By Sandeep Parekh*
The budget in India, an annual circus held by the Finance Ministry on the last of each February, has done a good job at entertaining its prime audience, the Indian middle class - again. Since 1992, the annual budget has ceased to be an event which was looked at with fears of extra income, customs and excise levies. People in those days would stock items before the budget in expectation of increased prices and taxes. The reverse has been true since the calamitous period between 1990 and 1992 when the government went nearly bankrupt on the foreign exchange account. Now, for instance, and in contrast, the number of cars bought in the month of February drops on optimistic expectations of lower levies, only to pick up again in March.
This trend is a result of a timid but sure process of liberalization and integration with the world markets. Liberalization dictated by economics was supplemented over the same period by lower tariffs mandated by the entry of India into WTO. Despite a severe reprimand by economists who have condemned the high deficit levels there is much to cheer about for the average Indian who can look forward to cheaper goods and lower taxes on income. However, the stock market has expressed its disagreement and it has done so with its feet. The benchmark index Sensex fell by over 5 % since the budget day.
This seeming contradiction, given the past years’ correlation of middle class euphoria and a bullish stock market, can at least partly be explained with the change in the capital gains tax levy. India has a capital gains tax on sale of securities. For securities held for over one year the gains are termed as long term capital gains and there is a lower incidence of tax than business income or short term capital gains tax. With this year’s budget, securities purchased in this financial year qualify for an exemption from long term capital gains tax if sold after one year. Thus there is a tax imposed on selling in this year in two ways. First, securities bought in the last fiscal and sold this year would be liable to the tax. Second, securities bought and sold in this fiscal would also be taxed, and in fact at a higher rate than those bought in the previous year since the holding period would be less than one year. What would be exempted would be securities bought in this year and held for over one year.
This creates a tax regime which would support the markets on the downside for the fiscal 2003 by penalizing sales in this year and rewarding purchases this year but not sold during the year. Theoretically, this is great planning by the finance minister Mr. Jaswant Singh. In an uncertain year of war, high oil prices and fiscal deficit the government does not want to eliminate capital gains and have people dump investments in equities in favor of other more secure saving avenues.
So why has it not worked as planned? There are several palpable reasons. First, the financial institutions and foreign institutional investors which are very active in the Indian capital markets are not affected. Being in the business of buying and selling shares most of them do not pay capital gains tax but are charged tax on business income. Second, the markets are following the proverbial cliché ‘You can take a horse to the water, but you can’t make it drink’. If people are averse to risk in this economic scenario, no amount of tax break will make them assume that risk by buying more securities. Thirdly, with this limited exemption, people are unable to sell past holdings and reinvest in other securities. To do so would tax the past purchase while granting an exemption only in the distant future. This has affected liquidity and has created a situation where there is a disincentive to trade in the markets. While thinner markets do not mean lower stock prices, coupled with the other factors, the bearishness of the markets has been amplified. Finally, people reacted adversely when their expectation that capital gains would be eliminated was not met.
Is there a way out for the unhappy minister who has been cheered by the media but not by the markets? It is possible to retain the benefits of the planned scheme and yet provide more incentive to people to invest and trade in equities. This could be done by allowing people to sell equities and pay no capital gains tax if the same amount is reinvested in other equities in the same year. This could address the problem of liquidity and the concern of people with no additional appetite of equity risk. On the sell side, such a regime would reduce the scope of a downside since exiting altogether from the equity markets would be an expensive proposition and on the buy side, it would still encourage new entrants into the market with future tax benefits.
Biographical note: Sandeep Parekh has done his Masters in Law, LL.M. (Securities and Financial regulations) from Georgetown University, specialising in Securities and Financial Regulations. He has worked briefly for the Securities and Exchange Commission in Washington, D.C. and has worked in the firm of Wilmer, Cutler and Pickering in Washington DC. Sandeep is admitted to practice in New York and New Delhi. He is a visiting faculty at the Indian Institute of Management, Ahmedabad where he teaches a course titled Securities Regulations.
* Advocate, LL.M. (Securities and Financial Regulations), admitted to the New York bar. Visiting Faculty, Indian Institute of Management, Ahmedabad.