Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Taxation of securities

I wrote a column
in the Financial Express today about the taxation of

Over a period of time, several distortions have crept into the
taxation of investment income in India. The budget later this month
provides an opportunity to correct some of these without waiting for
the sweeping reforms proposed in the direct taxes code. I would
highlight the non-taxation of capital gains on equities, the
securities transaction tax (STT) and the taxation of foreign
institutional investors.

In the current system, the capital gain on sale of equity shares is
not taxable provided the sale takes place on an exchange. Of course,
there is STT, but the STT rate is a tiny fraction of the rate that
applies to normal capital gains.

The taxation of capital gains is itself very low compared to the
taxation of normal income. There is no justification for taxing
capital gains at a lower rate than, say, salary income. After all, a
substantial part of the salary of skilled workers is a return on the
investment in human capital that led to the development of their

Why should returns on human capital be taxed at normal rates and
returns on financial capital at concessional rates? Even within
financial assets, why should, say, interest income be taxed at normal
rates while capital gains are taxed at concessional rates?

The discussion paper on the direct taxes code argues that a
concessional rate is warranted because the cumulative capital gains of
several years are brought to tax in one year and this would push the
tax rate to a higher slab. This factor is in many cases overwhelmed by
the huge benefit that arises from deferment of tax.

For example, consider an asset bought for Rs 100 that appreciates
at the rate of 10% per annum for 20 years so that it fetches Rs 673
when it is sold. A 30% tax on the capital gain of Rs 573 amounts to Rs
172 and the owner is left with Rs 501 after tax. By contrast, if the
owner had received interest at 10% every year and paid taxes at a
lower slab of 20% each year, the post-tax return would have been
8%. Compounding 8% over 20 years would leave the investor with only Rs
466. In other words, 20% tax paid each year is a stiffer drag on
returns than a 30% tax that can be deferred till the time of sale.

In practice, of course, indexation and the periodic re-basing of
the original cost of the asset makes the tax burden on capital gains
even lighter. There is no economic or moral justification for
subsidising the wealthy in this manner.

Ideally, tax rates should be calibrated in such a manner that equal
pre-tax rates of return translate into equal post-tax rates of return
regardless of the form in which that return is earned. This might be
too much to ask for, but a near zero tax rate for capital gains earned
on equity shares makes a mockery of the tax system in the country and
should be redressed as soon as possible.

The STT is by its very nature a bad tax because it is unrelated to
whether the transaction resulted in a profit or a loss. The real
reason for the STT was to make the process of tax collection
easier. In this sense, the STT is best regarded as a form of the
nefarious system of tax farming that is shunned by modern nation

Some attempts are being made to justify the STT as a form of Tobin
tax on financial transactions. Without entering into a debate on
whether a Tobin tax is good or bad, it should be pointed out that the
STT is not a Tobin tax. This is evident from the fact that
delivery-based transactions attract STT at rates several times higher
than on the presumably more speculative non-delivery-based
transactions. The rate on delivery-based transactions is far higher
than any reasonable Tobin tax.

A final argument for STT in lieu of capital gains is that
foreigners pay lower taxes in India. Many other countries tax foreign
portfolio investors at low rates. Indian investors can make portfolio
investments in the US (within the limit of $200,000 per annum
permitted by RBI). They would not pay income taxes in the US on their
income from this investment and would pay only Indian taxes.

There is symmetry here to the US portfolio investor paying taxes in
the US but not in India. The only difference is that the foreign
investor into India has to come through Mauritius while the portfolio
investor into the US can go in directly.

We should also exempt foreign portfolio investors from taxation
without forcing them to come via Mauritius. The real problem with the
Mauritius loophole is that it allows even non-portfolio investors to
avoid Indian taxes, but that is a different topic altogether.


3 responses to “Taxation of securities

  1. Ted K February 20, 2010 at 3:20 am

    Great post as usual Professor Varma, although I must admit my interest was not so high because it seems to pertain mainly to India. But the concepts and ideals are the same in any country, I feel certain you would agree.

    I also enjoyed your Schapiro post. Although thus far there has been extremely little ACTION by Schapiro’s SEC I do see some small glimmers of hope there (small positives). I see some personnel changes that give small encouragement. One of those personnel changes was the hiring of Rick Bookstaber. Are you familiar with this man or his blog??? I want to recommend when you have free time (maybe with a Pav Bhaji and Pepsi-Cola by your keyboard) to go visit his site and read it. He is now in the SEC and seems very intelligent and capable. Here is the link

  2. financialspreadbetting May 31, 2010 at 3:03 pm

    We are having a similar distortion in the UK at the moment. The new government are planning to introduce a 40% tax on capital gains up from 18% tax previously.

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