Last Updated on August 30, 2021 at 4:17 pm
The re-introduction of equity LTCG tax offers not only a chance to clean up our portfolios, but also recognise an important fact: returns from equity may gradually decrease in the next decade or so. No, I am not talking about tax eating away our returns. There are two reasons for this, – one positive and one not so much. We will consider the positive reason in this post.
Yes, the equity LTCG tax (assuming it stays at 10% for a few years) will reduce returns by at least 1% as shown in this study: Equity LTCG Taxation: How much tax do I need to pay? Illustration part 1. So I will now expect 9% from equity (instead of 10%). As explained below, this also means fixed income returns will come down, to about 6-7% after LTCG tax. With that, let us get tax out of the way and consider some history.
In December 2002, the Report of the Task Force on Direct Taxes by a committee chaired by Dr. Vijay L. Kelkar then Advisor to Minister of Finance & Company Affairs was published. Here is a quote.
Our proposals completely eliminate the dividend tax, and long-term capital
gains tax on listed equities in the hands of the investors. These have been recommended with the express purpose of reducing the exorbitant cost of equity capital in our country. These gains or benefits accrue entirely to individual shareholders.
As a result, from Oct. 1st, 2004, Equity LTCG was freed from tax, until it was changed on Feb 1st, 2018 (with effect from March 31st, 2018).
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥
What is the cost of equity capital? It is the return that an equity investor seeks in proportion to the risk that she takes for investing. If the return from investing in a stock is not significantly higher than (1) a risk-free bond and (2) the market itself, there is no incentive to invest in it. The same is also true of the market in general.
According to this survey, the cost of equity in India is about 15% (mid-2017). This is pretty high. So if you think, the government’s decision to reintroduce Equity LTCG tax is unfair or premature, it would be fair from the view point of high cost of equity. As mentioned in The Economic Survey 2017-2018, the government has sensed a shift in capital from fixed income to equity and therefore a loss of tax revenue.
It is perhaps premature because most first-time equity investors have less than zero understanding of volatility and are not likely to invest in 2018 as much as they did in 2017. Anyway, it is what it is.
In 2002, the cost of capital should have been at least 15%* as interest rates were high – although they had witnessed a sharp fall – see the evolution of Public Provident Fund (PPF) Interest Rates. The main difference is, retail participation was insignificant then.
* It should have been much higher as the 90s were a turbulent period as the govt recovered from near-bankruptcy and had to open the economy in exchange for IMF aid
When will our cost of equity come down? It depends on a lot of ifs!
IF long-term inflation in India is down to 4-5%. Then the risk-free return will fall close to that (meaning fixed income will be less rewarding). Then the cost of borrowing will also fall. So will the cost of equity or the expected return for the risk taken (the risk will not change!)
Unfortunately, inflation in India is a tricky multi-factored issue. If the currency is stable, if oil prices are stable, if monsoons do not fail often, if fiscal deficit is low, then we have a fair chance of inflation staying low. Most people will laugh or criticise me if I say this, but I will, since I don’t care: we must disclose all income and pay taxes properly to help keep fiscal deficient and inflation in check. Everything is connected.
Inflation has been low for the last couple of years, but the bank NPAs rocked the stability of the big lender. Banks are not healthy enough to lend at low rates. Again if businesses borrow at a high rate, they have to generate that much more profit to satisfy stakeholders.
I have said it before, I will say it again, we urgently need tax saving corporate debt funds. If we can mobilize retail money into these bonds, it could help lower the cost of capital over a decade or so.
Even though the situation does not look rosy as on date, I think the stage is set for lower inflation and lower cost of equity. This will not affect us in any way because if inflation is lower, then the real return required to beat it will also come down.
While expecting only 2% higher return on equity compared to fixed income (both before tax), will keep us calmer*, in time, it may soon reflect reality once the bank recapitalization and restructuring is completed and PSU disinvestment is in place. The next ten years should be a reasonable guess and it does not matter who comes to power.
* those who can manage to invest more. The rest will have to lower their aspirations.
The era of high interest fixed income is already coming to an end. Small saving scheme rates are now market linked. EPF now invests in equity. Higher income newer employees will not receive EPS pension. NPS is already the biggest mutual fund AMC in the country and growing at the corporate level. Regardless of when the cost of equity decreases with the next few years, at least for higher income group, the only market linked fixed income would make sense. And that is the first step towards lowering the cost of equity.
Unfortunately, those above 50 who have never invested in equity before are the most affected by this transition. They do not have the time to learn, get used to, and suffer the volatility of equity to enjoy the potential high return.
The second reason I mentioned in the first paragraph also has to do with “time”. People talk about the Sensex zooming to 50,000 in future. It will, but our returns will depend on when it will. That is how long it would take to get there. More on this with examples in part 2 – Why “hodling to the moon” will not always work.
It is amusing and perhaps ironic that market volatility lowers equity returns (affecting the cost of equity) but without it, beating fixed income is impossible!
🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 7000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 2,500 investors and advisors use this!
Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
- Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
- Have a question? Subscribe to our newsletter using the form below.
- Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
About The Author
Dr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! ⇐ More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free! One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course! Increase your income by getting people to pay for your skills! ⇐ More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
- Twitter @freefincal
- Subscribe to our YouTube Videos
- Posts feed via Feedburner.
Our publications
You Can Be Rich Too with Goal-Based Investing
Published by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want
This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.Your Ultimate Guide to Travel
This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)