Many years ago, on a vacation in Singapore, I was surprised to see the number of babies all over town. It looked like a baby boom in the city state. Cute, chubby babies everywhere. You can take the journalist out of the office on a holiday but you cannot take the office out of the journalist. So I dug deeper, asked people we knew, spoke to some locals and found that the government was worried about the falling population numbers and used taxes to solve this problem. The Parenthood Tax Rebate is a tax break given to tax residents to nudge them into making babies.
India’s new finance minister is crowdsourcing ideas for the budget and I want to suggest reworking the capital gains tax structure to nudge Indians into making the right choice in their asset allocation and product choices. The current tax matrix does not follow a first principle approach and is the result of annual tinkering with the rates and rules. There are two parts to this argument. First, the definition of what asset becomes “long-term" is crucial from a financial planning point of view. India has this definition backwards where we call a one-year holding period for equity as long-term, real estate goes long-term at two years and debt profits at three years. Unfortunately, tax policy has been made by people who sat on defined benefit pensions and had no personal understanding of market-linked financial products. They relied on theoretical models and academic versions of what households do. The result is the current mess. Financial planning 101 is that you use bonds and fixed income for either generating current income, for example, for the retired or for short- and medium-term money needs like a down payment of a home in two years or a college fee fund in the next three years. Long-term on this asset class should kick in after one year and not three.
Equity went “long-term" at year one, but this is an asset that is part of the long-term holding of a household and builds wealth. Long-term should kick in on, or after, the seventh year, given the data that a seven-year holding period for a broad market index in equity reduces the risk of volatility. There is a gradual slide down to a zero long-term capital gains status at the end of year seven. Tax equity profits as short-term till the seventh year. Have the rates slide down over the short-term tenure such that rates are high in year one and go down towards zero over the seven-year period. Real estate should go long-term from two years to at least 10 years, the current two-year holding period defies logic. Again use a sliding scale of short-term rates towards a lower long-term capital gains tax. If the policy direction is towards financialization, then tax long-term capital gains from real estate at 10% at the end of 10 years to give the equity culture a boost.
Two, switches within an asset class need to have the same rules. Today the lack of logic in the free switches allowed within asset classes is driving money towards certain products. For example, profits from long-term capital gains in real estate can be invested in certain bonds to go tax-free. Or they can be invested into another property to go untaxed. There is no tax on switching in insurance products. But each time you punish a poorly performing equity fund manager to redeem and buy another better performing fund, or in a debt fund, you have to pay capital gains tax. Use a first principle approach to solve the problem of thinking about switches and then apply to the various asset classes, rather than perpetuate a flawed system.
Back-of-the-envelope calculations say that capital gains revenue is just 3% of the total income tax revenue that’s collected from individual taxpayers. The wonks in the ministry of finance should do some modelling to see what this new system will deliver and what this will do to the financialization of the economy. Just tinkering with tenure and rates will not give the deep foundation needed to take India to a tax-buoyant $5 trillion economy in the next five years.
Monika Halan is consulting editor at Mint and writes on household finance, policy and regulation