More focused than populist

Limited sway: deficits, direct taxation, but LT equities tax: We see little possibility that budget 2018 delivers reasons for material upside to an already inflated equity market in India. Fiscal expansion (higher deficits) could have created some excitement, but we expect government to stay at 3.2 per cent of GDP for FY19. Indirect taxation is now decided by the GST Council; we expect any budgetary changes to direct taxation to have modest impact on personal disposable incomes or corporate profits. On the other hand if the government were to reinstate some form of long term capital gains tax on equities (we think likely), then that could be negative for returns / market sentiment.

Elections 2019, focused spending, but not a big splurge: There are two ways the budget could be ‘populist’: the government could allocate increasing amounts to existing rural programmes (homes, MGNREGA, cooking fuel, Swachh Bharat etc.) or create a new scheme to transfer ‘cash/upside’ to a large swath of voters. Farm loan waivers are underway in many major states. There may not be much left for the central government to ‘waive’ again in these places. A direct cash handout to poor families may be too direct (a bad precedent, with perhaps temporary impact). With these constraints, we believe the government could choose the first option. That should be good for rural focused stocks. Some sort of personal income tax relief is likely we think, but the net revenue transfer is likely to be small, and not a major demand stimulant.

Equity LT capital gains tax likely this year: India is one of few countries that do not tax long term gains on equities. Stock gains also get a preferential treatment: Long term for debt/real estate is defined as more than three years, and gains on these are taxable. The prime minister has earlier spoken of the need for LT tax on equity gains; expectations are that budget 2018 will level the field among assets to some degree. Our base case is that the definition of LT for equities is increased to three years and some level of taxation is introduced thereafter. Forecasting revenue from LTCG is difficult. The government is unlikely to do away with the Securities Transaction Tax (STT) or the Dividend Distribution Tax in our opinion. A new LT gains tax on equities would not only hurt market sentiment, but can also hurt domestic equity inflows.

Other things to look for in the budget  a) An increase in cigarette excise duties seems unlikely. This should be good for cigarette companies, b) a reduction in oil cess is also unlikely. The budget could provide additional incentives for housing; good for real estate stocks, but also for ancillaries (mortgages, cement, paints, appliances etc.). Clarity on tax treatment of IBC resolutions is likely.

Equities long term capital gains tax: Will he, won’t he? The debate on the reinstatement of long term capital gains tax on listed equities has again gained momentum ahead of budget 2018. These were abolished in 2004; India is amongst the few countries globally that does not tax long term equity capital gains. In contrast, capital gains on other asset classes — debt / real estate — are taxed (Exhibit 2). One of the key arguments in favour of taxing equities is to establish some sort of equality amongst asset classes.

The prime minister had expressed a need to tax equity long term gains late 2016. This was not implemented in budget 2017. The rapid rise in equity markets since seems to have added momentum to arguments in favor of such a tax.

What are the possible forms of equity long-term gains taxation?

1. Increase the definition of equity long term to three years with zero tax post: This would arguably be the bare minimum requirement in order to attain        equality in tax treatment of assets. There may be less of an argument to reduce the definition of long term on debt / real estate to one year (to match equities). The LT definition on debt was increased to three years in budget 2014. Real estate is a long duration asset; reducing the definition of Long Term for capital gains may not make sense and may encourage ‘investing’ behaviour.

2. Increase definition of long term to three years and match tax at 20 per cent with indexation: This is a likely outcome as it would broadly equate the taxation structure across asset classes while retaining some incentive for equities in the short term (less than three years).

3. Retain equity definition of Long Term at one year, but impose tax on gains thereafter: If without indexation, the equity long term capital gains tax cannot be higher than 15 per cent (the short term rate). This would otherwise encourage significant ‘churn’ of equity holdings on the 364th day from purchase. For similar arguments, it will be inadvisable to impose a 20 per cent LTCG with indexation after one year as well. The actual indexation for that year (not everybody will be able to avail double indexation on equities) would create a mismatch in short term and long term taxation and could influence trading behaviour.

Would equity LT tax produce additional revenue for government? Yes we think it would —but the amounts can be extremely difficult to predict. They would depend on not only the direction of equity markets, but also on individual  decisions to sell (or not). There is an argument that the government should eliminate the STT on equities, or the Dividend Distribution Tax (or both) if a long term capital gains tax on equities is imposed.

We think that might be a difficult proposition: the STT is expected to raise Rs 74bn in relatively predictable revenue in FY18. We estimate that all listed companies paid dividend distribution tax of Rs 170bn  in FY17. These are relatively large income sources for the central government. It seems unlikely the government will forgo these assured (and increasing) streams of income for a relatively unpredictable one.

A cut in corporate tax rates likely, but in a revenue neutral fashion: The Union finance minister had spoken of a desire to cut corporate tax rates from 30 per cent to 25 per cent in the FY16 budget while phasing out a host of tax exemptions. In the FY17 budget, the tax rate for small companies (with turnover of less than Rs 50 million) was reduced to 29 per cent. In the FY18 budget, corporate tax rates for companies with turnover less than Rs 500 million was reduced to 25 per cent.

There hasn’t been an overall cut in corporate taxes yet. Corporate taxes accounted for close to 30 per cent of the center’s gross tax income in FY17. It is unlikely the government will afford a major change in these collections in any particular year.

We think that a small cut in corporate taxes is possible — as a first measure. This would likely be accompanied with reduction in some tax deductions, and could help the finance minister attain some progress on a plan in the last year of this five year term.

Will the government cut cess on crude oil production? This seems unlikely to us. While arguably, the change in taxation from specific to ad valorem become disadvantageous to companies as oil prices rise, cess and royalties collected on domestic crude production are a meaningful source of revenue for government crude oil cess generated revenues of Rs 133 billion in FY17; which amounts will increase as oil prices go up.

An increase in the personal income tax slab is unlikely to have a large impact on aggregate consumption: An estimated 2.05 million individuals paid income taxes in FY17. This number is reported to have increased recently (post the demonetisation). Even if we assume a 25 per cent growth in this number, an increase of Rs 50,000 in the lowest tax slab would hurt government’s revenue by close to Rs 64bn. 

(with Nafeesa Gupta)

(The writers are research analysts at DSP Merrill Lynch India)