Time's up

Both equity and debt instruments carry investment risk and deserve a uniform tax treatment

The comeback of long-term capital gains tax on equities indicates a reversal of traditional policy formulation. Vehicles with uncertain outlook got preferential rates compared with those with predictable returns. Two arguments were offered in support of removing LTCG tax on stocks in 2005.  The most important justification was to encourage investors to take a longer view. The proposition was that it takes patience, ranging from three years to 10 years, for the investment to show a decent appreciation. The underlying message was only those who have surplus funds to spare should dabble in stocks. Yet the nil tax acknowledged that as the span of staying invested increases, so do the external and company-specific risks. Second, the unequal tax treatment punished trades based on arbitrage opportunities. Such strategies are capable of producing bumper gains in a short period and, hence, a higher tax rate. The nimble-footed participants, moreover, contribute to volatility, scaring the cautious investor as well companies who might want to pricing shares for private placement and follow-on offers, usually a function of historical averages. The higher rate of tax on fixed-income instruments, thus, is a response to the perception of predictable returns. In comparison with share capital, chances of a sharp appreciation or depreciation on debt are rare. The stock market reacts to news, minute by minute. Influencers of money market such as the credit policy and macro economic data dissemination are spaced out. 

Profit on debt is equated with income. Short-term gains are taxed accordingly. Ironically, most credit-worthy issues have coupons barely above inflation. Conceding that the interest rate scenario could undergo a change over a longer time, LTCG attract a lower tax rate with the benefit of indexation.  Even among debt instruments, the rate of tax is different. Interest on fixed deposits is deducted as per the personal tax slab. Indexation is not applicable irrespective of the holding period as banks and companies offer assured returns despite no guarantee about the trajectory of inflation going ahead. Bonds issued by companies and government absorb wide-ranging stimuli. Yields move in tandem with the outlook on interest rates. Prices depend on liquidity besides demand. As a nod to possible volatility, debt traded in the secondary market is categorized into short- and long-term holdings. The tax rate, however, is higher than that on short- and long-term gains from equities. Recent developments have ambushed the conventional theory. Over the last several years, liquidity was flowing into stocks and fixed-income paper from bond-buying by central banks in the developed world after a half-decade-long slump following the credit crunch triggered post September 2008. Indices have been hitting new highs at a pace that is not matching the earnings recovery. Investors in debt funds have been reaping rich gains as sluggish consumption kept interest rates low. The win-win scenario contributed to the perception of ease in making money.

Normally, bonds and equities find hard to coexist.  Investors opt for the safer debt over moody stocks when interest rates start climbing. Ironically, shares displaying exuberance in anticipation of the economy mending start shedding valuations when macro indicators confirm their confidence. Though the linkage has sustained over time, there is no surety that the equation will continue. Till recently, the money market was providing attractive returns in the belief that interest rates will only go down due to the fragile health of most countries even as the stock market was running ahead by betting on economic revival. Central banks by and large are reluctant to disturb the status quo to avoid panic in the financial markets. If they do so, they take care to sound contrite and give direct or indirect warnings on and off. As the developed and emerging nations stand poised to usher growth, the task of the monetary authorities is becoming complicated. Any hint that the economy is gathering pace creates turbulence instead of satisfaction. Dithering triggers even more chaos. Staying put is greeted with relief when the sentiment is bullish and frustration when it is bearish. Of late, the markets are taking away the power of the monetary authorities to shape the landscape. They react to fiscal deficit projections in India and unemployment data in the US to determine the direction of the economy without waiting for the central banks to act. As such it is time to revise the discriminatory tax treatment on equities and debt. Both are prone to sudden and violent movements and deserve a lighter tax touch irrespective of the duration of exposure.

-Mohan Sule