Budget and taxes: A balancing act between short-term challenges and long-term growth

The Union budget for 2024-25 has proposed several changes in the capital gains tax structure, some of which are surprising moves that the mutual fund industry and the wider market community were not prepared for.

One of the most significant was the hike in long-term capital gains tax from 10% to 12.5%. The budget's proposal to hike the exemption limit on equity and equity mutual funds to ₹1.25 lakh per year will soften the blow, but only to a miniscule extent.

India is a developing country where most of the savings are still parked in fixed assets. Mutual fund penetration is around 15% against the global average of 75%. With over 150 million demat accounts, the penetration of the stock market among Indians is even lower. 

This highlights that despite the rapid rush towards mutual funds and the stock market in recent years, the financialisation of savings is still at the nascent stage.

Considering these factors, hiking long-term capital gains tax may trim India’s newfound enthusiasm towards investing, at least in the short term. The government has, in the past, applauded the retail flows in the market, terming those as a “shock absorber” whenever foreign investors withdraw money. 

It remains to be seen if the shock-absorbing capacity may diminish in the short term. That said, in the long term, I believe the investor community will accept the new tax rate and continue investing in mutual funds and the stock market.

The budget has also tweaked the short-term capital gains tax, increasing it to 20% from 15% now. This can be termed a positive. Because if an investor sells their holdings before one year, they will have to shell out 20% of their gains as taxes. This will surely discourage investors from selling their investments in quickly or in panic. Hopefully, this will become a factor in stabilising the market in times of crisis.  

The government also sent a message to the market community that investments are for the long term and not for speculations, by raising the securities transaction tax (STT) to 0.1% for options and to 0.02% for futures.

One disappointment is that the budget has neither brought back the indexation benefit for debt mutual funds nor rescinded the decision to tax gains from it at the individual slab rates. 

Debt mutual funds are a great investment tool for conservative investors who want moderate returns with relative safety of capital. These funds need policy support to make them more attractive. Some relief from tax could have encouraged more investment in them.

Indexation as a concept brings the basic knowledge of the time value of money to an individual. Removal of indexation may be detrimental to investors looking at real estate as an additional investment avenue, and investors could turn towards real estate investment trusts and infrastructure investment trusts, or even mutual funds, for long-term investing.

The budget has also rationalised taxes applicable on fund-of-funds. It has proposed to amend the definition of Specified Mutual Fund in Explanation (ii) of Section 50AA of the Income Tax Act. This change will bring fund-of-funds on par with the scheme they invest in, rectifying the current anomaly.

Investing in mutual funds should be seen as a wealth-creation journey. You cannot create wealth in a short term. It takes time, patience, and a disciplined approach to investing. Overall, I would say the mutual fund industry is nascent. The domestic industry's assets under management was barely $730 billion as of June-end. In the US, it was $25 trillion as of the end of 2023. India's mutual fund industry has a long way to go, and it cannot be done without government policy support.

Swarup Anand Mohanty is vice chairman and CEO, Mirae Asset Investment Managers (India)