On discarding indexation for LTCG
Context
In the Union Budget 2024, Finance Minister Nirmala Sitharaman announced the elimination of indexation for computing long-term capital gains (LTCG) tax.
- Instead, long-term gains on all financial and non-financial assets would now be taxed at a flat rate of 12.5%, replacing the previous tiered structure that included indexation.
- This move, intended to simplify tax computations, has not been well-received and has sparked significant debate among economists, tax experts, and the public.
Relevance
GS-03 (Economy)
Dimensions of the Article:
- What is the Issue?
- What is LTCG?
- Why Has the Union Finance Minister Done Away with Indexation for Computing LTCG Tax?
- Feedback from Corporates and Industry Regarding the Move?
What is the Issue?
- The issue centers around the Finance Minister’s decision to do away with indexation for calculating LTCG tax.
- Indexation adjusts the purchase price of an asset for inflation, ensuring taxpayers are taxed on real gains rather than nominal gains inflated by rising prices.
- The removal of this mechanism has raised concerns about increased tax liabilities and the potential impact on investment decisions across various asset classes, including real estate, bonds, and infrastructure funds.
What is LTCG?
- Long-term capital gains (LTCGs) refer to the profits earned from investments held for over 12 months before being sold.
- In contrast, profits from investments held for less than a year are termed short-term capital gains.
- Typically, long-term capital gains are subject to lower tax rates compared to short-term capital gains.
What is Indexation and How Does It Help in Tax Savings?
- Imagine buying a house for ₹10 lakh in 2001 and selling it for ₹75 lakh in 2021.
- Without indexation, the apparent gain is ₹65 lakh, which seems taxable. However, this doesn’t account for inflation.
- Indexation uses the Cost Inflation Index (CII) to adjust the purchase price, reflecting the actual economic gain.
- For instance, with the CII for 2021 at 317 and for 2001 at 100, the indexed cost of the house becomes ₹31.7 lakh. This reduces the taxable gain to ₹43.3 lakh.
- At the former 20% tax rate, the tax payable would be approximately ₹8.7 lakh.
- Under the new system, the entire ₹65 lakh gain is taxed at 12.5%, resulting in a tax liability of ₹8.13 lakh.
- Indexation helps in two main ways:
- Adjusting for Inflation: It ensures taxpayers are taxed on real economic gains rather than nominal gains inflated by rising prices.
- Reducing Tax Liability: It lowers the taxable gain, thereby reducing the tax burden.
Why Has the Union Finance Minister Done Away with Indexation for Computing LTCG Tax?
- The Finance Minister’s rationale for this change is to simplify the computation of capital gains for taxpayers and tax administration.
- By adopting a flat 12.5% tax rate on long-term gains without indexation, the government aims to ease the tax calculation process and make the system more straightforward.
- However, this simplification comes at a cost. It disregards the varying rates of return on different assets and the impact of inflation, which can lead to higher tax liabilities for taxpayers, especially those holding assets for extended periods.
Feedback from Corporates and Industry Regarding the Move?
The response from corporates and industry experts has been mixed. While some appreciate the simplicity of the new system, many express concerns about the increased tax burden and its potential impact on investment behavior.
- Real Estate Sector: Experts argue that the removal of indexation could discourage investment in real estate. Investors may now prefer to sell properties quickly to benefit from the lower flat tax rate rather than holding them long-term. This could lead to a decline in real estate investments and a shift in market dynamics.
- Bonds and Infrastructure Funds: These asset classes, which typically offer lower returns compared to equities, are expected to suffer under the new regime. Without the benefit of indexation, the tax liabilities on these investments could rise significantly, potentially reducing their attractiveness to investors.
- General Sentiment: The overall sentiment in the market is one of caution. The reduction in the base tax rate provides some balance, but the absence of indexation dampens the enthusiasm for long-term investments.
Way Forward
Given the mixed feedback and potential implications of the new tax regime, a balanced approach is necessary. Here are some steps the government could consider:
- Re-evaluation of the Policy: The government should re-assess the impact of the removal of indexation on various asset classes and investor behavior. A comprehensive study involving stakeholders from different sectors can provide valuable insights.
- Introducing Safeguards: To protect taxpayers, especially those with long-term investments, the government could introduce safeguards such as a graded tax structure that considers the holding period and the type of asset.
- Enhancing Transparency and Awareness: Clear communication and awareness campaigns about the new tax provisions can help taxpayers understand the changes and make informed investment decisions.
- Periodic Review: A periodic review of the tax policy, considering economic conditions and market trends, can ensure that the tax regime remains relevant and fair to all stakeholders.
- Incentives for Long-term Investments: To promote long-term investments, the government could consider offering additional incentives or reliefs, such as tax deductions or exemptions for holding assets beyond a certain period.
Conclusion
The Finance Minister’s decision to eliminate indexation for LTCG tax aims to simplify tax computations but has significant implications for taxpayers and the investment landscape. While the flat tax rate offers simplicity, it may lead to higher tax liabilities and affect investment decisions.
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