capital gains: Capital gains intact, so what if they’re taxed a bit higher?

On events such as budget day, the market is prone to kneejerk reactions. So, as soon as the finance minister announced higher short-term and long-term capital gains taxes on financial instruments, the stock market tanked. Of course, it recovered towards the close as sanity set in.

And what’s that sanity? In my view, it is that capital gains are intact, only the capital gains tax is higher.

And what drives capital gains in the equity market? Clearly, two factors — one, corporate earnings growth and two, stock market fund flow.

Let’s take corporate earnings growth first. It too is driven by two macro factors — capex and consumption. Clearly, the recent few years have been driven by capex mainly by the public sector. With the need for fiscal consolidation, this lever has run out of steam for now. That’s when consumption needs to step up.

And this budget does its fair bit for consumption. Standard deduction on salary income is up from ₹50,000 to ₹75,000, deduction on family pension is up from ₹15,000 to ₹25,000, first-time employees stand to get one month’s salary; for fresh hires, employers stand to get a subsidy on their provident fund contribution, internship allowance for youth, and so on.

Maintained capex and the consumption boost should help the government achieve its projected nominal GDP growth of 11-12%.

The thumb rule is that the nominal GDP growth should translate into a similar level of corporate sector sales growth.With some operating and financial leverage, growth in profit after tax (PAT) for the corporate sector should be 13-15%. For this level of PAT growth, the market P/E (price to earnings) ratio of around 23x seems elevated. But this is where the second factor of capital gains kicks in — stock market fund flow.The Indian equity market is witness to unprecedented fund flow led by massive retail participation.

There are two main indicators of this — one the number of demat accounts and two monthly SIP (Systematic Investment Plan) flows into mutual funds. The quantum of SIP inflow keeps DII (domestic institutional investors) buying buoyant, enough to absorb the occasional heavy FII selling, if any. This primarily explains the elevated market valuations.

So the bottom line? Steady earnings growth coupled with a low probability of major valuation de-rating imply steady capital gains. So what if the tax on the same is a bit higher? The party continues.

The author is Chairman, Motilal Oswal Financial Services