing DDT here.

The problem of trying to tax income by proxy of investment income and returns is that the actual taxpaying Indian gets crushed under the burden of direct taxes. The effort to get everyone to pay their due is not just important for the government finances but is also about fairness and rule of law. The feeling that those who follow the law are idiots has not gone away. The unsung heroes of the Indian budget work about four to five months a year for the government if you add income, investment and indirect taxes. Please finance minister, fix this unfairness.

Monika Halan is consulting editor at Mint and writes on household finance, policy and regulation