However, it needs to be highlighted that indexation of long term capital gains is a must in all cases – past as well as future. Not only do proper valuation principles require indexation but it is also critically needed to promote social security and economic growth of the country.
LTCG should be taxed at a significantly lower rate than regular income. However, this is not sufficient. Indexation is also needed while calculating the gains on long-term capital investments.Encourage investment: Taxing LTCG at a lower rate encourages individuals to invest in real estate, stocks, and bonds for the longer term. Long term investments are essential for economic development, growth, job creation, and supporting innovation. Such investments are less speculative and more beneficial to the economy. The tax on gains earned after long holding periods must consider patience and commitment over extended periods, risk, and inflation. Therefore, tax policy on such profits should recognize the averaged-out effect of a multiyear holding period.
Inflation Adjustment: Capital gain also includes an increase in the value of an asset due to changes in price levels. Infact, most of the gain may be in the form of preservation of purchasing power. Nominal gains on such investments must be inflation-adjusted to know the real gains. Otherwise, one would be penalized by having to pay tax in circumstances where one has not made any real gains. Indexation is the way to provide a reasonable estimate of tangible gains. Therefore, it is necessary that LTCG tax is levied after indexation.
Economic Stability: Lower tax on gains from long-term holdings would encourage one to stay invested over the years rather than doing frequent short-term trading. This incentivizes investors against speculation, resulting in more stable financial markets. However, if inflation rate is high, short-term holding periods and speculation will become more attractive without indexation benefits for long-term holdings.
Long term Capital Gain Income Long-term investments have two essential features. First, blocking of capital for the long term. Therefore, long term financing using borrowed funds and opportunity cost of owned of capital become relevant. The interest cost for longer tenure loans taken to acquire property may often equal the acquisition price. The patience required for this and the nature of risk due to long-term commitment must be rewarded. Hence, there is implicit cost and factoring cost of capital is important for estimation of gains. Second, in case of investment in property or real estate, taxes, insurance, repairs, maintenance, security and safety and upgrade expenses are incurred to keep the property functional and worthy.
Hence, the level and nature of risk, recurring cost and financing cost for long-term investments are higher and different. Both types of expenses may exceed the original acquisition cost for older property. Individuals may not keep proper records and accounts of such expenses. These aspects are often ignored when estimating LTCG. Lower tax rates are not enough to estimate gains fairly; hence, indexation benefits are the only way to be fair and rational in levying tax on LTCG.
Attracting Foreign Capital: A developing economy like India requires a humongous amount of capital for economic and social development and infrastructure, which can only be met by encouraging long-term foreign capital. Lower capital gain tax can attract more capital and increase international competitiveness. However, given the higher inflation rates in the host country compared to the home country of foreign investors, the value of investments is ravaged. Indexation provides fair and accurate estimates of long-term capital gain after adjusting for inflation. With indexation, investors would avoid paying tax on nominal gains on top of losing purchasing power.
Social security and retirement: Home ownership is a matter of social security and financial safety during retirement in countries like India. Individuals also need to save for their retirement. Only option for retirement saving is staying invested for the long term. In India, where social security is inadequate, guaranteed pension benefits are systematically withdrawn. Investments in real estate and long-term financial investments are critical avenues for the ordinary person.
Valuation Perspective
Cost of Capital: India has higher cost of capital due to higher interest rates and higher inflation. As an emerging economy, risks are also higher. Investors expect higher return on equity, debt and thus over all a higher rate of return is expected. One may make nominal profits but profit in economic terms only occurs when investor earns return higher than the expected rate of return, which is cost of capital. Over longer periods the compounding effect on present value is immense. Simply reducing tax rate on LTCG is not enough. To estimate economic profit correctly, indexation can, to an extent, factor in the cost of capital for different amounts and holding periods and thus the compounding effect on present values.
Time Value of Money: The time value of money is an essential financial concept that holds that money in the present is worth more than the same sum of money to be received over a period in the future. This is because the money that you have right now can be invested to earn a return. However, inflation diminishes its purchasing power, and risk further depletes expected value. As per financial wisdom, the profit on a long-term investment must be arrived at after considering the time value of money. Removing indexation penalizes individuals, investors, and businesses in a country like India, where the inflation rate is high and unstable.
Conclusion: The amendment tabled in the finance bill is a welcome move as it will provide an option to choose between LTCG tax of 20% with indexation or 12.5% without indexation for property. It would encourage honest tax payment, long-term investment and fair play. However, removal of indexation benefit for properties bought after July 23, 2024 and other Long Term Assets classes must be revisited in the light of the factors discussed. Indexation benefits should be inevitably allowed on all types of LTCG before levy of tax. The policy must empower one to choose the best option for Sabaka Sath, Sabaka Viswas, and Sabaka Vikas. The amendments tabled would be fair only if they are made applicable for all asset classes and future also.
(The author is a professor of finance and accounting at IIM Indore. Views expressed are personal.)