Why Capital Gains Tax is good for the Economy

Let me state upfront that equities is my favorite asset class and my investing approach is going long.

It may not be so obvious to everyone that income can be converted to capital gains, and if the tax on the latter is lower than the tax on the former there is a perverse incentive to convert income to capital gains.

This has been happening all over the world resulting in two very damaging outcomes:

• Inefficiencies being encouraged and monopolies being created
• Accumulation of non income generating assets resulting in a higher capital output ratio in the economy

The beauty of a free market is that inefficiencies get picked up and penalized. Companies that are no longer performing well slowly die. But a low capital gains tax prevents this from happening. A company with say low return on capital employed can still avoid paying dividends, hold back earnings and let the share price go up. Because the tax on capital gains is low (or even zero), investors do not mind. They do not mind a share price going up by say Rs 15 per annum as opposed to payment of dividend of even Rs 20 per annum because of the tax arbitrage. Therefore there is a perverse incentive for inefficient companies to hoard capital rather than returning them as dividends to be deployed in more efficient and profitable avenues. So, inefficiencies persist and inefficient companies hold back money and grow bigger. The playing field is not level. It is tilted in favor of the big and inefficient.

Because capital gains tax is low, there is a tendency to create unnecessary assets (buying multiple homes etc) especially speculative assets and not income generating assets. Just look at the rent yields of property or dividend yields of stocks. They are both abysmally low compared to even the yield on bank deposits. Besides black money, the biggest factor that is creating this distortion is the gap between income tax and capital gains tax.

So, what is the right thing to do?

If you think from the basics this is such a no-brainer that sometimes one is wondering what the debate is all about. The right thing to do would be not to differentiate between income tax and capital gains tax. However, capital gains tax should be allowed an indexation benefit to offset inflation during the period between the purchase and sale of an asset. By this you even kill the artificial difference between long term and short term. So, for example, if you buy an asset for say Rs 100 and sell it for Rs 160, then the capital gains is Rs 60. However if the inflation index has gone up by say 40% in the period then after indexation the capital gains is only Rs 20 and this should be taxed.

In conclusion

These artificial differences between income tax and capital gains tax; between short term capital gains and long term capital gains create unnecessary distortions which create perverse incentives and wasted decibels. Keeping things simple and correct is the only way. But vested interests (the super rich) across the world have ensured that this does not happen. They have created a false impression using sophisticated arguments that capital gains somehow needs to be treated differently from income and if they are treated the same then entrepreneurship will die. On the contrary entrepreneurship will thrive and speculators and financial investors would suffer!

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Coming soon: "Cutting the Gordian Knot - India's Journey Towards Good Days"