The Union Budget for 2018-’19 has probably been more or less finalised by now, its key elements cleared by multiple departments. While there has always been paranoia about Budget leaks (and this government is paranoid about all leaks), it would be consistent with tradition for one of the many people who have seen bits of the proposals to divulge some information.

There are always persistent rumours in the run-up to the Budget. How accurate these are varies wildly, but all of them have an impact on prices. Such rumours are often started by traders looking to make a quick buck, or are are trial balloons floated by members of the babu-neta nexus to get a sense of how citizens will react to possible changes.

This time, the rumours centre around the possibility of a tax on long-term capital gains from shares. This has a ring of plausibility. The government desperately needs to bump up revenue in order to contain the fiscal deficit to a reasonable limit, and this would be an obvious way to do it. The government cannot cut expenditure, because this is an election-year Budget. There are eight assembly elections due in 2018-’19 leading up to the general election in May next year.

Revenue collection could be a cause for concern in 2018-’19. While direct tax collections have been decent, indirect tax collection is below par. The Goods and Services Tax has not yet smoothed out and it may take several quarters to stabilise. Until it does, indirect collections will be uncertain.

Fuel prices are also a cause of concern. Crude prices have risen with strong global growth leading to increased demand even as members of the Organisation of the Petroleum Exporting Countries have an agreement to curtail oil production until December 2018. Trouble in Iran, which is rocked by anti-government protests, might push crude prices up further.

High crude prices could potentially lead to several problems. Low crude prices since September 2014 allowed the government to decontrol retail prices, ensuring that oil and gas companies like Bharat Petroleum Corporation Limited Indian Oil, Hindustan Petroleum made profits instead of requiring subsidies. In addition, there are high duties on fuels, which help the government collect more revenues.

The current retail prices of petrol and diesel are quite close to those in May 2014 despite the increase in international prices, owing to the government’s deregulation of oil prices. Petrol was Rs 71.5 a litre in May 2014 and is Rs 70.66 (Delhi) as of Wednesday and diesel was Rs 56.7 a litre in May 2014 versus Rs 60.99 a litre now. But the price of the crude import basket was at $63 per barrel (in December 2017) compared to $107 per barrel in May 2014.

This bonanza enabled by the government’s decision to deregulate oil prices, which allowed public sector units to set their own. But the high excise collections and profits for public sector unit oil refining/ marketing companies is at risk if crude prices continue to trend high. The government must either reduce excise duties (thereby reducing tax collections), or control retail prices (reducing profitability for its PSUs), or risk a political backlash. There is also the concern about inflation caused by high fuel prices.

Great potential

In this scenario, long-term capital gains on stocks and equity mutual funds could be a massive new channel of revenue.

Long-term capital gain is the profit arising from the sale of capital assets held for more than a certain period. For equity, this period is defined as 12 months, while for other capital assets like property, jewellery and the like, it is between 24-36 months.

Assuming similar taxation norms as with other assets, a study by the Bombay Stock Exchange indicates that taxes on long-term capital gains could generate Rs 49,000 crore per annum. Even if we remove the amount accruing from the Securities Transaction Tax, which is already levied, the long-term capital gains tax would still generate over Rs 40,000 crore (Securities Transaction Tax raised about Rs 7,500 crore in 2016-’17).

Equity gets favourable tax treatment compared to other assets. There is no tax whatsoever on equity that is held for a year or longer. Long-term capital gains tax on other assets like debt funds, real estate, jewellery and the applies if the asset is held for at least two years or longer. The rate of long-term capital gains tax on non-equity assets is 20% after inflation indexation.

Moreover profits on equity sold in less than a year (known as short-term capital gains) is taxed at a flat rate of 15%, whereas profits on real estate transactions for property owned for less than two years are added to the sellers’ annual income and charged at whatever income tax rate is applicable. That could be 34.5% for somebody in the highest income group. In effect, most people who trade stocks are in that highest tax slab.

If, as the rumour mills suggest, long-term capital gains tax on equity becomes a reality in the upcoming Budget, there are many upsides in terms of revenue collection. Multiple tweaks are possible. The time periods could be aligned – with long-term capital gains on equity becoming applicable only after a two year holding period. The short-term gains tax rate could be aligned to that on other assets by adding it to normal income. The long-term capital gains could be taxed, like other assets. Any, or all of these measures would gain some revenue. And yet this would tax only the rich, in terms of voter-perception. It will also raise substantial revenue and the tax can be justified rationally – indeed, most countries do charge long term capital gains on equity.

The cons

But the downside is that the tax could affect the middle-class, given that it would logically apply to equity mutual funds as well. The ad-blitz urging people to invest in mutual funds primarily targetted this class, and ti worked. Retail investors own nearly half of all equity mutual assets – that’s half of about Rs 8 lakh crore.

Moreover, most stock trading volume is institutional and much of the volume comes from Foreign Portfolio Investors, who operate via subsidiaries located in countries, which have favourable tax treaties with India. They pay tax in one or the other country. A higher capital gains rate could affect Foreign Portfolio Investors’ perceptions and bias them in favour of other Emerging Markets with more favourable tax structures.

If changes in the long term capital gains tax do trigger a stock-market crash, both voters and corporations will suffer a “negative wealth” effect. This could affect hurt in terms of sentiment and make them less inclined to vote for the incumbent government in the next general elections.

Arun Jaitley and his boss will have to therefore have to weigh the many pros and cons. But going by the buzz, it is quite likely that they will opt to collect the revenue and worry about electoral considerations later.