How New LTCG Tax with STT violates Three Basic Principles of Taxation

Capital gain is an increase in the value of a capital asset that gives it a higher worth than the purchase price. The gain is not realized until the asset is sold. A capital gain may be short-term (one year or less) or long-term (more than one year) and must be claimed on Income taxes. For taxing such income, there are three principles to consider:

  • First, there can be gains or losses when an asset is sold. If gains are subject to tax, losses are eligible for set off.
  • Second, the gain is the difference between the sale price and cost, and a reasonable computation of cost has to be arrived at.
  • Third, not all gains may represent income. An asset may appreciate in value merely due to increase in overall cost of goods, or inflation.

The Budget proposal fails to apply above principles to long-term capital gains from equity, which leaves it open for argument, compromise and modification in the future. A flat rate of tax is also punitive as it fails to honour the primary principle of progressively taxing higher income at higher rates. Determining sources of income and taxing them at the marginal rate applicable to an entity is a simple and equitable principle. This ensures that a tax-exempt investor who earns capital gains is not subject to tax depending on the source of income, but stays at the slab that applies to his overall income.

Arguments that capital gains are earned by money that lies idle, smack of poor understanding of capital markets, and intent to infringe what might have been rightfully earned. They are thus wrong in principle. In taxing income, the recognition of subsequent earning capability of money that has been taxed already is an established principle. That is why rent and interest from property and bonds are taxable, even if bought using post-tax income.

The Government uses tax rates to direct investments and provides incentives. Exempting capital gains, taxing short-term capital gains at 15% instead of the marginal rate, are all specific incentives to encourage equity investments. There is data to show an enhanced level of activity in equity markets since these steps were introduced, but negligible increase in per engage of the population using equity investing as a choice.

Taxing capital gains at a lower rate was intended as an incentive for compliance. The proposed 10% tax also intends to encourage compliance by pointing out how small it really is compared to the gains made on equity.

There is nothing equitable about STT. It is a flat levy and is collected with no regard to income tax slab or status of the payer. Even a tax exempt mutual fund pays it. Its merit is the ease of collection and compliance. A few large business entities are responsible for implementation and it is easy to audit and hold them accountable. Levying STT enabled bringing short term capital gains tax rate from marginal rates to 15% and exempting long term gains.