The revised discussion paper on the Direct Tax Code has a couple of provisions that would mean a fundamental change for those investing in stocks, equity mutual funds and other equity-based assets. The biggest change is that long-term investments in such assets will no longer be tax-free. Even though there has been a great deal of public comment on the unfairness and inappropriateness of this change, the tenor of the draft code and the two discussion papers is quite clear.

Taxation on long-term equity returns is coming and investors will have to live with it. It’s interesting to see that the actual percentage of taxation will be linked to investors’ own income level.

Will this have a major impact on equity investors? Despite the initial reactions that you may have heard or read, I don’t think this tax will actually impact people’s equity investing behaviour. Mind you, I’m not going here into the issue whether this tax is unfair or unjustified. I’m just saying that it probably won’t affect long-term investor behaviour. All the protests you hear about taxation on equity returns are from people who are short-term investors and do not understand how long-term investment works.

There are two reasons for this. The facetious one is that you don’t have a choice. But the other is more interesting. The way the arithmetic of long-term investing works, such a tax will encourage long-term investing far more than a simple zero-tax does now.

Here is how it works. At present, the moment your holding crosses 365-day period, the returns become zero tax, whether you redeem your investment the next day or after 10 years.

However, if long-term gains were taxed at whatever rate, then selling your investment, even to reinvest it would carry a hit on returns. Consider a 10-year investment that yields 20 per cent a year. In 10 years, an investment of Rs 1 lakh at this rate will grow to Rs 6.19 lakh. If the long-term capital gains are taxed at 15 per cent, you will end up with Rs 5.41 lakh post-tax, an effective rate of return of 18.3 per cent.

Compare this to another investment that earns at the same rate overall, but is switched to a different share or fund twice. Each time the money is redeemed to be reinvested, tax has to be paid on the returns generated. Because the real gains of long-term investments come from compounding of returns, this shrinkage of the amount that is available for compounding has a major impact on final returns. In our hypothetical investment above, just two sell-and-reinvest cycles in 10 years reduce the final post-tax amount from Rs 5.41 lakh to Rs 3.24 lakh. Instead of earning at 18.3 per cent, your returns will be just 12.5 per cent.

This de-compounding effect of repeated taxation will actually be the biggest impact of the new tax code on equity investing. Over a longer period of time, individual investments can lose their suitability and attractiveness. This can make long-term investments in equity relatively less attractive even if you are a good stock picker. For investors, the best solution will be to invest in generalised equity funds, which will have the flexibility of switching to any stocks when conditions change over a long period.

The new tax code will enforce some fundamental changes in the way taxation works and the full impact of these will be understood only gradually.

(Dhirendra Kumar is CEO of Value Research India. His column

appears every Monday)