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).
🔥Secure your future with our Robo-advisory tool trusted by over 3,500 investors and advisors. From effortless retirement planning to funding your children’s biggest dreams, turn your financial goals into reality. 🔥
Subscribe for money management solutions via email! (Link takes you to our email sign-up form) Join 32,000+ readers in our community.
👉 New Tool Alert! NaviPlan: A Privacy-Focused Multi-asset Tracker and Goal Planner 👈
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!
We are on Google News
Use this button to add freefincal.com as a preferred personal finance source on Google News.
Explore 1,400+ videos on YouTube!
Subscribe to get posts via email!
Join 32,000+ readers and get free money management solutions delivered to your inbox! (Link takes you to our email sign-up form)Join our WhatsApp Channel
Explore our products
🔥Join our community of 9000+ users! 🔥- Use our Robo-advisory Tool to create a complete financial plan! More than 3,500 investors and advisors use this! Use the discount code robo25 for 20% off. Plan your retirement (early, normal, before, and after), plus non-recurring financial goals (such as child education) and recurring financial goals (such as holidays and appliance purchases). The tool helps anyone aged 18 to 80 plan for retirement, plus six non-recurring and four recurring financial goals, with a detailed cash flow summary.
- Our Flagship Course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! More than 3,500 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 conditions! Watch the first lecture for free! One-time payment! No recurring fees! Lifelong access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
- Join the freefincal investor circle! An exclusive space for investors, advisors, fintech employees and students to access financial planning and insurance tools, mutual fund and stock analysis tools, coding strategies and Excel macros for data extraction. 750+ members are now part of our investor circle.
- Increase your income by getting people to pay for your skills! More than 900 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 seeking more clients through online visibility, or a salaried individual looking for side or passive income, we will show you how to do it by showcasing your skills and building a community that trusts and pays you. (Watch the 1st lecture for free). One-time payment! No recurring fees! Lifelong access to videos!
- Portfolio Tracker! Track your mutual funds and stock investments with our Google Sheet!
- We also publish monthly screeners for
Our Podcast: Let's Get Rich With Pattu
On Spotify: Let's Get RICH With PATTU! Every single Indian CAN grow their wealth! On Audible: Listen to the Let's Get Rich with Pattu Podcast
Listen to the Let's Get Rich With Pattu podcast on YouTube.
Now watch Let's Get Rich With Pattu தமிழில் (in Tamil)!About The Author
Dr M Pattabiraman giving a lecture
- 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 14 years of experience publishing news analysis, research and financial product development. He has over 28 years of teaching and research experience. He is also a public speaker and keynote presenter.
- He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free, AUM-independent investment advice.
- Connect with him via @pattufreefincal on X LinkedIn YouTube
- Pattabiraman has co-authored three print books.
This book helps you ask the right questions and find the right answers. It also includes nine online calculators to create custom solutions.
(2) Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want. 
Both the boy and girl versions of "Chinchu Gets a Superpower".
Most investor problems stem from a lack of poor decision-making. We made bad decisions and money mistakes when we started earning, and we spent years undoing them. Why should our children go through the same pain? What is this book about? As parents, what if we had to groom one ability in our children that matters not only for money management and investing but for every aspect of life? My answer: Sound decision-making. So, in this book, we meet Chinchu, who is about to turn 10. The story follows what he wants for his birthday and how his parents plan it, while also teaching him key ideas about decision-making and money management. What readers say! 
Feedback from a young reader after reading Chinchu Gets a Superpower!
Must-read book even for adults! This is something that every parent should teach their kids right from a young age. The importance of money management and decision-making based on their wants and needs. Very nicely written in simple terms. - Arun.
About freefincal & its content policy
Freefincal is a News Media organisation 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: To get in touch, please use our contact form. (Sponsored posts or paid collaborations will not be entertained.)Our publications
- Your Ultimate Guide to Travel. This is an in-depth exploration of vacation planning, including how to find affordable flights, budget accommodations, and practical travel tips. It also examines the benefits of travelling slowly, both financially and psychologically, with links to relevant web pages and guidance at every step. Get the PDF for Rs 300 (instant download)
- How to profit from content writing: Our ebook is for those interested in getting a side income via content writing. It is available at a 50% discount for Rs. 500 only!