Not indexing LTCG tax on properties purchased after July 23, 2024 is unfair; will deter long-term investment: See

The 2024 budget reduced the tax rate on long-term capital gains from 20% to 12.5% ​​and eliminated the benefit of indexation. A subsequent amendment LTCG Tax The rule allowed people to choose between two options for property purchased before July 23, 2024: 20% tax rate with indexation benefit or a tax rate of 12.5% ​​without the benefit of indexation.
However, it is necessary to highlight that long-term indexation capital gains It is an obligation in all cases, both past and future. Not only do proper valuation principles demand indexation, but it is also a critical necessity to promote social security and economic growth of the country.

Long-term income should be taxed at a significantly lower rate than ordinary income. However, this is not enough. Indexation is also necessary when calculating profits from long-term capital investments.Encourage investment: Taxing LTCG at a lower rate encourages people to invest in real estateLong-term stocks and bonds. Long-term investments are essential for economic development, growth, job creation and supporting innovation. These investments are less speculative and more beneficial to the economy. Taxation of profits earned after long holding periods must take into account patience and commitment over long periods, risk and inflation. Tax policy on such profits must therefore recognise the average effect of a holding period of several years.

Inflation adjustment: Capital gain also includes an increase in the value of an asset due to changes in price levels. In fact, most of the gain can be in the form of preservation of purchasing power. Nominal gains from such investments need to be adjusted for inflation to know the real gains. Otherwise, one would be penalized by having to pay tax in circumstances where one has not made any real gain. Indexation is the way to provide a reasonable estimate of tangible gains. Therefore, it is necessary that LTCG tax is charged after indexation.

Economic stability: A reduction in taxes on gains from long-term investments would encourage investors to hold their investments over the years rather than making frequent short-term transactions. This incentivizes investors not to speculate, resulting in more stable financial markets. However, if the inflation rate is high, short-term holding periods and speculation will become more attractive without the benefits of indexation for long-term investments.

Long-term capital gains income Long-term investments have two essential characteristics. Firstly, the locking up of capital for the long term. Therefore, long-term financing by borrowed funds and the opportunity cost of equity capital become relevant. The interest cost of long-term loans taken to acquire a property can often be equal to the acquisition price. The patience required for this and the nature of the risk due to the long-term commitment must be rewarded. Therefore, there is an implicit cost and factoring in the cost of capital is important for the estimation of profits. Secondly, in case of Property Investment or real estate, taxes, insurance, repairs, maintenance, security and upgrade expenses are incurred to keep the property functional and decent.

Therefore, the level and nature of risk, recurring cost and financing cost for long-term investments are higher and different. Both types of expenses may exceed the original acquisition cost of older properties. People may not keep proper records and accounts of such expenses. These aspects are often ignored while estimating long-term gains. Lower tax rates are not sufficient to estimate gains fairly; therefore, the benefits of indexation are the only way to be fair and rational while taxing long-term gains.

Attracting foreign capital: A developing economy like India requires a huge amount of capital for economic and social development and infrastructure, which can only be met by encouraging long-term foreign capital. A lower tax on capital gains can attract more capital and increase international competitiveness. However, given the higher inflation rates in the host country compared to the home country of foreign investors, the value of investments is devastated. Indexation provides fair and accurate estimates of long-term capital gains after adjusting for inflation. With indexation, investors would avoid paying taxes on nominal gains in addition to losing purchasing power.

Social security and retirement: In countries like India, home ownership is a matter of social security and financial security during retirement. People also need to save for their retirement. The only option to save for retirement is to stay invested for the long term. In India, where social security is inadequate, guaranteed retirement benefits are systematically withdrawn. Real estate investments and long-term financial investments are essential avenues for the common person.

Valuation perspective
Cost of capital: India has a higher cost of capital due to higher interest rates and higher inflation. As an emerging economy, the risks are also higher. Investors expect higher returns on equity and debt and hence a higher rate of return is expected overall. Nominal gains can be made, but gains in economic terms only occur when the investor earns a return in excess of the expected rate of return, which is the cost of capital. Over longer periods, the compounding effect on the current value is immense. Simply reducing the tax rate on LTCG is not enough. To correctly estimate the economic benefit, indexation can, to some extent, take into account the cost of capital for different amounts and holding periods and hence the compounding effect on current values.

Time value of money: The time value of money is an essential financial concept that holds that money in the present is worth more than the same sum of money to be received in a future period. This is because the money you have now can be invested to earn a return. However, inflation decreases its purchasing power and risk further reduces the expected value. According to financial wisdom, the gain from a Long-term investment This figure must be arrived at after taking into account the time value of money. Removing indexation penalises individuals, investors and businesses in a country like India where the inflation rate is high and unstable.

Conclusion: The amendment brought in the Finance Bill is a welcome measure as it will provide an option to choose between 20% LTCG tax with indexation or 12.5% ​​without indexation for property. It would encourage honest payment of taxes, long-term investment and fair play. However, the removal of indexation benefit for properties purchased after July 23, 2024 and other long-term asset classes needs to be reviewed in the light of the factors discussed. Indexation benefits should inevitably be allowed on all types of LTCG before the imposition of the tax. The policy should empower one to choose the best option for Sabaka Sath, Sabaka Viswas and Sabaka Vikas. The amendments brought in would be fair only if they are made applicable to all asset classes and also for the future.

(The author is Professor of Finance and Accounting at IIM Indore. The views expressed are personal.)