The morning after

The union budget for the fiscal year 2024-2025 has been read, analyzed, criticized, and apparently brushed aside by the markets. Changes in the taxation of capital gains; changes in the custom duty and capital gain tax structure for gold; and higher rate of STT on derivative transactions are three points that have attracted the maximum attention, especially from the market participants.

I had posted my first impression of the Union Budget FY25 on Tuesday. On a second reading of the budget documents and listening to the views of a variety of experts, I have gathered some more inputs that I would like to share with the readers.

Impact of capital gain tax changes on equity markets

The long-term capital gain tax (LTCG) on sale of listed shares has been increased from 10% to 12.5% and the short-term capital gain tax (STCG) has been increased from 15% to 20%. The market reacted negatively to the announcement initially. However, all the losses were recouped within an hour. This has surprised many market participants who believed that any hike in capital gain tax would be detrimental for the markets.

My thoughts on this are as follows:

(a)   Tax is a function of actual profit gained or loss incurred by an investor. Stock price of a stock is a function of the demand and supply of such stock at a given point in time. Demand and supply in turn are determined by the future price expectations. If a larger number of buyers expect the stock price to rise in future, the demand will stay higher, and vice versa. Thus, if the "return expectations" of investors stay high, stock prices may not correct regardless of the cost of transaction and/or taxation of gains. The market correction may need a bigger reset for a meaningful correction. Tax or STT alone would not do much.

(b)   The capital gain tax structure has not only been simplified, on an average, the effective rates of taxation may be actually lower for many investors. For example, tax rates for STCG on listed bonds, Equity FoF, Gold/Silver ETF, have been reduced and holding periods are also aligned with listed shares. Similarly, tax rates for LTCG on Equity FoF, Overseas FoF, Gold/Silver FoF, Gold Funds, physical gold, unlisted stocks and foreign equity have been materially reduced.

(c)   Contrary to first impression, the budget may be positive for the real estate sector. The effective LTCG on sale of properties may be lower, despite lack of indexation benefit, in a majority of cases. Besides, the likely reduction in stamp duty may benefit the buyers.

(d)   By bringing taxation of listed bonds at par with equities, while keeping bond funds taxable at a much higher rate, the government wants to kick start the growth of the retail debt market, especially after inclusion of Indian government bonds in the JP Morgan bond index.

Gold

The finance minister has cut effective import duty on gold from 15% to 6% in this budget. Besides, the capital gains tax on physical gold, gold funds and gold/silver ETFs has been reduced materially.

These proposals have baffled my market participants. They have argued that this may lead to undue rise in import of gold, this adversely affecting the trade balance. Secondly, bringing LTCG taxation of gold at par with equities and bonds is against the spirit of financialization of domestic savings. It is pertinent to note that the NDA government has strived to financialize gold holdings through Sovereign Gold Bonds and other measures in the past 8 years.

In my view, there could be three reasons behind the proposal to cut tax and duties on gold.

(a)   RBI has been the largest importer of gold in India for the past couple of years. It is likely that RBI wants to further enhance its gold holdings, like the central banks of China and Russia, amidst rising global uncertainties over USD supremacy. Lower duties may help RBI to import gold cheaper.

(b)   The first series of SGBs is coming up for redemption next month. The government wants to redeem these bonds at a 9-10% lower price.

(c)   The policy makers have recently raised the issue of “excessive financialization” of the Indian economy. For example, the latest Economic Survey highlighted, “the financial sector should expand at a pace that is in lockstep with economic growth. In particular, India can ill-afford the economy's over-financing at its current development stage.” Cheaper gold prices may be an effort to set the clock back.

STT

The budget proposes to increase the securities transaction tax on sale of an option in securities from 0.0625% to 0.1% of the option premium, and on sale of futures in securities from 0.0125 per cent to 0.02 per cent of the price at which such “futures” are traded. This is an effective hike of 60%.

This is obviously supposed to act as a deterrent to excessive speculation in derivative trades by retail investors. The finance minister, the SEBI Chairperson and other policymakers have categorically expressed their displeasure over the rising retail participation in the derivative trading.

It is pertinent to note that as per a study conducted by NSE/SEBI over 90% retail traders lose money in their derivative trades.

It is interesting to note that the finance minister has assumed a ~16% rise in STT collection in her budget calculations. This implies that the government does not believe any material reduction in trading volumes at stock exchanges.

Besides, the hike in STT may not serve its stated purpose, as the retail traders treat option trades as lottery tickets. A small absolute hike in transaction cost may not deter them from trying their luck. It is the high frequency traders (HFT or Algo driven traders) who will be affected the most. If this affects their volumes, it may actually have detrimental impact on the entire market. For example, some of the HFTs may shift their base to overseas; the liquidity may diminish materially affecting the returns on arbitrage funds and hedging function.