The brand of equity is suddenly out of fashion

The revised Direct Tax Code revises a quarter century of philosophy behind popularising the equity cult

If the revised version of the Direct Tax Code (DTC) is implemented, it will mean a huge departure from over 25 years of policymaking in India under which equity capital and stock markets have progressively come to attain a pride of place as a key source of raising capital. The DTC proposes to bring down this pre-eminence of equities by slashing their post-tax returns while enhancing the post-tax returns of six forms of retirement products, only one of which may have a substantial component of equity investments.

The government has proposed a new regime for truly long-term savings schemes under the new DTC while making long-term gains from equities and equity-linked mutual funds taxable. Short-term capital will be fully taxed. These moves will completely alter the relative attractiveness of retirement products and equity investments. The former, like the New Pension Scheme (NPS), Public Provident Fund (PPF) and pure insurance schemes, are being favoured while equity products and Unit-linked insurance schemes are suddenly out of favour. This is not minor tinkering.

The difference in tax treatment of these two classes will be so huge as to substantially undermine what the government has been preaching and advocating for the past quarter century that reached a crescendo a few years ago.

Simply stated, the government is now saying that mutual funds, equities and ULIPs are just another source of capital-just as fixed deposits and bonds-that do not deserve much preferential tax treatment. There is no need to treat providers of risk capital, namely, equity, as Brahmins. This represents a massive setback for equity investments which the government went all out to promote ever since India started liberalisation in the mid-80s. Equity markets used to be open for two hours everyday back then and were seen as dens of speculation. There were no mutual funds-only Unit Trust of India. The Indian market was closed to foreign investors and Life Insurance Corporation of India was virtually the only domestic institutional investor.

After Rajiv Gandhi became the prime minister, capital market reforms became a key agenda. Various committees were formed which progressively led to formation of the first mutual fund (1989), first venture capital fund (1988), formation of the Securities and Exchange Board of India (1992), allowing foreign institutional investors (1993), allowing private sector mutual funds (1994), creation of first anonymous order-matching electronic exchange (1994) and so on.

Fostering the "equity cult" became the new mantra. A huge bull market started at the peak of which in 1994, Indian equities became most expensively valued in history-a P/E of 30. At the same valuation, the Sensex would be 33,000 today.

 The wild success of Reliance Industries and other children of liberalisation such as Videocon and Gujarat Ambuja only served to burnish the sheen of equities.

All the institutional developments described above were matched by a progressively more and more favourable tax treatment which really boosted the attractiveness of equities. Till last year, short-term capital gains were taxed at 10% (increased to 15% now) and long-term returns were tax-free. This means that for the value-creating activity of, say, buying the shares of Reliance Industries for one day and selling it a few days later you would pay a tax of just 10%. More concessions poured that boosted equity returns. Interest from corporate fixed deposits is taxed but dividend income is not. To spread insurance, the government allowed investment in Unit-linked Insurance Plans to qualify for tax exemption when the bulk of ULIP money goes into equity markets in search of higher returns.
The revised tax code, if implemented, will mean a fundamental change in the way people will perceive equity capital from now. Short-term capital gains from equities and mutual funds would be fully taxed and long-term capital gains would be taxed too. ULIPs would no longer enjoy tax-free status.

How will these changes affect the key players in the stock markets? The businesses of life insurance companies have been badly hit. They have been thriving on ULIPs, aggressively sold as tax-savings products at different times during the year, most notably in March. Many of these are private insurance companies that seem to have turned the corner on the strength of their ULIP sales; they were getting ready to make public issues and get listed. Mutual funds are another set of players who would be hit by the revised DTC. They had problems of their own since last year when SEBI changed the rules of how funds can be sold. As a result mutual funds have been hit by continuous redemptions since August 2009. A possible tax hit for unit-holders under the revised DTC worsens their business model. The only redeeming feature, if any, is that pension funds are supposed to invest in index companies (50 for Nifty and 30 for Sensex) and that will ensure that the market indices stay up. But this also means that 99% of the companies will not receive investment from pension funds. Further, even if thousands of crores flow into pension funds, the asset management companies have bargained to manage the pension money at a negligible fee. It is not a business model worth talking about.

But faced with momentous change that rolls back 25 years of relentless progression towards making equities attractive, the stock market has held steady.

It even went up sharply today. There is surprising calm among companies with huge stakes in the stock market. Does this mean that the market does not believe that these changes will actually happen? Possibly. But if the government is indeed firm on implementing these changes, expect a major market correction. But that will be most visible but least impactful of the massive changes that will roil the capital market for years together.
 

User

COMMENTS

M.R.Borkar

6 years ago

Foundation para of the article is well researched n laid down. This type of changing long term plg of an individual or institution is not good for anyone. Then why restrict it to 30 only? Why not expand it to 60/90? E.G why one only from group in which Reliance is? Why not one (if increased to 60) or two(if increased to 90) more. Is the Govt trying to ward off the burden it has to shoulder by way of interest, etc due to PPF a/c holders or employees. This is why people -f.investors do not trust us. We go on changing rules, laws too often -but not orrecting where they shud be. If something suits or does not suits politicians or babus then only it is done or not done. Take the latest move of exempting gratuity upto 10laks. who is really benefitting from this? - Arthachakra

Roopsingh

6 years ago

The real agenda of FM and our greedy govt is visible clearly now-
they want to promote pension funds at any cost-so that govt has access to a huge huge treasury which will never vacate-that too without burden of paying interest to depositers-
but these guys are not burdened about its foolish implications-
like whole chunk of money will go to sensex and nifty stocks which will push these indices continuosly in one direction only-to the upwards-because there is no chance of redemption for investors before age of 58 yrs-
what about other stocks and other companies?they will never rise besides their innovation and profitability-is this not a example of gross injustice to these new ideas and innovations?
but no one is caring about all these matters-only one thing matters now
GRAB PEOPLE'S MONEY AT ALL COST

Making Yourself Heard – The Dos and Don’ts

On 15 May 2010, Moneylife Foundation held an interactive workshop on banking services.

The...

Premium Content
Monthly Digital Access

Subscribe

Already A Subscriber?
Login
Yearly Digital+Print Access

Subscribe

Moneylife Magazine Subscriber or MSSN member?
Login

Yearly Subscriber Login

Enter the mail id that you want to use & click on Go. We will send you a link to your email for verficiation
Mutual Funds: Mutual Confusion

Fund companies are struggling with a broken business model, regulatory confusion and declining...

Premium Content
Monthly Digital Access

Subscribe

Already A Subscriber?
Login
Yearly Digital+Print Access

Subscribe

Moneylife Magazine Subscriber or MSSN member?
Login

Yearly Subscriber Login

Enter the mail id that you want to use & click on Go. We will send you a link to your email for verficiation

We are listening!

Solve the equation and enter in the Captcha field.
  Loading...
Close

To continue


Please
Sign Up or Sign In
with

Email
Close

To continue


Please
Sign Up or Sign In
with

Email

BUY NOW

The Scam
24 Year Of The Scam: The Perennial Bestseller, reads like a Thriller!
Moneylife Magazine
Fiercely independent and pro-consumer information on personal finance
Stockletters in 3 Flavours
Outstanding research that beats mutual funds year after year
MAS: Complete Online Financial Advisory
(Includes Moneylife Magazine and Lion Stockletter)