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Rethinking Tax Treatment of Capital Gains from Securities

In July 2004, the United Progressive Alliance government removed long-term capital gains tax and introduced a tax on transactions. There are good reasons - on grounds of revenue, efficiency and equity - to reconsider the abolition of the capital gains tax.


Rethinking Tax Treatment of Capital Gains from Securities

In July 2004, the United Progressive Alliance government removed long-term capital gains tax and introduced a tax on transactions. There are good reasons – on grounds of revenue, efficiency and equity – to reconsider the abolition of the

capital gains tax.


“Sensex spurts 426 points to close at

a record 14,057 (on January 12,

2007)” reported the front page headlines of newspapers on January 13. The day’s rally also made investors richer, said the report, by about Rs 1.10 lakh crore with BSE’s market capitalisation at Rs 37.41 lakh crore.1 Two years ago (March 2005) the BSE index stood at 6595 and market capitalisation at Rs 16.61 lakh crore.2 That means an accrual of capital gain of Rs 20.8 lakh crore to holders of listed equities in the country registering an increase of over 200 per cent in the course of just two years.3

Under the law as it stands after the changes made by the first budget of the UPA government in July 2004, none of these gains would be taxable to income tax if realised over a “long term”, i e, after a holding period of more than 12 months. Tax at the rate of 10 per cent will apply if the equities are traded within the year of their acquisition. Earlier such gains – called “short-term capital gain” (STCG)

– were taxable as ordinary income of the taxpayer and taxed accordingly while long-term gains were taxed at 20 per cent flat with indexation, depending on the period of holding, or 10 per cent flat. Given that asset holding in India, as in most countries, is more sharply skewed than income and there is no transfer tax either at death or by gifts4 the implication of the phenomenal surge in the stock price index is not hard to imagine. Even allowing for the fact that economic growth is often accompanied with some accentuation of inequalities that should be a matter of some uneasiness to policymakers aiming at “inclusive growth”, and wanting to maintain some progressivity in the tax system in the interests of a stable society.

While abolishing the tax on long-term capital gains (LTCG) from transactions in securities and reducing the tax on shortterm gains to 10 per cent, the finance minister had proposed to levy instead a “small tax on transactions in securities on stock exchanges” (STT). The rate proposed was 0.15 per cent of the value (sale price) of the securities. This, he claimed, would be a “win-win situation” for all concerned presumably meaning it would bring some revenue and also meet the ends of equity and efficiency. It is time some stock was taken of how far this expectation has been met by the experience of the last two years.

Revenue Implications

So far as revenue is concerned, it is difficult to make any definitive judgment about the impact of the change in the absence of requisite data. We do not have any information on how much of the accrued gains are realised on the sale of securities every year and of them what proportion is long term and how much short term, or what is the distribution of the realised gains among different income groups. Nor is any reliable data available on the revenue that had accrued to the exchequer from the tax on capital gains from securities during the years prior to 2004-05.5 Thus the revenue impact of the changes made in the scheme of CG tax on securities cannot be estimated with any degree of precision. However, based on plausible assumptions some estimates can perhaps be made.

According to figures given in the RBI’s Annual Report, the value of equities traded on the BSE during 2005-06 was of the order of Rs 8 lakh crore. Value of actual deliveries, however, was of the order of Rs 6.8 lakh crore.6 Assuming that 50 per cent of this, that is, Rs 3.4 lakh crore was on account of securities held for more than one year, and the capital gains realised from the sale thereof was no more than 50 per cent of their sale price or 100 per cent of their price on acquisition – a conservative assumption – the LTCG arising from the transactions can reasonably be taken to have been not less than Rs 1.7 lakh crore (even setting off losses from some equities). After allowing for the possibility that a part of the equity holdings were by FIIs of whom some are based in tax havens like Mauritius, one arrives at a figure of Rs 1.4 lakh crore liable to be taxed at LTCG.7 At a flat rate of 10 per cent which was applicable earlier to gains without indexation, a revenue of Rs 14,000 crore would have accrued to the exchequer from the tax on LTCG had no change been made.

This leaves out the revenue impact of the introduction of a flat 10 per cent tax on short-term gains instead of treating the gains as ordinary income. Assuming that the element of gain from equities traded during the year that were of the short-term category was only 20 per cent of the sale price, Rs 68,000 crore (20 per cent of Rs 3.4 crore) would then have come under the tax net as STCG. Assuming also that three-fourths of this (i e, about Rs 51,000 crore) would have gone to shareholders in the top income brackets, at a marginal rate of 30 per cent applicable to them around Rs 15,000 crore should have accrued to the exchequer as revenue. Taking the tax on both ST and LT gains, Rs 29,000 crore would have come to the exchequer had no change been made in the CG tax regime.

As against this, revenue from STT in 2005-06, it is gathered, came to a little above Rs 2,500 crore. Assuming that at 10 per cent rate, tax on STCG yields about Rs 5,100 crore, the net revenue cost of the changes may be put at not less than Rs 20,000 crore. The figure would of

Economic and Political Weekly January 27, 2007 course vary depending on the assumption one makes regarding the proportion of long-term and short-term holdings delivered in the market and the gains realised on their sale. But it is unlikely to be made up by STT and the STCG tax now in force. Thus, apart from being a tax of a different character – being essentially a tax on sales with all its distortionary effects, unlike a destination-based VAT – revenue-wise, STT and 10 per cent tax on STCG, are far from substitutes for the tax on capital gains.8


Revenue, however, cannot be the sole consideration for tax policy although for a resource stressed government that does or should matter. Equity and efficiency must also be taken into consideration.

From the equity angle, if it is to represent the best single index of taxable capacity, then income should include all ingredients of accretion to economic power and there can be no case for excluding capital gain from the income base for taxation. A conceptually pure income base should include capital gain on accrual itself and that was the rationale behind the comprehensive definition of income as made up of increments in the value of wealth between two points of time and the consumption of the taxpayer during the period known as the Haig-Simons definition. Exclusion of capital gain goes against this logic and offends both horizontal and vertical equity.

However, as is well recognised, implementing the concept of comprehensive income as the tax base presents practical problems requiring as it does valuation of assets at the beginning and at the end of the year. There is also the problem of getting taxpayers to pay the tax without realising their gain from asset appreciation. Hence income tax systems all over the world proceed by taxing incomes when they are realised. But this results in “bunching” and so under a system of progressive taxation, taking gains accruing over several years in the year of realisation, may give rise to inequity to taxpayers in lower income brackets. Arrangements are usually made to alleviate the inequity in various ways such as with a lower rate of tax or by excluding a portion of the gain from the tax base and indexation for inflation. But all these create an incentive for dressing up ordinary income as capital gain. One has only to look up the cases that came up before the Privy Council and later the Supreme Court to decide whether a given receipt is income or capital under the Indian income tax law. In the US the practice of “bond washing” and “stock dividends” bear testimony to the problems that arise for tax administration when capital gains are treated differently from ordinary income.

Conceptually too the line between the two is rather tenuous. As Samuelson pointed out in his illuminating article on the nature of income,9 the distinction in fact arises from the practice of measuring income on a calendar year basis. With a short enough accounting period all incomes would turn out to be capital gain while with a sufficiently long period for income accounting all capital gains would take on the character of ordinary income.

Since 1956 Indian income tax recognises the logic of having capital gain in the tax base but also seeks to provide relief for bunching and inflation in various ways such as through partial deduction, lower rate of tax and so on.10 Attempts are also made to use the system of capital gains tax to promote non-tax objectives by allowing tax free roll-over for gains invested in specified assets (e g, bonds issued for financing infrastructure, etc). The exemption for LTCG from securities and concessional treatment of short-term gains are, however, prompted primarily by considerations of equity and one suspects the feel good factor that a buoyant share market generates for investors.

The equity argument for exempting CG from securities was put forward most succinctly by the Kelkar Task force (KTF) on Direct Taxes on whose recommendation the exemption for LTCG on listed securities was apparently based. The main plank of the argument was that corporate profits bear taxation in the hands of the companies. Profits after tax either get distributed as dividend or are retained by the company; capital gains are a reflection of the latter. Hence taxing either dividend or capital gains from sale of shares when corporate profits are taxed, it was argued, amounts to double taxation.

The double taxation argument, however, loses ground when, as is often the case, the effective tax rate on corporate incomes happens to be lower than the statutory rate because of the myriad tax breaks available for businesses. KTF sought to counter this argument by contending that with the reforms proposed by them for ending the “exemption Raj” the gap between statutory rate and effective rate would vanish and so the double taxation argument would hold.



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Economic and Political Weekly January 27, 2007

It needs to be noted, however, that the tax on corporate profits is rarely if at all borne entirely by the equity holders. Depending on the market conditions a part is passed on to consumers of the product of the companies (“forward shifting”) while a part of it is also shifted backward with lower production and cuts on wages and/ or employment. Besides, the KTF’s recommendations notwithstanding, quite a few of the tax breaks for businesses remain on the statute book and some sumptuous ones are in the offing with the setting up of the special economic zones (SEZs). Even the dividend distribution tax currently in force which is supposed to take care of the gap between the statutory and the effective rate of tax on company profits (though in a regressive way) will not apply to dividends distributed out of profits of companies located in an SEZ.

It is also pertinent to note that capital appreciation of securities often reflect not only the undistributed after-tax profits of companies but also the expectation of profits in the future. A good part of the capital gains is thus in the nature of a pure windfall for equity holders. Thus the equity case for totally exempting the capitalgains from securities on the double taxation plea stands on weak ground. If at all, there can be a case for some concessional treatment of capital gains from securities but not total exemption as has been granted now to LTCG from transactions in securities.

Efficiency Arguments

The plea for exempting CG from taxation sometimes takes another tack. Since the tax is levied unavoidably on realisation, leaving it to the asset holder to decide when to realise the gain, CGT, it is argued, inhibits realisation thereby creating a “locked-in effect”. And that, it is contended, goes against efficient use of company surpluses, risk taking and investment. While not denying that capital gain exemption would make the rich richer advocates of a zero or low rate of tax on CG claim that it would stimulate the flow of new investments, new venture capital will “come out of hiding”, technological advances would accelerate and economic growth would “soar”. As a result of the locked-in effect, an individual may hold on to his assets whereas there may be others who would value them more, causing what is called “exchange inefficiency”. By inducing realisation, lowering the rate of tax on capital gains, it is also said, may bring more revenue apart from promoting more efficient use of resources.

The adverse impact of the locked-in effect is contested by economists by pointing out that there is no “very direct or strong relationship between the effect of the capital gains tax on the performance of the stock market and the decisions made by managers and owners of firms concerning… investment and production”.11 A comprehensive survey of empirical studies on the issue finds “considerable uncertainty in attempting to determine the effects of capital gains tax cuts on saving, investment and growth and concludes that the effect on domestic investment and growth is likely to be quite muted” and further, “it is rather unlikely that such a (cut) will result in a significant increase in economic growth”.12

As for the revenue impact an earlier study by Alan Auerbach, a leading fiscal economist, had concluded: “The behavioural effects of capital gains taxes are too uncertain for precise revenue calculations, but there is very little reason to expect that a reduction in capital gains tax rates would raise revenue”.13 A more recent study on capital gains realisations and tax rates, using data covering the period 1986-97 finds higher long-term elasticities than reported in many previous studies. But the estimates decrease substantially when the effect of the reforms of 1986 are removed.14

The strength of the locked-in effect not being all that clear it is not certain that CG tax rate cuts raise more revenue by inducing asset holders to realise their gain in greater measure. US evidence suggests that the revenue maximising rate of CG tax probably lies between 19 and 28 per cent.15 It is interesting to find that the volume of trading in both the BSE and NSE to the value of the stocks (market capitalisation) has gone down quite sharply since 2004-05, i e, after the concessions/exemptions for the tax on CG from securities were announced.16

While there is no perfectly satisfactory way of its taxation, capital gains are subject to tax in the income tax system of almost all countries, with, however, concessions in some form or other. Treatment of CG on corporate stocks is a particular source of uneasiness when corporate incomes are taxed in the hands of the companies and dividends are also taxed out of after tax corporate profits but as pointed out earlier this argument has its pitfalls.

US Practice and Current Thinking

The arguments for and against CG taxation figure prominently in the debate over the tax treatment of CG that has gone on for years in the US and constitutes a big bone of contention between the Republicans and the Democrats.17 During the 1940s, 1950s and 1960s, capital gains were taxed in US effectively at a top rate of 25 per cent when the top rate of personal income tax was much higher. With the reduction of the top IT rate under the reforms of 1986 – the Reagan reforms – to 28 per cent the tax rate on capital gains also was equalised at 28 per cent. It remained at that level thereafter for some years even when the top income tax rates were raised. In 1997 the US CG tax rate was brought down, for high income tax payers from 28 to 20 per cent and for those in lower brackets from 15 to 10 per cent. Currently, capital gains from both corporate and non-corporate investments are taxed at a maximum rate of 15 per cent; for taxpayers in the lower income brackets the rate is 5 per cent. Canada, Australia and UK all levy tax on capital gains on realisation with arrangements to take care of bunching, inflation and so on.

Taxation of dividends and CG figures prominently in the report of the Tax Reform Panel set up by president George Bush in 2005 to recommend measures to reform the tax system to make it “simpler, fairer and more pro-growth”. In its report submitted in November 2005 the panel offered two variants of its proposals for reform, the Simplified Income Tax (SIT) Plan and the Growth and Investment Tax (GIT) Plan. To avoid double taxation of corporate incomes that is believed to occur under the system that prevails in US whereby dividends are taxed even when distributed out of taxed profits – the “classical system” as it is called – SIT proposes inter alia, to exclude, from the taxable income of shareholders dividends distributed out of the profits of a corporation on which tax is paid in US. In the case of CG however the SIT would exclude 75 per cent of CG received by individuals from sale of US corporation stocks if held for more than one year. This would mean such gains would be taxed at a maximum rate of 8.25 per cent. CG from all other assets would be taxed like other incomes subject to some relief for home owners. The GIT plan on the other hand

Economic and Political Weekly January 27, 2007 would tax dividends, capital gains and interest at a flat rate of 15 per cent.

Concluding Observations

The US president’s tax panel’s proposals have not been acted upon but have come in for some rather sharp comments from fiscal economists.18 The main criticism seems to be that it is a hybrid – an “awkwardly blended system” skirting the most fundamental choice of the tax structure – income tax vs consumption tax.19

However, the suggestion of the GIT plan of the panel to tax capital income at a lower rate than labour income is in line with a worldwide trend. A system of “dual income tax” is now prevailing in the Nordic countries whereby capital income is taxed at a low flat rate while a progressive rate schedule applies to income from labour. This reflects the recognition that in a globalised world no country can afford to tax capital at a rate higher than prevailing elsewhere. Besides there is also the concern about double taxation of savings and the definitional and measurement problems associated with taxing income from capital. Kaldor’s suggestion for switching over to expenditure as the tax base rather than income sought to address these problems. For various reasons Kaldor’s scheme did not find favour and experiments with expenditure tax ended soon. The recent trends seem to be moving in that direction again.

However, until one moves completely towards a system of consumption tax, exemption LTGG from securities totally from tax does not stand to reason from any account, either revenue or efficiency or equity. Soft treatment of short-term CG clearly violates equity. The tax regime for capital gain no doubt has to maintain a delicate balance between equity and efficiency and so LTCG cannot be treated on the same footing as ordinary income but for reasons advanced above, the total exemption for LTCG is not warranted even allowing for the possibility of some double taxation of corporate profts. Some enhancement of tax on STCG also is desirable to discourage FIIs from too frequent turnover of their holdings. That would also act as a check on the unhealthy volatility in the stock markets which the operations of FIIs tend to generate.20

Admittedly, given the mobility of capital in a globalising world, we have to live with the reality that until a full-fledged consumption tax replaces the income tax capital incomes will be taxed at a relatively moderate flat rate. However, consistency demands that dividends and capital gains are treated similarly. The present practice in India of levying a tax on dividend distribution while exempting LTCG from securities traded in the stock exchanges and taxing STCG at a lower rate than applicable to dividend distribution is inconsistent and illogical. A tax of 15 per cent on both dividend and LTCG would remove the anomaly. In equity, LTCG should be taxed at a higher rate since as noted earlier, much of it represents windfall gains for the investors. As for STCG, in principle all STCGs should be taxed as ordinary income, whether from securities or other assets.

Notice should also be taken of the immense concentration of wealth that is occurring and consideration should be given to reimposing the tax on transfers – estates duty and gift tax – a point forcefully made by Auerbach in his critique of the US tax panel’s proposals.21

A fresh look needs to be taken of the provisions governing taxation of CG from other assets as well. The provisions have been cluttered up with all kinds of exemptions and concessions and safeguards to prevent abuse. These provisions comprise no less than nine lengthy sections,22 occupying nearly 20 pages of the Tax Manual.23 It is to be hoped the simplification of the income tax law now under way will do something to simplify and rationalise the provisions governing the taxation of CG as well.




1 Times of India, January 13, 2007. 2 Reserve Bank of India Annual Report 200506, Appendix Tables 45 and 46,

3 Allowing for new issues during the two years of about Rs 30,000 crore each year (vide Table 2.1, SEBI Annual Report, Part Two, p 32).

4 Transfers by gifts or inheritance require some fees/stamp duty for obtaining succession certificates or probate of will. Revenue from these fees/duties however is not very significant.

5 All India Income Tax Statistics gives the number of returns, gross income from capital gains and gross tax by range of income from capital gain under short term and long term. But it provides no idea of the gains asset group-wise like securities, real estate, etc. Doubts also persist about the reliability of the data as it seems these are not collected on a systematic, statistically sound basis.

6 SEBI’s website and annual reports.

7 Net investment by FIIs during the three years 2002-03, 2004-05 and 2005-06 was of the order of Rs 45,000 crore. Of this, roughly onethird was from Mauritius, vide Table 1.76 of

SEBI’s FII Trends Trends.

8 It may be argued that STT nets in some tax from transactions which would escape CG tax for non-reporting etc. However, with “demat”, recording of transactions in securities should now be fool-proof.

9 ‘Evaluation of Social Income, Capital Formation and Wealth’ by Paul Samuelson, in Lutz and Hague (eds), Theory of Capital, 1961.

10 Capital gains were brought under taxation in India for the first time in 1948-49 but was discontinued soon after and was reintroduced only in 1956-57.

11 Economics of the Public Sector by Joseph Stiglitz, Norton, 1999, p 595.

12 ‘Economic Analysis of Capital Gain Taxation: Realisations, Revenue, Equity and Efficiency’ by George Zodrow, Tax Law Review, 1993.

13 ‘Capital Gains Taxation and Tax Reform’ by Alan Auerbach, National Tax Journal, September 1989, Vol 42, No 3.

14 ‘Capital Gains Realisation and Tax Rates: New Evidence from Time Series’ by Mathew Eichner and Todd Sinai, National Tax Journal, September 2000, Vol 53, No 3.

15 The US Income Tax by Michael Graetz, Norton 1999.

16 Here are the relevant figures:

Turnover/Market Capitalisation (Per Cent) 2002-2003-2004-200503 047 0506

BSE 55 42 30.5 27 NSE 115 98 71.9 55.8

Source of basic data: RBI Annual Report 2005-06, Appendix Table 46.

17 For a delightful account of the controversy over the tax treatment of capital gains in the US, see Graetz, op cit.

18 ‘The Tax Reform Panel’s Report: Mission Accomplished’ by Alan Auerbach,Economists’ Voice(, December 2005.

19 ‘Tax Reform for Grown-ups’ by Joel Slemnod, Milken Institute Review, 8(1) First Qr 2006, pp 16-27.

20 The recent decision of the Advance Ruling Authority in AAR Nos 678-688, and associated cases holding that gains from transactions of FIIs in securities in India should be treated as capital gain and not business income clears the way to levy LTCG tax on FIIs. However, it has evoked some adverse reaction from foreign investors (Economic Times, January 17, 2007). The impact of this ruling is yet to be known. Going by the FIIs’ net investment in the last few years however, it would appear that the FII flow is not all that responsive to CG taxation. Giving total exemption for LTCG, does not speak too well of a tax system. Excessively soft tax regime for sectors like IT, is a source of embarrassment to business leaders like Narayan Murthy (Economic Times, January 18, 2007).

21 Auerbach op cit.

22 Sections 54, 54B, 54D, 54E, 54EA, 54EB, 54F, 54G, and 54H of Income Tax Act 1961. Costs and benefits of these provisions are unknown. The tax expenditure analysis presented with the budget each year provides no idea of the revenue cost of concessions in capital gain tax.

23 Vide Taxman’s Income Tax Act.

Economic and Political Weekly January 27, 2007

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