In India, income is taxed under five broad heads, namely salary income, income from house properties, profits and gains from the business profession, capital gains and income from other sources. The major issue that erupted after the budget presentation by the finance minister on 23 July 2024 was the treatment of capital gains, especially the removal of indexation benefits for long-term capital gains (LTCG) from house property, gold and other unlisted assets. According to the finance minister, “(T)his will ease computation of capital gains for the taxpayer and the tax administration.” The government also defended its position arguing that though the indexation benefit has been removed, the LTCG tax has been reduced. Thus, the effective rate of taxation will not be affected. Various estimates have been made by the Income Tax Department and published on social media to show that the incidence is lower with the reduction in the tax rate of LTCG even after the removal of the indexation benefit. However, the whole issue of capital gains taxation is not just about the quantum of tax alone. The issue is far more complex and needs a deeper analysis.
To start with, it is a serious conceptual error to link the issue of indexation with the level of tax rate. Indexation is an economic principle and is about estimating the real value of capital gain for the purpose of taxation at the time of the market transaction. The rate of tax is secondary here. Applying any tax rate on a wrong tax base violates the very basic fairness principle of taxation. This conceptual fallacy needs appropriate correction to ensure that the fairness principle prevails in the matter of taxation of LTCG.
Second, the removal of indexation also violates the equity principles of taxation of long-term capital with different holding periods. The incidence of taxation will depend on the value appreciation and the appreciation of value is directly dependent on the holding period of such assets. Given the market condition and appreciation at a certain specified rate, it is perfectly possible that a person holding the asset for a longer period of time would end up paying more taxes compared to a person holding it for a shorter period. Since both house and gold are also intimately linked to the financial security of Indian households, this is going to impact those who invested in gold and house property and have held it for a long period and intend to market it to realise the gain. This is going to encourage short-term transactions and has the potential to make the real estate market volatile.
Third, bringing parity in the taxation of different asset classes, as mentioned during the budget speech, appears to be a step towards simplifying the tax policy. However, there are practical difficulties in adopting such a practice. Sometimes it is not desirable either. For example, if the indexation of listed securities in the stock market is not possible for the purpose of LTCG, it does not mean the indexation benefit should be removed from house property, gold and unlisted assets in the name of bringing parity.
Fourth, we must not forget that the removal of the indexation benefit will encourage more short-term transactions and under-reporting of capital gains. Since it is well documented in the literature that two sources of black money accumulation are real estate and gold, the removal of the indexation benefit for the purpose of LTCG may encourage short-term speculative activity in the real estate market, which in turn can encourage financial instability. Let us not forget that a decade and a half back, the real estate bubble in the United States led to the global financial crisis.
Fifth, capital gains taxation needs a different lens when it comes to taxation. The capital invested has already been taxed as income. Since investments are always associated with a risk, a lower rate of capital gains is considered the most prudent way of taxing capital gains. Some international experience in this regard may be useful. The country-specific framework of capital gains taxation shows that irrespective of the level of development and taxation, capital gains are taxed at a lower rate than regular income. In all countries, capital gains are taxed when they are realised. Also, some countries tax only 50% of the capital gains. The Canadian example is worth highlighting here. In Canada, capital gains are estimated as and when one sells, or is considered to have sold, a capital property for more than the total of their adjusted cost base and the outlays and expenses incurred to sell the property. In Canada, 50% of realised capital gains (the actual increase in value following a sale) are taxable at a marginal tax rate according to income. There is a capital gains tax (CGT) discount of 50% for Australian individuals who own an asset for 12 months or more. This means that tax is paid on only half the net capital gains on that asset. Some assets are exempt from CGT, such as home.
Thus, given the principles of taxation and the international experience, it needs to be emphasised that a good tax policy needs to be based on three principles: vertical equity, horizontal equity, and the fairness principle of taxation. Vertical equity requires appropriate differences in taxation of people in different economic circumstances; horizontal equity requires equal treatment of people in similar economic circumstances; and the fairness principle requires that the incidence of the tax should fall on the appropriate base. So, the LTCG tax policy needs to be based on the foundationally right principles as described.