Budget 2018: Will long-term capital gains tax imposition bring market rally to a halt?

According to reports, the government is estimated to lose Rs 50,000 crore every year on account of non-imposition of LTCG tax.

The loss is substantial for the government which has taken steps such as demonetisation and imposition of GST to shore up tax revenues.

Even Prime Minister Narendra Modi has commented on tax collection in the economy. On December 24, 2016, the PM in his speech said, "The low contribution of taxes may be due to the structure of our tax laws. Low or zero tax rate is given to certain types of financial income. Those who profit from the financial markets must make a fair contribution to nation-building through taxes. For various reasons, the contribution of tax from those who make money on the markets has been low. To some extent, it may be due to illegal activities and fraud," Modi said without mentioning about any particular tax.

The markets witnessed a tremendous run during the last two years. On February 11 2016, the Sensex stood at 22,951. Since then, it has gained nearly 13,000 points, translating into a gain of 56%.

The Nifty has gained nearly 4,000 points or 57% from 6,976 since 11 February 2016.

And foreign and domestic investors have played a significant role in supporting the indices.

But things could change completely if the government imposes LTCG tax on equities.

No investor remains glued to a particular investment in the long term, say during a period of 3-5 years. They will have to switch to other investments and the switch after the LTCG tax will cost them more since it will lead to less capital left for compounding in the future. Thus, the impact of the tax will be quite huge as FIIs and DIIs might prefer other attractive destinations to park their money and get better returns.

The government already imposes Securities Transaction Tax (STT) on transacting in shares, bonds, debentures, derivatives units, interest in securities and equity mutual funds.

For delivery-based equity transactions, STT for purchase and sale is 0.1% of turnover. For intra-day transactions, STT for purchase is nil and sale is 0.025% of the turnover.

Former Finance Minister P Chidambaram introduced STT in 2004. When introduced, the rate was 0.125 percent for a delivery stock and 0.025 per cent on intra-day transactions and 0.017 percent on futures and options transactions, to stop tax avoidance of capital gains tax.

The 2013 Budget reduced STT to 0.1 percent on the turnover for delivery and also futures, while for equity options, it was cut to 0.05 per cent on sale premium.

The imposition of LTCG tax would be a double whammy for investors who pay STT on every transaction.

To mitigate the effect of LTCG tax, the government could do away with STT to pacify the investors.

The flip side of such move is the government will have to collect LTCG tax in a manner similar to the income tax since it can't forecast the timing and profit/loss arising from sale and purchase of securities by an individual.

The taxpayer will have to calculate and pay tax and declare it in tax returns. This will require more groundwork for taxmen to assess the returns and revenue arising from the LTCG tax.

Another aspect of LTCG tax collection is any loss arising out of sale/purchase of securities can be set off against their gains, thereby reducing the net gains on which tax will be calculated. On the other hand, STT is collected irrespective of the loss or profit arising on transaction of shares.

The government will have to take into account the ease with which it collected STT instantly, likely collection from LTCG tax compared to STT and the impact on market and divestment programme before it imposes the much feared tax on investors.