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).
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!
Subscribe and join the freefincal Youtube community!
Connect with us on social media
- Twitter @freefincal
- Subscribe to our Youtube Videos
- Posts feed via: Feedburner
- We are also on Google PlusandPinterest
Do check out my books
Get it now. It is also available in Kindle format.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You WantMy second book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at low cost! Get it or gift it to a youngearner
The ultimate guide to travel by Pranav SuryaThis is a deep dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, how travelling slowly is better financially and psychologically with links to the web pages and hand-holding at every step. Get the pdf for ₹199 (instant download)
Free Apps for your Android PhoneAll calculators from our book, “You can be Rich Too” are now available on Google Play!
Install Financial Freedom App! (Google Play Store)
Install Freefincal Retirement Planner App! (Google Play Store)
Find out if you have enough to say "FU" to your employer (Google Play Store)